What Is The Right Level Of Consumption And Investment? Globally, consumption represents a fairly stable 65 percent of GDP. Over the past decade this average has encompassed a group of high-consuming countries, such as the United States and peripheral Europe, whose average consumption exceeded 70 percent of GDP, as well as a group of low-consuming countries, mainly in Asia, whose average consumption, excluding China, ranged from 50 percent to 58 percent of GDP. This distribution of over- and under-consumption should change in the next few years. It is unlikely that the high-consuming countries will be able to maintain their excess levels of consumption for the rest of this decade, and indeed their consumption rates have already come down substantially, with more probably to come. Peripheral Europe is in crisis, and the United States is taking steps to raise its savings rate so as to reduce its current account deficit. Japan, although already a relatively low-consuming country, is also likely to try to increase its savings rate so that its massive debt can be funded by patient domestic savers, rather than by impatient foreigners. This means that the rest of the low-consuming countries are also unlikely to be able to keep their consumption levels as low as they have in the past. A world with low-consuming countries requires high-consuming countries in order to balance. If global consumption drops in the high consuming countries, with no corresponding rise in the low-consuming countries, it is unlikely that investment will rise quickly enough to replace it (why invest if no one is going to buy the output?), and so the global economy must respond with enough of a contraction in GDP to maintain consumption at roughly 65 percent. The great consumption and savings imbalances of the past that led to the current crisis, in other words, have to adjust. This means that if there are no longer large economies consuming 70 percent of more of their national income, the world is unlikely to be able easily to accommodate large economies consuming just 50–58 percent of their national incomes. Let us assume, nonetheless, that the world can accommodate a minimal amount of Chinese rebalancing. Within a decade Chinese household consumption, according to this assumption, will rise to no more than 50 percent of GDP, as difficult as it will be for the world to accept such low consumption from its second-largest economy. This will mean that China still produces far more than it absorbs – especially if investment growth were to come down sharply, and it would mean that the rest of the world would be forced to absorb excess Chinese production without resorting to trade intervention. For the sake of completion let us make a second assumption that, because the world is unable to accommodate such a low consumption level for the world’s second largest economy, global pressure forces an even more dramatic change in Chinese household consumption so that it rises to 55 percent of GDP, instead of 50 percent as in our first assumption, in ten years. Both of these assumptions can be modeled in a way that combines consumption and GDP growth to arrive at the desired outcomes, and I will ignore the possibility that if the world forces China to raise its consumption rate to 55 percent in ten years, this will probably happen through negative growth and trade disputes, thus making all my numbers overly optimistic. So much for our assumptions about the consumption rate – the second set of assumptions involves investment. Currently China has the highest investment share of GDP in the world, with investment comprising 46 percent of GDP or more, depending on how it is calculated. A 2012 IMF paper that I have cited in earlier issues of this newsletter shows investment as high as 49 percent of GDP, and it calculates excess investment, i.e. the spread between actual investment levels and the level predicted by an historical model, which began growing around the year 2000, as being 5-10 percentage points. What is the appropriate level for a country like China? A number of studies have examined other high-investment developing countries during their growth miracle stages, and for most of these countries investment peaked out briefly at 35-40 percent of GDP (in Malaysia, Thailand and Singapore investment did at one point exceed 40 percent, but in each case only for a very brief period). In emerging markets investment is typically around 30 percent of GDP. How should China compare to these countries? Some analysts argue that China, a very poor country, suffers from a capital stock that is too low, and so the optimal investment level should be much higher. This reasoning, I hope I was able to show in my June blog entry, is based on a fallacy. The optimal amount of investment for any country depends not on how far it is from the capital frontier but rather on its level of social capital, and this implies that very poor countries should optimally have lower levels of capital stock per capita than richer countries. China’s capital stock per capita, for example, is higher than that of Mexico, and much higher than that of Russia and Brazil, three other large developing countries that are substantially richer than China and whose workers are more productive. When analysts say that China’s capital stock is relatively low, they are completely befuddled. It is low compared to the richest and most productive countries in the world, as it should be, but