Since I’ve been making a fool of myself with all these contrarian posts, I might as well get it all out of my system.  When Tyler Cowen asked me for my most absurd belief, one idea that I came up with was that India will have the world’s largest economy in the year 2109.

First let’s ask ourselves why most people would find this prediction a bit far-fetched.  Most of us have never even visited India, but we have seen media images that often show a very crowded and underdeveloped country.  It is very hard to imagine how India’s economy could ever surpass the US.  More astute observers might notice that India does have nearly 4 times the US population, and it is not that hard to imagine that their per capita GDP might eventually reach 30% of US levels. 

But the population advantage of India raises an even greater hurtle.  Right now China has a per capita GDP that is twice as high as India’s.  Even worse, China is growing more rapidly.  And China’s total population is larger than India’s.  So how could India possibly overtake China within the next 100 years?

Before delving into the numbers, I’d like to first try to dissuade you from thinking about this problem in terms of mental images.  To do so, I am going to first talk about two other countries; German and Greece.   Which of those two countries has the largest GDP?  Obviously Germany.  And why is Germany’s GDP much larger than Greece’s GDP?  Most of us have mental images of each country:

Germany:  A manufacturing powerhouse full of sleek Bauhaus-style factories churning out turbines and BMWs

Greece:  A beautiful sleepy backwater, full of fishing ports and mountain villages with donkeys walking down the street.

But it turns out that these images are very misleading–and in fact have little or no role in explaining the wide gap between Germany and Greece’s GDP.  The three institutions cited in Wikipedia’s PPP GDP tables all estimate Germany’s per capita GDP at about $35,500.  Unfortunately, the three sources differ on Greece, ranging from $29,000 to $32,000.  Let’s say it’s $30,500, which would make Germany about 15% richer. 

The means that the reason Germany’s GDP is roughly 10 times bigger than Greece’s is almost entirely due to it much bigger population (80 million vs. 10 million.)  If you had a country of 100 million at Greece’s level of development, then it’s GDP would be larger than that of Germany.  So among developed countries, variation in total GDP is almost entirely determined by variation in population.  So here is my argument in a nutshell:

1.  I believe that in 100 years the US, China, and India will all be developed countries.

1.  I believe that in 100 years China’s per capita income (PPP) will be at least 75% of US levels.

3.  I believe that in 100 years India’s per capita income (PPP) will be at least 60% of US levels.

4.  I believe that in 100 years both India and China will have populations at least twice as large as the US.

5.  I believe that in 100 years India’s populations will be at least 25% larger than China’s.

I’m going to skip over the US comparisons for the moment, as later I’ll argue that China will surpass the US very soon, indeed much sooner than most people realize.  So it’s between China and India.  To make the case for India I have to make two arguments; India’s population will be at least 25% larger than China’s, and its per capita income will be within 20% of China’s.  Let’s start with population:

The truth is that no one has any idea what each country’s population will be 100 years from today.  But nevertheless we do know more than you’d think.  I had trouble finding estimates, but I did notice that over the past decade India seems to have had about 30% more births than China.  India’s infant mortality rate is still higher than China’s, but rates everywhere have come down to the point where it no longer dramatically affects population growth rates.  So we can be pretty sure that 20 or 30 years from now India will have at least 25% more people of child-bearing age than China.  At that point it is anyone’s guess.  I am going to assume that from that point forward the two countries have the same birthrate.  In two ways this is a conservative assumption:

1.  India currently has a much higher birth rate

2.  The richer parts of China have some of the lowest birth rates on earth (Hong Kong and Shanghai, for instance.)

Cutting slightly the other way is that China’s birth rate has recently picked up a bit (from relaxation of the one-child policy) and India’s has dropped a bit.  

Demographers expect China’s population to peak at 1.5 billion (in a few decades), and then start falling.  I have no idea where it is expected to be in 100 years.  India’s population is almost certain to surpass China’s in about 20 years, and we really don’t know where its population will peak.  But again, I see no reason to believe Indian birth rates will fall below those of China (which as I said, are expected to become ultra-low as China gets richer.)  BTW, Hong Kong has perhaps the lowest birth rate on Earth, and they don’t have a one-child policy.

So I think the population part of my argument is very consistent with the best demographic estimates that we have, which admittedly aren’t very good.  What about the rest of my argument; that India will reach about 80% of China’s per capita GDP.  That looks more iffy, especially given the fact that it has fallen from a rough parity with China when Mao died in 1976, to just under 50% of China’s per capita income today.  How can they turn this around?

The answer is that they need to keep growing at 6-8% a year, and wait for China to ”hit the wall.”  Almost every fast-growing economy eventually hits a wall at roughly 80% of US per capita GDP, and then starts growing much more slowly.  The most famous example is of course Japan, which hit the wall in 1990.  But the same thing happened in Western Europe and elsewhere.  The only exceptions are tiny tax havens like Luxembourg, and oil-rich states like the UAE and Norway.  Once China hits that wall, it will no longer be having any population growth, and so its total GDP growth rate will slow to 1-2%, just like Japan.  That may happen sooner than people think.  I’m guessing that places like Korea and Taiwan are no more than 20 years away from that wall, and China is a 20 or 30 years behind those two tiger economies (it’s hard to tell because places like Zhejiang province are even closer to the tiger economies, and western provinces like Gansu are much further away.)

So in about 50 years China will be growing very slowly.  India will be the logical place for the lower wage manufacturing industries, and will be attracting a lot of foreign investment.  Because China will then be highly developed, the “rich world” that India can export to will be something like 3 billion people, not the 1 billion of today.  That is a big market.  With any sort of sensible economic reforms (admittedly a big if) India should be able to continue growing rapidly between 2059 and 2109.  They won’t catch up to China in per capita terms, but they will get close enough to have a larger total GDP.

I’m sure you all remember the 1500 meters part of the 1960 Olympics decathlon:

On Sept. 5, the first day of Olympic decathlon competition ended at 11 p.m. with Johnson leading Yang by 55 points though he had scored highest on only one of the five events. When Johnson hit the first hurdle badly in the next day’s first event, the 110-meter hurdles, he didn’t gain as many points as he had expected. But he made up for that with a personal best of 13 feet, 5½ inches in the pole vault.

