Institutional inertia

A constant problem of economics as a policy tool is that it tends to be backward looking and reactive. Data, even if correct, tend to be yesterday’s news. Thus policies are made to treat conditions which may have already passed – and certainly will have done by the time the medicine starts to take effect.

The problem is made much worse by government. Layers of hierarchy make rapid implementation of policy changes very difficult, while politicians who are accountable to the public (even if only remotely) find it easier to make decisions based on established facts rather than predictions about the future.

Stock, commodity and currency markets do not help either, their predictive powers frequently undermined by violent mood swings.

A perfect storm

There has seldom been a stronger reversal than that seen by some markets over the past year. Never before has there been such a coordinated, globalized one. Nor has the world ever witnessed such a dramatic turnaround in the monetary policies of the major countries, including China.

The European Central Bank and the Chinese government spent much of 2008 in tightening mode, repeatedly edging up interest rates. In Europe, this was a natural response to the bull market in commodities. China, meanwhile, wanted to choke off what it saw as bubbles in several sectors, especially real estate. In hindsight, the excesses had already happened and prices were about to collapse under their own weight – irrespective of the monetary squeeze and the global credit crisis.

So the problem for governments became how to react to a sudden change in the facts. Would the price collapse lead naturally to slow growth and eventual recovery in a normal business cycle? Or was this an altogether different phenomenon because it was both global and characterized by a seizing up of the financial mechanisms that oiled trade and investment?

Beijing – which can rely on a large command economy reinforced by its political structure – was among the first to initiate a large-scale response. In November 2008, it unveiled a huge package of stimulus spending intended to deliver economic growth of 8% and in the process help the world have a much softer landing.

However, China too faces obstacles to quick change. First, it became clear early on that the November package had been hastily assembled and was announced for political reasons as much as for economic ones. Much of it was simply a re-packaging of existing projects. By the time the National People’s Congress met three months later, the leadership, though still committed to its 8% target, expressed concern at the extent of the economic crisis.

Yet policy remained essentially very conservative. The target budget deficit of 3% of GDP is higher than in recent years but still quite modest given the scale of the downturn in the once-leading export sector, and weaker local consumer demand caused by a mix of employment concerns, falling asset prices and modest household income growth.

Apart from its limited size, the stimulus is heavily focused on infrastructure and housing. This will help industries like steel and cement, but it does little for employment compared to spurring consumer demand in a way that boosts service providers and light industry. More government money and bolder methods are needed to spur household incomes. In particular, structural changes are required to focus on the income growth potential of the lower 70% of domestic households.

Inflexible mandarins

But huge deviations from norms don’t sit well with economists accustomed to trends, or politicians loath to admit that rosy forecasts are wrong or earlier initiatives have failed. And a conservative bureaucracy needs convincing that, given the circumstances, a much bigger deficit is not fiscally irresponsible.

All three – economists, bureaucrats and political leaders – must recognize that the aim of economic growth is to increase consumption. Investment is a means to an end, not an end in itself. China’s investment to GDP ratio of over 40% is a case in point: It has resulted in low returns on capital and excessive reliance on foreign demand to keep factories busy.

While the US has consumed far too much for its own good, China consumes far too little. Whatever happens to the global economy, that must change.