it is high compared to other developing countries, and even compared to developing countries with much higher levels of productivity Because investment shares in other developing countries peaked out at 35-40 percent, some analysts argue that this is the appropriate level of investment for China. There are of course a number of problems with this argument but two stand out especially. First, the countries for which investment peaked out at 35-40 percent of GDP nearly all had subsequent periods of very difficult adjustment, with burgeoning growth in debt and either sharp economic contraction or many years of very slow growth, during which periods the investment share of GDP dropped substantially. It is not at all clear, in other words, that for these countries 35-40 percent was the optimal investment share of GDP. This was probably already too much investment because in many if not most cases it was subsequently followed by many years of low or even negative growth, probably as the economy was forced to grind its way through the debt associated with the excess investment. The optimal level, in other words, was probably much closer to 30 percent. ]Second, even if 35-40 percent was somehow the optimal level for China all along, investment in China has substantially exceeded this level for many years, so it seems obvious that an appropriate adjustment should mean not that investment drops from 46 percent of GDP to 35-40 percent, but rather that is drops to something well below 35 percent for many years before returning to the “optimal” level. This, I think, is just common sense. Making the implicit explicit So I assume that investment must drop as a share of GDP. One way or another, either because Beijing forces changes in the growth model, or because Beijing does nothing and allows debt to build to the point where debt capacity constraints are breached, after which investment collapses automatically and the investment share of GDP will drop substantially. How long will it take? I am going to assume Beijing has ten years to bring investment levels down to the new “optimal” level just to make my calculations easier, but as in the case of taking ten years for consumption to adjust, I think this is an heroic and frankly implausible assumption. Debt levels are simply too high in China for it to continue this level of investment growth for so many more years. To repeat the exercise, then, let me make two separate assumptions – that investment will drop to 40 percent of GDP in ten years and that investment will drop to 35 percent of GDP in ten years. In either case I will assume that investment is currently 46 percent of GDP, although it is probably closer to 49 percent. It turns out that it is fairly simple arithmetic to work out the implications of each of these assumptions relative to GDP growth. Rather than start with growth assumptions in consumption and investment and use these to determine what the corresponding GDP growth rate is likely to be, I thought it would be more useful if I reverse the process and simply assume a bunch of GDP growth rates ranging from -2 percent to +10 percent. These are the different average GDP growth rates possible under different scenarios for the next ten years. We will assume two sets of adjustments for investment and consumption. The “easier” adjustment scenarios have household consumption growing from 35 percent of GDP to 50 percent of GDP, while investment declines from 46 percent of GDP to 40 percent of GDP. The “tougher” adjustment scenarios have household consumption growing from 35 percent of GDP to 55 percent of GDP, while investment declines from 46 percent of GDP to 35 percent of GDP. The table below lists the consumption and investment growth rates needed for rebalancing to take place at each of the highlighted GDP growth rates. To read the table, let us start by assuming, as an example, that we believe the average GDP growth rate over the ten-year period will be 6 percent. For China to do a minimal amount of rebalancing that gets consumption to 50 percent of GDP and investment to 40 percent of GDP, we can quickly figure out what the corresponding growth rates of consumption and investment must be. Consumption must grow by 9.9 percent a year and investment must grow by 4.5 percent a year to get us there. Notice the reason why I do it this way rather than the “normal” way most other economists would. Instead of estimating what I expect the growth rates in consumption and investment will be, and then calculating the implicit GDP growth rate from those numbers, I start with an assumed GDP growth rate and then calculate what the implicit growth rates in consumption and investment must be in order for rebalancing to take place. I am not making predictions, in other words. I am simply working out logically what any GDP growth rate must imply in terms of consumption and investment growth rates in order for China to rebalance. This allows me to make statements like this: If you think that China’s GDP will grow by 7 percent a year over the next decade, and if you expect a minimal amount of rebalancing, then you are implicitly predicting that consumption will grow by 10-11 percent a year for ten years and that investment will grow by 4-5.5 percent. If you believe these two implicit predictions are plausible, then your 7 percent prediction is also plausible.
Posted on: Sun, 08 Sep 2013 12:23:36 +0000
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