… and so it came down to the 1,500 meters. Johnson’s strategy was to stay close, and he dogged Yang throughout. When Yang attempted desperately to pull away in the final lap, Johnson stuck close.

He finished only six yards and 1.2 seconds behind Yang, coming home in a personal best of 4:49.7. Johnson had the gold medal, setting a then-Olympic record of 8,392 points in the process. At the age of 25, Johnson had fulfilled his high school dream.

China’s like CK Yang, they’ll win the per capita race with India.  But India’s like Rafer Johnson, they will stick close enough to China that they’ll eventually have the world’s biggest GDP.

So the message is that one shouldn’t pay too much attention to stories in the media.  Don’t let images of Mother Theresa and Slumdog Millionaire cloud your judgment.  The Indian economy has a lot of growth ahead of it.

Part 2.  When will China surpass the US?

Next year?  Maybe.  In 15 years?  Maybe.  Actually there is no objective answer to the question.  As philosophers would say:  ”There is no fact of the matter.”  This is because there is no well-established agreement as to what we mean by GDP, especially PPP GDP.  In fact, there isn’t even any agreement as to what we mean by “China” and “the US.”  The US isn’t a big problem, as the only significant question is whether Puerto Rico should be included.  But what about Hong Kong, Macao and Taiwan?  Are they part of China?  You may be surprised to find out that both the Mainland Chinese and the Taiwanese constitutions agree that there is only one China, they just disagree as to who should rule over it.  Everyone agrees that Hong Kong and Macao are part of China de jure, but de facto they are separate.  So much so that Hong Kong has an entirely different currency and separate GDP accounts. 

Let’s assume that the region called “China” includes Hong Kong but not Taiwan (this will probably get me blocked in China, despite my cowardly use of the term “region.”)

The 2008 figures show that Hong Kong’s GDP is $215 billion, and $306 billion in PPP terms.  Mainland China has a GDP of $4.4 trillion, and $7.9 trillion in PPP terms.  The US has a GDP of $14.4 trillion (the same in PPP terms.)  Now let’s stop right there.  If you’ve ever been to Hong Kong and China you should immediately be suspicious of these numbers.  The Hong Kong PPP numbers look reasonable compared to the US (although if you put a high weight on real estate then they may be too high.)  But in these figures the PPP adjustment for mainland China is only slightly larger than Hong Kong.  This seems absolutely nuts to me. 

Hong Kong has a per capita income only slightly lower than the US, whereas mainland China is far below even Mexico.  I think China’s GDP figures, which assume its cost of living is 55% of US levels, is way too low.  Here are some examples.  My wife had tailoring done in Beijing, one of the most expensive cities in China.  The shirt was restyled for $1.20.  She told me it would have cost $20 in the US.  I had my shoes re-soled for about the same price.  I went to a very nice barbershop and had a much more elegant haircut than I get at Great Cuts, and I paid $2.25.  BTW, no tipping in China.  Across the street was a much more rundown hole-in-the-wall type barbershop.  The sign said 5 yuan (75 cents) for haircuts.  That place was much more typical of what haircuts would cost across the vast interior of China, indeed even that is an overestimate. 

Why am I boring you with all these stories?  Because the service sector in China is perhaps 10 times larger than the nominal figures would show.  Remember all those articles talking about how only 40% of the Chinese economy is consumption?  What would happen if you added up all the services produced in China in PPP terms (i.e. US prices).  The Chinese haircut industry alone might be larger than the economies of many small countries. 

A few years ago the World Bank re-did their PPP estimates for China, and dramatically shrank the size of the Chinese economy.  Instead of assuming the Chinese cost of living was a third US levels, the assumed it was half (and now with the yuan appreciation, 55%.)

In 2010 the US GDP will be about $14.5 trillion.  China’s nominal GDP will be about $5.2 trillion.  If the World Bank were still using the old 3-1 conversion for Chinese PPP, they would already be the world’s largest economy, even without $300 billion from HK.  Let’s assume the HK numbers are about right, is there a reasonable case to be made that Mainland China’s PPP economy will be $14.2 trillion in 2010?  Assuming $5.2 nominal GDP, that would require a 2.73 conversion factor, somewhere between the old and new estimates from the World Bank.

I don’t think there is an objective answer to the question of which ratio is “right.”  The World Bank was criticized for drawing their new estimates from richer coastal cities.  Places like Shanghai have a cost of living that is dramatically higher than the vast interior of the country, where most people live.  Before I had read about the World Bank estimates I had formed my own guesstimates of about 3 to 1 from casual empiricism.  I based that on conversion ratios ranging from 1 to 1 for products like Buicks (made in China and very popular there) to perhaps 3 to 1 for food, to perhaps 10 to 1 for labor-oriented services.  Because the basket of goods consumed in each country is so different there is no objective answer to the question of which country has the bigger GDP. 

I think the best way to approach this issue is to use Rorty’s maxim “truth is what your colleagues let you get away with.”  Truth is socially constructed.  So imagine a timeline with a bell-shaped distribution above it.  The distribution shows the point in time when each economist thinks China has surpassed the US.  At the left end in 2010 is me, a China booster who (shamelessly) wants to get credit for being first to notice that America’s more than 100 year reign as number one is over.  The mode occurs when the World Bank says that China has achieved what Italians call “Il Sorpasso.”  And at the far right of the distribution, well into the 22nd century is Lester Thurow.  The mode occurs around 2016.  Mark your calendars.

To conclude:

In one year either China or the US will be number one, India or Japan number three.

In 50 years China will be number one, and either India or the US will be 2nd.

In 100 years either China or India will be number one, and the US will be 3rd.

Does any of this matter?  No, but it is interesting to think about.

I want to talk a bit more about the Chinese “bubble city” of Ordos, but do so indirectly, by discussing how I interpret news stories.  (First read the previous post.)  Unlike many other people, I don’t like to interpret news as “narratives,” instead I like to think in terms of numbers, and highly abstract economic principles.  This often makes me a contrarian. 

