The financial crash and macro-economic policy – why the US and Europe have budget crises and China does not

The financial crash and macro-economic policy – why the US and Europe have budget crises and China does not

By John Ross

The events precipitating the renewed financial crash were the combination of debt crises and confirmation of slow US economic growth. Regarding the former countries were either trying to cut deficits (the US, Greece, Italy, the UK) or feared they will have to bail out those running unsustainable ones (Germany, France). But these large deficits were not accompanied by strong economic growth – although it can be cogently argued that they were necessary to stave off sharp economic downturn.1

Japan is currently preoccupied with overcoming the consequences of the tsunami and earthquake, but it also will soon have to face the reality that, due to decades of budget deficits, it has the largest government debt as a percentage of GDP of any country – twice that of the US.

In contrast China in 2008 launched the world’s largest state stimulus package to counter the international financial crisis. But it is not running any substantial budget deficit – this year it will only be around two per cent of GDP. But China has enjoyed rapid economic growth.

It has been claimed that China is applying ‘Keynesianism’, but if budget deficits were the key issue defining such policies then China is clearly not pursuing ‘Keynesianism’ at all.

Actually, the core of Keynes’ analysis did not lie in advocating budget deficits, and in some ways China has a policy which more corresponds to his views than that pursued in the US and Europe. This is is briefly outlined below. But before dealing with this it is illuminating to contrast the nature of the economic policies pursued by the US and Europe in the last three years on the one hand, and by China on the other, and to analyse why the latter was able to launch such a large stimulus package without a significant budget deficit.

The actual core of the Great Recession

The core of the difference between the policies pursued in the US and Europe on the one hand, and that followed in China on the other, requires understanding what actually occurred during the ‘Great Recession’ after 2008. A more extensive analysis has been given elsewhere but to summarise in the US and Europe the Great Recession was dominated by an investment collapse. To take the largest example, in the 2nd quarter of 2011 US GDP was still $56 billion below its 4th quarter of 2007 peak. However all major components of US GDP except fixed investment were already above their previous peak levels – inventories were $37 billion above, government consumption $51 billion above, personal consumption $66 billion above, and net exports $159 billion above. But US private fixed investment was $388 billion below its 4th quarter 2007 level. The entire decline in US GDP was therefore due to the fixed investment fall.  These changes are shown in Figure 1. A similar pattern exists in almost every major developed country.

Figure 1

11 08 01 Figure 1 - US


This investment fall, by driving and maintaining the downturn, produced a decline in personal and company income and therefore a fall in tax revenue – the latter being the primary reason for budget deficits. The crucial issue, both for economic development and to close the budget deficit, is therefore how to relaunch growth.

China’s situation was different and explains why it ran no significant budget deficit. China abandoned administrative running of its economy with the economic reforms beginning in 1978, but it still has a sufficiently large state sector that this could be, and was, instructed to increase investment. As the key banks are state owned they could be instructed to increase lending to companies – in the US the opposite occurred and lending to companies fell sharply. The rapid economic growth initially generated by China’s state companies in turn stimulated the private sector.

The result, during the crucial period 2008-2009, is shown in Figure 2. Instead of China’s investment falling it rose by $420bn. Consequently there was no recession. Under the impact of the increase in jobs and incomes created by the stimulus package, China’s household expenditure also rose by $160bn. Therefore despite the combined effect of a fall in net exports and inventories of $160bn China’s GDP in 2009 rose by $440bn.

As there was no recession there was no fall in tax revenue and no major budget deficit. As this process continued, by 2011 China’s GDP had increased by over 30 per cent, $2.3bn in current price terms, compared to pre-crisis level. In contrast by the 2nd quarter of 2011 US GDP was still 0.4 per cent below its 2007 peak level.

