After the pandemic, China's economy remains steady, but the challenges are unprecedented. After the epidemic, one of the basic lessons of economic policy practice in various countries is that the debate on deflation is actually a debate on macroeconomic policy choices
Text | Jiang Bo
Edit | Wang Yanchun
In the decade leading up to the pandemic, the most frequently asked question in the economics profession was where inflation went. With zero interest rates and quantitative easing in the United States, a prolonged period of negative interest rates in Europe, and Japan as the creator of these unconventional monetary policies, inflation has never been able to meet the central bank's 2% target.
The latest CPI (Consumer Price Index) and PPI (Producer Price Index) data released by China's National Bureau of Statistics are both negative, and there is a lot of discussion about deflation in the market.
The Deflationary Debate: Lessons from the Post-Pandemic Debate
Understanding deflation, after the epidemic, foreign policy practices provide rich enlightenment. The chart below shows the inflation rate in the United States. It can be seen that starting from the proposal of the "American Rescue Act", the price index has risen rapidly, and the CPI once exceeded double digits. Massive fiscal stimulus and ultra-loose monetary policy have pushed aggregate demand higher, while supply chain constraints brought on by the pandemic have exacerbated inflationary pressures. The decade-long debate on "where inflation goes" was then closed.
Looking back at the current round of inflation in the United States, the biggest takeaway is that instead of asking "where did inflation go under the loose monetary policy", it is better to ask why the government did not implement more aggressive fiscal stimulus to end deflation in one fell swoop. In other words, deflation is an equilibrium product of government policy choices. From the basic logic of economics, deflation does not need and should not be feared, because the government has more than enough policy tools to push up prices. With a low interest rate environment, the government is borrowing to finance it, and higher government spending is bound to help bring prices back to normal levels. Therefore, the current debate on deflation is more about the debate of macroeconomic policy choices. Whether to implement a more active fiscal policy and an accommodative monetary environment has become the most important question to be answered.
Fiscal Accommodity: Lessons from the 1998 Asian Financial Crisis
At present, there are two basic ideas for fiscal policy choices: First, exchange time for space, and maintain a stable tone of fiscal policy and moderate expansion; second, implement a more active fiscal policy to push up aggregate demand and reverse the downward trend of prices. Analyzing this kind of policy, the government's policy response to deflation after the Asian financial crisis in 1998 may provide some useful references.
After the Asian financial crisis in 1998, under the impact of the slowdown in external demand, the Chinese government, as a responsible major country, made the decision to maintain the renminbi from depreciating, which played a huge role in stabilizing the Asian financial market, but in the short term, it is bound to increase the downside risk and deflationary pressure of the economy. In response to the shock of falling aggregate demand, the Chinese government has decisively implemented a massive fiscal stimulus package. Through the issuance of special treasury bonds to support infrastructure construction, the economy maintained a relatively rapid development, and the economic growth rate was still as high as 7.8 percent in 1998.
Analyzing and comparing the internal and external environment faced by China after the 1998 Asian financial crisis and the epidemic can provide useful reference for policy choices. In terms of the internal macro environment, the government debt problem in 1998 was similar to that of the present. From the perspective of the commercial banking system, in 1998, the big four banks were technically bankrupt. An in-depth study of the reasons for the high NPL rate and technical bankruptcy of the four major banks is undoubtedly the local government debt and the non-performing loans of state-owned enterprises. At present, the non-performing ratio of the commercial banking system is relatively low, and the non-performing ratio of the four major banks remains at about 1.3% as a whole. But the problem of local government debt is two sides of the same coin. The credit liabilities of local governments and state-owned enterprises are assets of commercial banks. Therefore, if the central government allows local governments to default, the non-performing ratio of commercial banks is bound to rise. In other words, in 1998, the debt problem broke out on the bank side, while the current debt problem is left with the local government.
If 1998 and the present face similar debt problems, then what are the advantages and disadvantages of the macro environment in 1998 and the current situation? First, the overall economic environment is significantly better than it was in 1998. In 2022, China's economy will have a nominal GDP (gross domestic product) of more than 120 trillion yuan, making it the second largest economy in the world, with a per capita GDP of more than $12,000 and foreign exchange reserves of more than $3.1 trillion, which are 15 times, 13.4 times and 21 times that of 1998, respectively. At such a large economy, the central government's debt-to-GDP ratio is about 21 percent, up sharply from 8 percent in 1998, but still significantly lower than the 125 percent in the United States. Secondly, the current international environment and external demands are similar to those of 1998. At present, the U.S. export tariffs on China have not been lifted, and the U.S.-led decoupling and technological blockade have increased China's external dangers. At the time of the 1998 Asian financial crisis, China had not yet joined the WTO, and its economic openness was even more backward than it is now.