There have been some recent studies suggesting that right now the world is less violent than it has ever been in all of history, and even pre-history.  I have no idea whether the studies are correct, but I find them very appealing, as they seem to so dramatically contradict the “impressions” we get from watching the evening news.  And yet they do fit in with economic theory.  You’d expect violence to gradually become a less appealing option for people as the world got richer and life expectancy increased.

The video about the empty Chinese city outside of Ordos presents some stunning pictures that trigger all sorts of stories, or narratives, in our minds.  But this “manipulation” just makes me all the more determined to dig deeper, to try to find alternative interpretations. 

Even someone ignorant of economics would form all sorts of instant impressions from the sight of an empty city built to hold 1 million residents:

1.  Folly; the absurdity of building a city without residents

2.  Hubris; the belief that the Chinese government could get people to live in the middle of nowhere

For those who have studied economics there are even more narratives:

3.  Bubbles; another real estate bubble in the desert, even worse than Phoenix and Las Vegas

4.  Communism; the inefficiency that results from central planning

5.  Misallocation; a neo-Austrian vision of business cycles

and many others.

Although I am no China expert I have visited China 6 times, and traveled to many different regions.  So I also thought of other issues when viewing the video: 

1.   The people who live in the wealthier parts of China’s east coast tend to look down of the interior of the country as being very poor and backward.

2.  Even 15 years ago most Chinese construction looked very ugly and slipshod.

3.  Many Chinese people don’t like peace and quiet, they like to live in bustling cities.  (Obviously a crude stereotype, so let’s just say compared to Americans.)

The first two points led me to be pretty impressed by what I saw.  When I first visited China’s interior in 1994, something like the new city of Ordos would have been inconceivable.  The local government would have lacked the money and expertise to pull it off.   Just the fact of its existence points to the fact that Inner Mongolia must have made enormous economic strides in the past 15 years.  Those houses may look repetitive and bland to Americans, like the endless suburbs of the Southwest, but they look pretty impressive to the average Chinese citizen.  The third point listed above, however, makes me view it as even more of a boondoggle than the average American might think.  Lots of Americans like to buy houses in quiet suburbs 30 km from the hustle and bustle of downtown NYC or Chicago.  That is much less true in China.  (Although just as in Europe, you are beginning to see wealthy people moving to suburbs.)

Beyond these impressions, I like to think in terms of hard theory and hard numbers.  Here are three questions:

1.  Was the investment as bad as it looks?

2.  If it was as bad as it looks, how typical is it of current trends in China?

3.  If it is typical, how serious of a macroeconomic problem is it?

1.  I think it probably was as bad as it looks, although the fact that most units have been snapped up by investors makes even that seemingly obvious point a bit uncertain.  One person who was interviewed said that the prices were too high; people couldn’t afford to live there.  OK, but if the speculators are losing money, won’t they eventually cut the prices to the point where people can live there?  And if there is a sort of Chinese cultural agoraphobia, is it possible that a tipping point might be reached, where there is enough liveliness to the place so that it then rapidly fills up?  This is probably wishful thinking on my part, but I don’t think we know enough to rule out the possibility.  After all there were also building sprees in the 1990s in places like Shanghai that were reported by the American press as being “bubbles,” but turned out to be the exact opposite.  (As the guy interviewed in the video notes, few people have lost money in Chinese real estate.)

2.  I am much more dubious of the second point, the argument that Ordos is representative of China.  I won’t rehash everything from the previous post, but my impression is that it is atypical.

3.  Even if it is typical, does it mean what we are led to believe it means?  It is hard to see those pictures without thinking about the recent sub-prime fiasco in the US.  But Chinese banks don’t make sub-prime loans, so it is not at all clear that loan defaults will rise to US levels.  I also don’t know the relative importance of the government and the private sector in Chinese housing.  But I do know that some of China’s wealthiest people have gotten rich through property, so I assume that the private sector plays a significant role (as does the government.)

So we need to think in terms of what is the “worst case?”  Suppose Ordos really is as bad as it looks, and suppose there are lots of other places around China with significant overbuilding of housing.  What does that mean?  Well assume the US were to have overbuilt its housing stock by 10% (in fact our bubble was nowhere near that large.)  If so, it would have taken us years to work off that excess.  But in China the demand for housing is skyrocketing, and that excess would be worked off very quickly (except perhaps in a few extreme cases like Ordos.)

But let’s also suppose I am too optimistic about Chinese housing demand, and suppose there turn out to be massive loan losses for Chinese banks.  What then?  Well China experienced exactly that problem in the 1990s, and there were many rather apocalyptic statements made about Chinese banks.  I seem to recall that in the early 2000s China’s government did some banking reforms about the time it joined the WTO, pumped in some additional capital, and listed the banks on the stock exchange.  I presume another bailout is coming at some point.  Am I suggesting this is a good thing?  Of course not. Rather I am suggesting that as Adam Smith once said:

There is a great deal of ruin in a nation.

By moving away from communism China unleashed enormous growth.  Even if the Chinese economy is like a 8 cylinder engine where a couple cylinders aren’t firing, it can still grow very fast until it reaches a far higher per capita GDP.  (It is still poorer than Mexico.)   And that’s even assuming no further reforms.  But I believe that further reforms are very likely.

So these are the sorts of questions I ask when I try to put a story like Ordos into perspective.  I get the same impression as anyone else does by watching that video.  And it is very likely that the impression one draws is at least partly correct.  But the implications one draws about the Chinese housing sector as a whole are much less likely to be correct.  And even if those implications are correct, the implications that the Chinese housing sector have for their banking system, and the broader economy, may be incorrect.

