PRESIDENT OBAMAíS recent trip to China reflects a symbiotic relationship at the heart of the global economy: China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector. Yet this arrangement may unravel in a dangerous way, and if it does, the most likely culprit will be Chinese economic overcapacity.
Several hundred million Chinese peasants have moved from the countryside to the cities over the last 30 years, in one of the largest, most rapid migrations in history.
To help make this work, the Chinese government has subsidized its exporters by pegging the renminbi at an unnaturally low rate to the dollar. This has supported relatively high-paying export jobs; additional subsidies have included direct credit allocation and preferential treatment for coastal enterprises.
These arenít the recommended policies you would find in a basic economics text, but itís hard to argue with success. Most important, it has given many more Chinese a stake in the future of their society.
Those same subsidies, however, have spurred excess capacity and created a dangerous political dynamic in which these investments have to be propped up at all cost.
China has been building factories and production capacity in virtually every sector of its economy, but itís not clear that the latest round of investments will be profitable anytime soon. Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. In Shanghai, the central business district appears to have high vacancy rates, yet building continues.
Chinese planners now talk of the need to restrict investment in sectors that are overflowing with unsold products. The global market is no longer strong, and domestic demand was never enough in the first place.
Regional officials have an incentive to prop up local enterprises and production statistics, even if that means supporting projects or accounting practices that are not sustainable. For an individual business, the standard way to get more capital resources is to put forward a plan for growth. Because few sectors are mature, and growth has been so widespread, everyone can promise to be profitable in the future.
Over all, there is a lack of transparency. Chinaís statistics on its gross domestic product are based more on recorded production activity than on what is actually sold. Chinese fiscal and credit policies are geared toward jobs and political stability, and thus the authorities shy away from revealing which projects are most troubled or should be canceled.
Put all of this together and there is a very real possibility of trouble.
China has had a 30-year run of stellar economic growth. But itís only human nature for such expansion to breed too much optimism, overextending an entire economy. Americans have found this out the hard way in their own financial crisis.
History has shown that no major economy has grown into maturity without bubbles, crises and possibly even civil strife or civil wars along the way. Is China exempt from this broader pattern?
The notions of excess capacity and malinvestment were common in business-cycle theory of the 19th and early 20th centuries, when growing Western economies had frequent crashes of this kind. Numerous writers, from the Rev. Thomas Malthus to the Austrian economist Friedrich A. von Hayek, warned about the overextension of unprofitable capital deployments and the pain from the inevitable crashes. These writers may well end up being a guide for understanding China today.
What will the consequences be for the United States if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments and recoup their losses. American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And even if the Chinese are selling more at lower prices, they may be taking in less money over all, so they may have less to lend to the United States government.
In any case, China may end up using more of its reserve funds to address domestic problems or placate domestic interest groups. The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.
Thatís not so much a prediction as a very possible contingency, and we should be prepared for it. For now, we should avoid two big mistakes. The first would be to assume that just because borrowing costs are now low, we can postpone fiscal responsibility and keep running up the tab ó with the aid of Chinese lending, of course. The history of financial crises shows that turning points can come swiftly and without much warning.
The second mistake would be to demand too many concessions from the Chinese. What we see in the numbers today are a growing China and a somewhat ailing America. Yet thereís a real chance that, soon enough, Chinese economic weakness will be a bigger problem than was Chinese economic strength.