Comparing the advantages and disadvantages of the current situation with that of the 1998 Asian financial crisis, it can be concluded that China's fiscal policy space is still quite large, and the introduction of a larger fiscal stimulus plan at the right time can reverse the current dilemma of insufficient aggregate demand in one fell swoop.
The possible cost of "exchanging time for space".
The "time for space" policy option is to expect the economy to repair itself, thereby reducing the possible costs of an active fiscal policy. The "time for space" option seems sound, but the fundamental structural problems of China's economy are likely to be more serious.
Population ageing is likely to accelerate the decline in China's economic growth rate under the "time for space" policy option. In addition to the traditional troika of economic growth, the recently deceased Nobel laureate Sono also offered a supply-side approach. The basic gist of the Sono model is that the economic growth rate consists of the population growth rate, the capital growth rate, and the total factor growth rate. Using the Sono model as a benchmark, a decline in the working-age population will inevitably lead to a decline in population growth over the next five to 10 years. As the rate of urbanization draws to a close, the rate of capital growth slows, and the growth rate of total factor growth (TR) is undoubtedly the one that can drive China to maintain a higher potential growth rate. However, promoting the rapid growth of total factor growth often requires deeper structural reforms, which are difficult to accomplish in the short term. Therefore, the decline in the working-age population brought about by the aging population and the slowdown in the growth rate of capital expenditure due to the urbanization rate will inevitably lead to a decline in the economic growth rate.
This concern is reinforced by a number of micro-studies based on the labor market, which found that if a person exits the labor market due to unemployment, then the five-year income will fall by 15% compared to the one who did not, and if the marginal productivity is measured in terms of one's wages, that is, the marginal productivity decline due to unemployment may further slow down total factor productivity and thus further prolong the period of low economic growth. Furthermore, in the context of slowing economic growth, young people's incomes will rise uncertainly, and fertility rates will inevitably be affected, exacerbating the structural problems of population aging.
Structurally active fiscal policy
If we implement a proactive fiscal policy, how to be proactive is a major topic that needs to be studied comprehensively. In terms of direction, there are basically two options: the first is to continue the "four trillion" stimulus plan in 2008 and continue to target infrastructure construction to promote a positive cycle of infrastructure, real estate, and local finance, and the second is to implement structurally active fiscal policies for the household sector and key areas.
The author believes that the first way of thinking has been detached from the basic facts of the current new stage of China's economy. In 1998, China's active fiscal policy focused on infrastructure construction, when China's urbanization rate was only 33%, and a large number of working-age people stayed in rural areas. At present, China's urbanization rate has exceeded 65%, and although there are still differences with the West, it is undeniable that the space for investment in traditional urban infrastructure has been greatly reduced. A recent study on China's infrastructure returns (Alder, Song, and Zhu) found that up to 34% of China's roads were uncongested and 28% were slightly congested, compared to England, where almost all roads were congested. The study shows that China's infrastructure utilization rate is low, which is also a reflection of the low rate of return on infrastructure. With such a low rate of return on infrastructure, continuing large-scale infrastructure construction and real estate investment is undoubtedly a thirst quenching.
It would be preferable to focus on structured and active fiscal policies in the household sector and key areas. The first is to focus on the household sector. After the pandemic, the balance sheet of the household sector has generally been impacted, mainly in the flow effect of declining incomes and the wealth effect of falling real estate prices. Improving the balance sheet of the household sector is primarily about improving the income flows of the household sector. If direct monetary incentives are difficult to achieve, larger tax and fee cuts could also lead to higher household incomes. The second is financial support for key areas such as digitalization, electrification, and intelligence in government, military, and enterprises. The government can increase infrastructure investment and consumption subsidy support in these key areas.
In the first year after the pandemic, China's economy remained robust, but the challenges were unprecedented. After the epidemic, one of the basic lessons of economic policy practice in various countries is that the debate on deflation is actually a debate on macroeconomic policy choices. By comparing the economic policy choices in 1998, the current policy space for China's economy is huge, and the introduction of a larger-scale structural proactive fiscal policy can effectively stimulate aggregate demand and create more space for alleviating structural contradictions.
(The author is an Assistant Professor at the International Business School of Xi'an Jiaotong-Liverpool University)