One commenter asked me whether I was misusing Say’s Law.  Of course Say’s Law doesn’t settle any argument, it doesn’t prove any point.  But thinking in terms of Say’s Law can help us clarify our views.  For instance, Say’s Law may be violated in a cyclical context if the economy overheats and output exceeds the natural rate.  This essentially means you produce too little of the leisure good, and too much of all other goods.  But is this China’s problem today?  Obviously not, tens of millions of jobs were lost in global meltdown.  So then the argument must be sectoral, you have too much of some goods and not enough of others.  And that obviously is a problem in China.  But if you look at the Shilling and Dow videos back to back, it is also obvious that Dow has a more sophisticated understanding of the current boom in China, which is directed much more toward the domestic economy than the export economy.  Rather, the misallocation of goods in China is pretty much what you’d expect from a half-communist country—too much spending on big showy projects, not enough consumer services.  But even if Chinese growth was more balanced, there would still be rapid growth in spending on big projects, just somewhat less rapid than what is actually occurring.  As Dow indicated, 10% RGDP growth will quickly cover up a lot of resource allocation mistakes.

Part 2.  Chimerica

I believe that the historian Niall Ferguson coined the term ‘Chimerica’ to denote the emerging global duopoly of the US and China.  Many news discussions focus in the pathologies of this relationship, sometimes describing it like a dysfunctional married couple that is unable to live without each other despite the fact that each country’s policies create problems for the other.  I think these narratives are all wrong.  I don’t see the US/Chinese economic relationship as being particularly dysfunctional, or even important.  So why do so many believe otherwise?

1.  One mistake is the psychological tendency to overemphasize the importance of the biggest object in any group.  Back in the 1980s we often read reports about how “Germany” (then a country of only 62 million) was the key to the EU economy.  But this was silly.  Germany probably had about 25% of the EU GDP, but France Britain and Italy each had nearly 20%.  So there was really nothing very special about Germany, it just gave economic reporters a “story” to tell so that they looked more sophisticated.  Readers want the picture simplified; they don’t want mind-numbing numbers about the percentage of EU GDP produced in Holland, Belgium, etc.  And the German “locomotive” was a nice metaphor.  To the extent there was any truth to the story, it should have focused on the capital goods sector, which is indeed more cyclical than other sectors, and is somewhat over-weighted in Germany.  But that’s another (and less interesting) “story.”

The US/China relationship seems the same.  Yes, we do lots of trade with China.  We buy from China stuff we used to buy from Korea, Taiwan, Mexico, etc.  Big deal.  (Indeed lots of our “Chinese” purchases are actually stuff made elsewhere in Asia, and simply assembled in China.)  We also still do lots of trade with Canada, Mexico, and many other countries.  Yes, China buys lots of Treasury bonds, but so do many other countries.  And why is it important that the Chinese buy lots of Treasury bonds?  The implication is that something bad would happen (for them, or us, or both) if they stopped buying lots of Treasury bonds.  But what is that bad thing that would happen?

1.  One possibility is that China keeps running big trade surpluses and uses the funds to buy other assets.  Perhaps they could buy various Japanese and European government bonds.  OK, then the price of Treasury bonds falls a bit and the price of alternative bonds rises a bit, and some bonds are swapped between investors.  Who cares?  It’s not like the prices would change all that much, after all, various government bonds are close substitutes.

2.  Another possibility is that China stops running a big trade surplus.  So now we need to think about whom would then buy these bonds (assuming other countries don’t pick up the slack.)  I suppose the fear is that the Treasury bond prices would have to fall, and interest rates would have to rise, until Americans could be induced to increase their savings enough to buy these bonds.  And (so the argument goes) the extra saving and higher interest rates would depress the economy.  But it isn’t clear whether this is supposed to be a cyclical or secular problem.  Here is where rigorous theoretical analysis is crucial.  What exactly is the problem we would allegedly face?  Does the increased saving put us into a recession?  Remember that we are assuming China and the US are moving closer to balanced trade.  So doesn’t the negative of more saving get offset by the positive of more net exports from the US?

A more sophisticated argument might use some sort of Keynesian model where the net effect is lower aggregate demand (or lower velocity.)  I’m not quite sure how higher interest rates on Treasury bonds would lower velocity, but let’s suppose there is some mechanism.  In that case all we have is a cyclical problem, not a secular problem.  And if the monetary policymakers are at all competent, we don’t even have a cyclical problem, as they could print enough money to prevent the higher interest rates from slowing AD. 

As we saw between mid-2006 and mid-2008, when resources were reallocated out of housing construction and into export industries, there isn’t much impact on the US unemployment rate when the tradable goods sector of the US expands.  Only when NGDP falls do we have a major cyclical problem.

To conclude, these Chimerica stories sound very appealing.  They appeal to the deep human instinct to arrange boring and abstract facts into appealing narratives.  But a closer look at the numbers involved and the relevant economic theory shows that these stories are completely vacuous, just a bunch of fairy tales about current account “day of reckonings” that never seem to arrive.

And the Chinese development stories are also appealing.  They appeal to our wanting to know “what’s really going on in China.”  There is no single narrative ”really going on in China.”  There are 1.3 billion narratives going on, that can only be understood through careful analysis of the relevant numbers, and the relevant abstract economic principles.

Soon I’ll explain why despite our negative impressions of India, formed through media stories, it will have the world’s biggest economy in 100 years.

This video shows a brand new city in China with no residents, and has attracted a lot of attention.

In this video Gary Shilling takes a pessimistic view of China’s future.

In this video Mark Dow is much more optimistic.

Is China producing too much of everything?  Say’s Law says that’s impossible.  Then how about too much housing?  Perhaps, but here are some relevant estimates (or I should say guesstimates, as I had trouble finding data):

1.  When I visited in 2006 the Chinese media indicated that the average urban apartment had increased from about 85 sq feet in 1980 to somewhere around 250 sq feet.  By now I imagine it is well over 300 sq feet.

2.  Much of the urban housing is very substandard, and should be torn down at some point.

3.  In a modern economy housing units are up closer to 1000 square feet.

4.  Somewhere around 60% of Chinese residents (750 million people) live in rural areas.

5.  In the next few decades China will become overwhelmingly urban and middle class.

6.  China’s population will grow by at least another 100 million.

Now let’s put these numbers together.  No matter how I look as this picture, I can’t help thinking that China is going to build a mind-boggling amount of housing over the next few decades.  It is hard for me to imagine that China has too much housing.  Rather, the problems are quality and aesthetics.  Sometimes the housing is being built in the wrong places.  But the overwhelming majority of new housing units are built in existing cities.  Cities that are extremely overcrowded by western standards, and also that are attracting millions, tens of millions, and eventually many hundreds of millions of new residents.  I think the shock video on the Inner Mongolian city tends to obscure that reality.

