Dean Baker | The China Syndrome: Bubble Trouble

The financial markets have been through some wild and crazy times over the last two weeks, although it appears that they have finally stabilized. The net effect of all the gyrations is that a serious bubble in China’s market seems to have been at least partially deflated. After hugely over-reacting to this correction, most other markets have largely recovered. Prices are down from recent peaks, but in nearly all cases well above year ago levels.

But the stock market is really a side-show; after all back in 1987 the US market fell by almost 25 percent for no obvious reason, with little noticeable effect on the US economy. The more serious question is what is happening with the underlying economy, and there are some real issues here.

China’s economy had become a major engine for world growth just as the US economy had been a major engine for world growth in the last decade. While predictions of an economic collapse in China will almost certainly prove wrong (many China experts have a long history of such predictions), it does seem likely that its growth going forward will be considerably slower than it has been in the past.

This will be bad news for exporters of oil and other commodities, the price of which were being sustained by the rapid growth in China. But a slowdown in China will also be bad news for the United States and other rich countries who were expecting that continued strong growth in China would boost their net exports, thereby lifting their weak growth rates.

Over the longer term it is reasonable to expect that China will continue to move from large trade surpluses to trade deficits or at least near balanced trade, the movement will likely be in the other direction in the immediate future. This means that trade with China will be a factor slowing growth in Japan, Europe and the United States for the immediate future.

While we can be unhappy with China for slowing our growth, the important point to remember is that we do still possess the keys for more rapid growth. After all, the problem is simply a lack of demand in the US and world economy. We can create more demand by having the government spend money or give out tax cuts. Larger deficits will boost the economy.

If the private sector isn’t prepared to spend, the government can increase demand by repairing and improving the infrastructure, increased funding for health care, child care and education, or subsidizing wind, solar and other forms of clean energy. With interest rates at extraordinarily low levels and no signs of inflation anywhere in sight, there is no economic barrier to spending in these and other areas. Such spending would both help to make up the demand gap resulting from our trade deficit, thereby creating jobs, and also increase our economy’s longer term potential and the country’s well-being.

The only obstacle to such spending is political. This spending would mean larger budget deficits and our politicians are scared of talking about budget deficits.

The current economic situation is more than a bit absurd. Essentially, we have a worldwide shortfall in demand. Countries that have their own currencies, like the United States, United Kingdom and Canada could deal with their own shortfalls simply by running larger budget deficits. But for political reasons these countries don’t want to run large budget deficits. Instead they are praying that their trading partners will increase their budget deficits, which will increase net exports and lead to more economic growth.

If the path to increase growth and employment remains blocked for political reasons, we should always remember that we can look to increase employment by going the opposite direction of decreasing supply. This can begin with work sharing, the policy of encouraging companies to reduce work hours rather than lay off workers. This was the key to Germany’s low unemployment rate even at the worst points in the recession.

And, we can look to measures such as mandated paid sick days, parental leave and vacation, which have the effect of reducing the average number of hours worked in a year. These are all policies that can be implemented without running large budget deficits. Furthermore, since the reduced labor supply is likely to tighten up the labor market, it could lead to stronger wage growth. And, these measures will provide for a better balance between work-life and family life.

The best part is that these policies may be more politically feasible than other approaches. In addition to national governments, state and even local governments can put in place policies that shorten the average work year. Many states and cities across the United States have already implemented regulations in these areas.

If we had a saner conversation on economic policy in this country, we would be talking about stimulus to boost the economy and create jobs. But if we can’t go this route due to irrational fears, we should look to getting to full employment by reducing labor supply. It cannot be acceptable to do nothing when so many people need jobs and can’t find them.