Why China Stimulus is necessary

The truth is the world is entering a recession, possibly the worst since the second world war. The open world economy forces every player to act at home and abroad.

In the short term, there is no alternative to another massive fiscal boost, strongly supported by aggressive monetary policy. Forecasters have been downgrading their views of 2009, for both the US and the rest of the world, at an extremely rapid rate (see chart). Last week the IMF reduced forecasts for world economic growth in 2009 from the 1.9 per cent forecast as recently as October to a mere 1.1 per cent. The advanced economies are now forecast to shrink by 0.3 per cent.
Let’s start from U.S. A bigger US fiscal deficit would offset the rise in the desired financial surplus – the excess of income over spending – in the private sector at a time of recession. In the early 1980s, the private sector surplus reached 6 per cent of gross domestic product (see chart). But the US would also probably run a current account deficit of 4 per cent of GDP at high levels of employment. Since the private, foreign and government balances must sum to zero, the fiscal deficit may need to be as huge as 10 per cent of GDP.

Such vast fiscal deficits are only a temporary solution. So how might they end? In the US and other countries with highly indebted private sectors, such as the UK, a return to large private sector financial deficits would be highly undesirable, even if achievable. A vastly better outcome would be bigger savings and a reduction in current account deficits. Thus, the expansion in net exports that has recently been so vital for US growth must continue (see chart).

If the US external correction is to be consistent with global growth, demand must expand vigorously elsewhere, particularly in chronic surplus countries. The new administration should lead the world towards an understanding of a point that concerned John Maynard Keynes: it is hard to accommodate countries with massive and persistent current account surpluses. If that’s the truth, the counterpart will remain in deficits, and if prolonged, almost always lead to financial crises. The way out is for most surplus countries to spend more at home. So the expansion program announced by the Chinese government early this week is a must now, maybe just a beginning.