Gary Shilling suggested they are building massive capacity in steel and cement facilities in order to supply their export industries.  My hunch is that most of this steel and cement will be used for housing, roads, subways, high-speed rail, sewage treatment plants, airports, power plants, office buildings etc.  Not exports.  I think Mark Dow has it exactly right; China probably isn’t the disaster in waiting that many expect.

China is the perfect illustration of the glass half full/half empty metaphor.  The system is still half communist.  Without property rights the environmental situation is deplorable (as it was in the Soviet bloc countries.)  There are all sorts of ways that the little guy gets abused by the system.  Much of the new housing is poorly insulated, which further worsens the environment.  Provincial governments have an incentive to build excess capacity in some industries.  And I could go on and on. 

But don’t lose sight of Say’s Law.  Even with all the distortions in their economy, this rapid growth in investment will probably continue to drive fast GDP growth.  The distortions might mean that they need 12% measured GDP growth to get 9% growth in livings standards.  But whatever the numbers are, living standards are rising fast by almost any indicator.

Anyone who has an extremely optimistic or an extremely pessimistic view of China sees only a portion of what is happening there.  It is too complicated to be understood by simple statements like “they’re building too much capacity.”  China doesn’t really fit neatly into any models of communism or capitalism.  I have no idea what all these SOEs listed on the stock exchange are trying to maximize.  Every day they look less and less like the old Maoist-era SOEs, but they still don’t look anything like Western firms.  So what are they?  I doubt we have any good models.  Read people like Yasheng Huang and Michael Pettis, who know far more about the system than I do.

Even the Ordos video is more ambiguous than it might appear.   The video said most of the new Ordos apartments had been snapped up by speculators.  Who are they?  Why did they invest?  Is the price rising or falling?  These questions aren’t answered. 

The most famous housing speculators in China are the people from Wenzhou, a capitalist enclave on the coast of Zhejiang province.  Even the sophisticated residents of Shanghai and Beijing are somewhat in awe of their business acumen. Now I have no idea how many Ordos apartments have been purchased by Wenzhou people, but I do know that it is almost impossible for you and I, sitting here in a Western country, knowing next to nothing about China, to try to decide whether these Ordos investments are wise.

Please don’t accuse me of blindly applying the EMH to Chinese housing.  There may well be bubbles in certain markets.  In fact I think it is quite likely.  All I am saying is that we don’t have any reason to second-guess the current market price of housing in an obscure provincial city in China, merely on the basis of a 4 minute video.

PS.  I will go to Houston in a few days, then to San Antonio.  Any suggestions?  I hope to see a few museums in Houston, and perhaps a Bucks game in San Antonio.

Since October 2008 I have devoted much of my life to educating people about the need for further monetary stimulus.   Thus I was pleased to see that in the past few days both Krugman and Yglesias have addressed the issue, although in somewhat different ways. 

It shouldn’t be hard to convince liberals of the need for more monetary stimulus.  So why is monetary stimulus discussed so rarely?  I see the problem as more intellectual than ideological.  Although I am a right-winger, my proposals would actually help Democrats more than Republicans, particularly in the 2010 and 2012 elections.  But there is so much confusion about monetary policy that it is even hard for people to see policies that are in their own interest. 

Let’s start with the confusion over the merits of setting an “inflation target,” which is discussed in both the Krugman and Yglesias columns.  My concern is that people will misunderstand what is meant by this term, as we are used to thinking of inflation as a “bad thing.”  Thus is sounds like inflation is the price we must pay for creating jobs.  This ”trade-off” idea has some merit when the economy is faced with supply-shocks, but seriously distorts the real issues when the key problem is a demand shortfall.  Even worse, the press often treats fiscal policy asymmetrically, suggesting that whereas an expansionary Fed policy would be designed to boost inflation expectations, fiscal stimulus is aimed at boosting real growth.  But this creates a completely fictitious distinction; both policies have exactly the same objective; boosting aggregate demand.  Look at the simple AS/AD diagram:

Both fiscal and monetary stimulus have exactly the same objective, to shift AD to the right, which will increase both prices and output.  We would hope that more of the increase is output and less is prices, but that depends on the slope of the AS curve.  Unfortunately, the press often suggests that monetary stimulus is aimed at raising prices and fiscal stimulus raises output, which tends to make fiscal stimulus look better.

This problem becomes even worse when rates have fallen to zero.  Not one person in a hundred really understands how monetary policy works.  The average guy on the street can picture how lower interest rates could boost spending, but has no understanding of the long run relationship between M and NGDP, where interest rates play no role.  So to explain how monetary policy could work at the zero bound, we are forced to explain the mechanism using interest rates.  Higher inflation expectations result in a lower real interest rate, which boosts aggregate demand.  But that is equally true if the stimulus comes from the fiscal side.  Higher expected inflation will lower real interest rates (if nominal rates are stuck at zero.)

Nick Rowe recently pointed out that the focus on interest rates is really just a “social construction. ” (I wish I had thought of that term first.)  Here’s how I interpret Nick’s recent post.  Central banks traditionally set the monetary base at a level that is expected to hit their policy goals.  In my view the Fed has recently preferred about 5% NGDP growth, although they don’t state their goal in those terms.  The Fed also finds it convenient to set a target for the overnight bank rate (the fed funds rate) in the hope that the target will create the amount of money necessary to hit their NGDP growth goals.  When they need more money to hit their goals, they lower the fed funds target though open market purchases.  But the “actual policy” in “reality” isn’t the interest rate target; it is open market operations, which change the size of the monetary base.   