Figure 2

11 08 01 Figure 2 - China


In the US and Europe the budget deficits were increased by government attempts to restart growth. China could instruct its state companies to invest and its state banks to lend, but the state sector in the US and Europe is too small for this to be effective. Only indirect means, such as quantitative easing (printing money) and budget deficits were available as policy tools. Both proved ineffective in restarting rapid growth. But the latter policy worsened the deficits. China, due to the rapid growth resulting from the investment stimulus, had no significant budget deficit.

Relative scale of economic problems in the US, Europe and China

Naturally the above does not mean China escaped all economic problems – particularly food price inflation, but these are not on the same scale as the budget deficit crises gripping the US and Europe.

Nor do such developments mean China does not face economic policy choices. It is impossible to judge the size of a stimulus package perfectly in advance. The crucial thing in 2008, confronted with the worst economic crisis for eighty years, was to act rapidly and forcefully to head off downturn. This was achieved.

Indeed, so successful was the stimulus that by the 2nd quarter of 2010 China’s GDP growth was 11.9 per cent – well above the average 9.9 per cent since its economic reforms began and unsustainably high. Also, despite the government’s efforts, it is always impossible to prevent some part of a stimulus spilling into unintended areas  – creating a too high rate of increase in China’s house prices.

In summer 2010 world food price inflation also began. China suffered from this less than other comparable BRIC countries – Brazil, India and Russia. But countering these price rises required monetary tightening and slowing the economy

Finally, a medium term problem must be tackled. It is impossible to implement a huge lending increase, under conditions of international economic downturn, without some increase in bad loans. When China’s government launched the 2008 stimulus package it anticipated this by making banks increase provisions for bad loans and stating they would have to raise extra capital. The government’s calculation was simply that large scale economic growth resulting from its policies would generate more than sufficient resources to deal with any bad loans problem of the type now appearing in municipal debt – i.e. far more would be gained than lost. With more than 30 per cent growth in three years China’s economy has easily enough resources to deal with bad loans.

In short China’s economic structure does not produce perfection – which only exists in heaven. But the problems it faces are far smaller than the budget deficit and debt crises in Europe and the US.

China’s economy grew by more than 30 per cent in three years while Europe and the US remain below their peak levels of output. It is therefore easy to see which policy has been more successful.

Keynes and Chinese descriptions of China’s economic system

How is such an economic system as that operating in China to be described? China itself, of course, uses Marxist terminology – it describes itself as passing through ‘the primary stage of socialism’ and its overall system as ‘socialism with Chinese characteristics’. However there is another, more familiar in the West, way of looking at it.2

Keynes in the General Theory of Interest, Employment and Money evidently did not advocate an administered economy.3 But he did explicitly argue that the state would have to intervene sufficiently to determine the overall level of investment: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (p320)

Keynes, as is well known, attached great weight to changes in the rate of interest in affecting the investment level. But he did not believe these would be sufficient by themselves: ‘Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital… will be too great to be offset by any practicable changes in the rate of interest.’ (p164)

This led Keynes to the conclusion: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.’ (p378)

Keynes noted that ‘somewhat comprehensive socialisation of investment’ and ‘the duty of ordering the current volume of investment’ did not mean the elimination of the private sector, but socialised investment operating together with a private sector: ‘This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.’ (p378)

It does not seem the most interesting question whether we should accept China’s definition of its own system, or whether its economy instead should be regarded as conforming in important features to the system described by Keynes in the General Theory of Employment, Interest and Money. What is important is understanding how China’s economy actually works, why it has been able to run the world’s largest stimulus package without a budget deficit, and why therefore its macroeconomic policy has come through the international financial crisis more successfully than the US and Europe.

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This article originally appeared on the blog Key Trends in Globalisation.


1. For an analysis of this see Richard Koo’s The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.

2. A more detailed discussion of these issues can be found in Ross, J. ‘Deng Xiaoping and John Maynard Keynes’. Soundings Winter 2010.

3. All page references are to the 1983 Macmillan edition of the The General Theory of Employment, Interest and Money.