Normally the interest rate targets are just a convenient fiction.  Ordinary people like to visualize things in terms of interest rates, and indeed so do many central bankers.  Now suppose the fed funds target runs into a brick wall at zero percent.  You cannot lower nominal rates below the zero rate earned on cash.  Now it looks like the Fed has no more options.  Of course they can still do all the OMOs they wish, and can still keep expected NGDP growing at about 5%.  But the perception is that policy has failed, and that perception makes the Fed’s job much harder.  People will think the Fed has “run out of ammunition,” and that they won’t be able to counter the fall in AD.  Unless the Fed moves very aggressively to overcome those bearish expectations with an announcement of a very transparent and explicit policy, people will begin to fear deflation.  And here’s the problem; once the public starts to fear deflation it is much harder for the Fed to run its monetary policy via changes in the monetary base.  If deflation is expected then people and banks may hoard base money.  So increases in the base won’t send out the signal that money is being eased.  Hence you need something else.  And what you really need is an NGDP target. 

Unfortunately, economists are not used to thinking about NGDP.  Instead they tend to think about inflation and real output, which are the two components of NGDP, and also the two variables that are affected by increased in aggregate demand.  Why not have the Fed set an 6% real growth target?  Why do economists speak in terms of an inflation target?  It’s not because the Fed could not hit a 6% real growth target—I believe they could, for one year.  But real growth targets were discredited years ago, because in the long run they leave the price level completely unanchored.   So people talk in terms of inflation targets, not real growth targets.

With fiscal stimulus the language is completely different.  Unlike with the money supply, there is no thought of permanently raising the budget deficit.  The goal of fiscal stimulus is to merely pump up government spending for a year or two, in order to temporarily boost AD (and hopefully real output.)  The implicit hope is that once recovery is achieved then monetary policy will take over.  So the discussion of fiscal “multipliers” is often framed in terms of its effect on real output, not inflation.

Now take another look at the AS/AD diagram.  Both fiscal and monetary stimuli aim to boost AD.  In both cases it is assumed that prices and output will rise in the short run.  In both cases the assumption is that in a deep recession output will rise much more than prices, and in both cases the assumption is that at full employment prices will rise much more than output.  But because the language we use to describe these two types of stimuli are so different, fiscal stimulus “sounds” much more appealing.  It sounds like fiscal stimulus is directly aimed at jobs, and monetary stimulus is aimed at inflation, with a sort of vague hope that we might get some jobs as a side effect.

I have always believed that monetary stimulus is much more effective than fiscal stimulus in a deep recession.  That was certainly true for FDR—the dollar depreciation program had a much bigger impact than his fiscal stimulus.  We can argue all day about “jobs saved vs. jobs created,” but the fact remains that fiscal stimulus has failed to achieve its objective in the US.  The 10.2% unemployment rate is far too high, and President Obama would not be able to get another huge stimulus through Congress.  Monetary stimulus can provide virtually unlimited increases in AD, and (if done through inflation or NGDP targets) it can do so without raising the budget deficit.  It is our only realistic option for quickly and dramatically boosting AD.  Indeed with monetary stimulus the only real danger is going too far, and ending up with hyperinflation.  We are far from that point, however, for the foreseeable future the risk is too little spending, and too little inflation.

With nominal rates at zero, common sense suggests that monetary policy can’t do any more.  That’s why it is so important to see Krugman clearly stating that, at least in principle, monetary policy is still the number one option.  Liberals pundits should listen to Krugman’s economic analysis of monetary policy, and ignore his pessimistic political views on its feasibility.  The Fed is a political institution that responds to public pressure.  If the rest of Washington really understood the logic of Krugman’s views on inflation targeting, then the political pressure on the Fed would become almost unbearable.  But first they need to understand why monetary policy is so powerful, and that requires unlearning some social conventions about interest rates and inflation.

Last week I did a post that discussed a recent NYT article on the Dutch health care system.  The quotation I provided claimed that the Dutch health insurance industry is entirely private, with nothing like our Medicare, Medicaid, and VA plans.  I noted that conservatives would probably prefer this approach, even with universal health insurance coverage, to what we are likely to have 5 years from now.  Matt Yglesias commented on my post as follows:

The Obama plan is, in my view, sort of loosely modeled on the Swiss and Dutch systems. And it’s attracted no support whatsoever from conservative politicians. But the GOP leadership did release a health care plan, focused on deregulation of health insurance companies, that would do nothing to reduce the number of uninsured people. I think it’s perfectly fair to say that universal coverage is the issue separating the left and right. When I see conservative politicians getting behind some version of universal coverage—even something like Martin Feldstein’s plan to give everyone catastrophic coverage—then I’ll stop saying conservatives don’t care about helping the uninsured.

As far as I know Obama is not proposing that we abolish Medicare and Medicaid, so Yglesias ignored the observation that had motivated my post.  I’m not saying that his appraisal of right-wing politicians is necessarily wrong (he knows much more about politics than I do.)  But the clear implication of my post was that if you presented conservatives with a Dutch-style plan, i.e. universal coverage but no public health insurance at all, they might jump for it.  The fact that conservatives oppose a massive increase in the role of government on top of a system that is already 50% socialized, certainly doesn’t disprove my observation.

Some conservative/libertarian bloggers have touted the Singapore plan, which has universal coverage and government subsidies for the poor.  So at least among conservative intellectuals the problem doesn’t seem to be so much the universal nature of these plans, or even their subsidies, but rather the fact that proposals coming from the left in the US don’t seem to utilize market-oriented incentives to hold down costs.  Of course conservative politicians are a different story from conservative intellectuals.  Indeed politicians in both parties are so afraid of the powerful health care industry that any sort of sensible reforms are unlikely at this point.

Nick’s one of the most creative thinkers in the field of monetary economics.  This post is brilliant.  We need more people thinking outside the box, and less doing VAR studies.

In a post written on June 14th, I warned Krugman that it was foolish to play politics; he should just advocate the policy that is most effective:

As I read Krugman, his attitude seems to be something like the following (which is my interpretation, not his words):

“Ah, what a pity it is that these conservative central banks aren’t willing to commit to a modest amount of inflation.  That would be the easiest way to boost AD, and the least costly.  But as they aren’t willing to adopt effective policies, we can assume that monetary policy is ineffective.  Now let’s move right along and look at fiscal policy.”

At this point Krugman directs his moral outrage at the conservative knuckleheads in Congress who won’t accept anything bigger than a measly $800,000,000,000 stimulus package, which he thinks is woefully inadequate.

In my view Krugman is mixing science and advocacy in a very misleading and inappropriate way.  When he evaluates central banks, he seems to take a deterministic, scientific, and clinical attitude, as if studying a colony of ants.  (I assume that for entomologists there is no “should.” The only question is how ants behave.)  Central banks are assumed to be impervious to public pressure.  On the other hand his stance toward fiscal policy is much more normative.  Now he is an advocate, he’s part of the game, passionately calling for more stimulus.  But I don’t see how this makes any sense.  If we are going to take a deterministic view of things, it seems likely that Congress is also far too conservative to implement the sort of spending that Krugman advocates.  Indeed, hasn’t that already been shown?   Couldn’t one just as reasonably say: “Since Congress clearly won’t do what it takes, we must fall back on the Fed as our only hope for the sort of stimulus that the economy needs.”

I view my own role as that of an advocate; I am trying to change the consensus view of economists about the causes of this crisis, and the most effective solutions.  I want to describe the most effective solutions, not those I think are politically feasible.  We need to change the political climate, if that is the problem.  Indeed if policy is deterministic, then all hope is lost.  I hope that my ideas will eventually filter down to policymakers.

Krugman is 100 times more influential than I am.  With his NYT column, and his ideological allies in the White House, he is arguably the most influential economic pundit in the world.  And he is also known (for better or worse) for his moral outrage over perceived injustices.  In many cases I think he goes a bit over the top.  But here it is just the opposite.  I am outraged over Krugman’s lack of outrage over current monetary policy.

In this new post Krugman concedes that monetary policy is the best way of reducing the high unemployment rate, and fiscal policy is second best.  But he’s no longer working the fiscal policy route.  Instead, he is now advocating the third best option, wage subsidies and job sharing:   

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

So some readers have asked why I’m not making the same arguments for America now that I was making for Japan a decade ago. The answer is that I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.

OK, so what’s next? The second-best answer would be a really big fiscal expansion, sufficient to mostly close the output gap. The economic case for doing that is really clear. But Washington is caught up in deficit phobia, and there doesn’t seem to be any chance of getting a big enough push.

That’s why, at this point, I’m turning to what I understand perfectly well to be a third-best solution: subsidizing jobs and promoting work-sharing.

Call it constrained optimization, where the constraint comes from the power of bad ideas.

This is a foolish game to play.  There is zero chance Congress would spend enough money on these “third-best” options to make a dent in unemployment.  God only knows what his 4th best option is. 

Krugman should have been advocating monetary stimulus all along.  The real problem is that his allies in government; Obama, Pelosi, Reid, etc., don’t even know the first best option exists.  And how could they?  How often is monetary stimulus mentioned in columns written by liberal pundits?   If they realized that they were about to get decimated in the 2010 midterm elections because a few nutty right-wingers at the Fed think the economy needs less stimulus, not more, there would be outrage in Congress and the Administration.  They’d be marching down to the Fed (metaphorically of course, to avoid looking heavy-handed) and make it very clear that the Fed needs to produce robust growth in aggregate demand or else there will be big changes in the way the Fed is set up and regulated.  If they don’t seem “receptive,” then quietly tell the FOMC; “Think the Dodd bill is bad?  You can’t even imagine how much worse we can make it.”

Would this work?  Go read the history of 1937.  (Why does that year keep coming up, anyway?)  Google the phrase “a switch in time saved nine,” and you’ll see that unelected third branches of government have a lot less power than you might assume.

Here’s what I find so bizarre.  Almost the entire political establishment thinks we need much more AD.  Even Republicans that argue against the fiscal stimulus don’t say the problem is that it will boost AD; rather they make the opposite argument, they claim it will “fail” where failure is defined as a lack of AD, a continuation of the recession.  Meanwhile the people at the Fed are perfectly aware of Woodford’s argument that I discussed in a recent post.  They know that they could boost AD by setting a higher inflation target.  They simply don’t want to.  And yet almost the entire political establishment thinks Bernanke is doing all he can from the monetary end. 

How can we get the people in power to understand what is going on?  There is one person who understands what monetary policy can do, who understands Woodford’s views, who understands Svensson’s views, and who also has a news column read by every single influential person in government.  Do I even need to tell you who I am talking about?

HT:  rob and JimP

The Financial Times is a very respected newspaper, so I guess there must be some logic to this column.  But I confess I have no idea what this Belgian professor is talking about.  First prize to someone that can explain this to me.

The dilemma for the US authorities now pops up in the following way. The US monetary authorities pursue a policy aimed at keeping inflation low. It’s not an explicit inflation target as in the case of the UK or the eurozone, but it is certainly an implicit one. This implicit inflation target is close to two per cent which implies that when the Federal Reserve issues dollars it gives an implicit promise that these dollars will buy a basket of US goods and services which is approximately constant (ie declines by only two per cent per year). Given that the US economy grows on average at a rate of close to three per cent per year, this implies that the yearly increase in the supply of dollars should be close to five per cent (two per cent inflation plus three per cent economic growth).

This price stability commitment however conflicts with the international role of the dollar. The worldwide demand for dollars increases at yearly rates that by far exceed the five per cent money supply growth rate that will keep prices in the US approximately stable.

Thus the US monetary authorities have to choose between a policy that accommodates for the high demand for dollars in the world, but then the supply of dollars will increase much faster than the one that will keep approximate price stability in the US. Alternatively, the US sticks to the inflation target, but this requires limiting the supply of dollars to a much lower level, frustrating the high demand for dollars worldwide.

If foreign demand for dollars is rising faster than US demand, doesn’t that mean that the Fed can increase the world supply of dollars at faster that 5% rate and still hit its target.  So what is the “dilemma?”

Even worse, if the Fed didn’t respond by increasing the supply of dollars by more than 5% a year, I still don’t see a problem.  Foreigners would still be free to accumulate all the dollars they wished, it would just mean that the dollar would tend to appreciate in nominal terms (but not real terms) over time.  So what’s the dilemma?

HT:  Marcus

Here is a long passage from pp. 33-36 of a November 2009 paper by Woodford and Curdia, which describes a 2003 paper by Woodford and Eggertsson (you’ll need to open the PDF):

Eggertsson and Woodford show that it can be a serious mistake for a central bank to be expected to return immediately to the pursuit of its normal policy target as soon as the zero bound no longer prevents it from hitting that target. For example, Figure 11 (reproduced from their paper) compares the dynamic paths of the policy rate, the inflation rate, and aggregate output under two alternative monetary policies, in the case of a real disturbance
(here interpreted as an exogenous increase in the probability that loans are bad, requiring intermediaries to increase the credit spread by several percentage points) that begins in period zero and lasts for 15 quarters, before real fundamentals permanently return to their original (“normal”) state.

Note:  I wasn’t able to copy the figure 11.  It is on page 61, and is worth looking at.  The dotted line shows a deep and prolonged recession with a policy of inflation rate targeting.  The solid line shows the economy avoiding a recession (and avoiding deflation) with a policy of targeting the price level.  Note that they are proposing an elastic price target, so it is actually quite close to NGDP targeting.  Of course the other difference is that they do not contemplate targeting the forecast, which I think would make it even more likely that a recession could have been avoided.
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1. I thought the weak Chinese yuan was stealing business from American firms:

Here’s today’s report on the rising US stock market. 

NEW YORK (Reuters) – Blue chips rose for a sixth day, capping their longest winning streak since August on Wednesday, as an upbeat forecast from a top homebuilder and data from China pointed to a strengthening global economy.

BTW, the US stock rally started in March.  And the Chinese recovery?  It also began in March.
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You may recall that a week ago I made a sort of “Emperor has no clothes” accusation against the economics profession.  I claimed that economists are always talking about “easy money” and “tight money” without have any coherent definition, indeed not even knowing that they have no coherent definition.  In this post Bob Murphy challenges my dismissal of real interest rates as the proper indicator.  He makes some good arguments, which I will address as well as I can, but in the end I am still left with 4 reasons for dismissing the view that real interest rates provide a useful indicator of the stance of monetary policy.  Furthermore, I think that any one of these four arguments would be sufficient to prove my point:
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Update:  Here’s my EconTalk with Russ Roberts, where I describe my views on macro.

A few weeks back someone suggested that I describe how my views differ from the mainstream.  A few days ago I did a post describing what I thought was wrong with the standard models of monetary economics.  I ended up with a call for a new paradigm and left the impression that I’m about to provide it.  One commenter said my last paragraph was “remarkably ambitious,” which is a polite way I suggesting it’s crazy for a Bentley professor to be talking about new paradigms.  And he’s right.  So I’ll just list some of the areas where my views differ from others, provide lots of links, and then let others decide whether there is anything coherent in my approach.
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This is a follow up to my somewhat misunderstood previous post.  In the comment section Bill Woolsey made the following point:

Krugman is explicitly saying that real interest rates must be very negative to motivate an increase in real and nominal expenditure.

If the Fed promised 3% inflation, people would still not spend much, and any increase in the quantity of money (aimed at generating that inflation) would be hoarded.

The Fed’s promise of 3% inflation would have little effect, and inflation wouldn’t be 3%.

I agree with Bill that this is what Krugman has in mind.  It’s hard to be sure, but he has said that “high” inflation expectations were needed, and at the same time linked to Fed studies showing the Taylor Rule implied a negative 6% interest rate was needed for a robust recovery.  This of course implies that expected inflation needs to be at least 6%, as nominal rates on loans can’t be negative.  But Krugman also says the SRAS curve is fairly flat right now.  He frequently uses the Keynesian “slack” model of inflation, which suggests that when unemployment rates are very high a large increase in AD would initially lead to much higher output, with at best a small rise in inflation.  I have some problems with the slack model of inflation, but in this case I think Krugman’s about right.  If we had a 10% rise in AD or NGDP over the next 12 months, then we’d probably get around 7% or 8% RGDP growth, and around 2% or 3% inflation. 
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It’s always a good day when Paul Krugman throws a nice easy pitch over the fat part of the plate.  In this post commenting on Beckworth he combines all of the worst features of his blog, in one nice package with a bow on top.

Here’s my problem. Underlying the focus on nominal demand or GDP is some notion that there’s a quantity equation:

MV = PY

where M is the money supply, V the velocity of money, P the price level, Y real GDP. And of course this always holds true, by definition. But the temptation is to take it as a causal relationship — to say that real GDP fell because nominal GDP fell, and that this in turn was caused by either a fall in M or a fall in V; and furthermore that any such decline is a failure of monetary policy, because the central bank should have either prevented the fall in M or increased M enough to offset the fall in V.

The second sentence has to be one of the weirdest things I have ever read by a famous economist.  I have no idea the point he is trying to make.  It is essentially saying that underlying the statement that A*B is important is the implication that A*B = M*(A*B/M).  Okay  . . .
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Everywhere I look I see patterns.  Because of the off year elections I started thinking last night about the odds of Obama being re-elected.  I was familiar with the data showing that when presidents run for re-election, more often than not they succeed.  But then I started noticing another pattern; the more interesting correlation was between success in being re-elected and the number of years a given party has held the presidency. 

I have finally memorized all the Presidents since 1900, and noticed that only in 1980 was a party rejected after 4 years in the presidency (out of 11 chances.)  So I thought “wow, it looks like Obama’s got a 91% chance of being re-elected.” 
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I’ve been giving some thought to how my views of macro are different from those of other economists.  Until this crisis hit, I assumed that I was doing “normal economics,” to use Thomas Kuhn’s terminology.  NGDP targets are different from the Taylor Rule, but they aren’t all that different.  Even Ben Bernanke has talked about targeting the forecast.  You’ve seen me endlessly recite Mishkin’s 4 key concepts from his monetary textbook.  They are a virtual blueprint for my current critique of monetary policy.  So I’ve never thought of my views as being particularly heterodox. 

And yet . . . .  You could count on one hand the number of economists who think money was tight last fall.  And you could count on one hand the number of right-wing economists who think that the economy currently needs much more stimulus.  So although my views are not completely unique, there is apparently something rather unusual about my approach to macro.
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