Paul Krugman has become very bearish on China:

All economic data are best viewed as a peculiarly boring genre of science fiction, but Chinese data are even more fictional than most. Add a secretive government, a controlled press, and the sheer size of the country, and it’s harder to figure out what’s really happening in China than it is in any other major economy.

Yet the signs are now unmistakable: China is in big trouble.  .  .  .

It’s all very peculiar by our standards, but it worked for several decades. Now, however, China has hit the “Lewis point” “” to put it crudely, it’s running out of surplus peasants.

That should be a good thing. Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing” “” the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump.

And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve’s policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.

Overall a reasonable article, but I have a few quibbles:

1.  Despite saying the data is “unmistakable,” Krugman actually present no evidence at all that China is suddenly in trouble.  Or perhaps one piece of evidence; Chinese wages are rising rapidly, indicating that the endless flow of surplus labor is coming to an end.  But there’s one problem with this fact—it’s been true for many, many years.  Indeed Chinese wages have been rising at double-digit rates for several decades.  China may suddenly be out of surplus labor, but Krugman presents no data to support this hypothesis.

2.  The interior regions of China are much larger and much poorer than the coastal areas.  Krugman presents no evidence that the Chinese growth model cannot keep plugging away in the interior regions for many more years.

3.  I actually agree with Krugman that China is reaching a turning point, where it will have to begin shifting toward a more consumer-oriented economy.  However, I have a hard time seeing how China is approaching a cliff. One of two things will happen.  The new government might cut back on subsidies to SOEs and allow more foreign investment.  That would be good.  Or they might continue over-investing in certain sectors.  That would be wasteful, but not a cliff.

Krugman seems to overlook the fact that the Chinese economy is flexible, despite being highly distorted.  If they decide to stop building ships and start building 100,000,000 washing machines per year, there is no country on Earth that can do that switchover as fast as China.  Indeed no other country even comes close.  The flexibility of the Chinese economy is mind-boggling.

So what could go wrong?  

1.  Unstable monetary policy–i.e. unstable NGDP growth.

2.  Even if monetary policy is sound, they might continue over-investing.  That would be wasteful, and reduce living standards in China.  But it probably would not lead to an economic cliff.

Chinese growth will slow, but I doubt it will hit a cliff.

PS.  China can keep its currency “undervalued”, i.e. it can keep running CA surpluses if it wishes to.  That’s a completely separate issue that has no bearing on the “cliff” argument.  Indeed if it was running persistent CA deficits people would also be warning about a “cliff.”

PPS.  Beware of “pessimism bias” among intellectuals.  Intellectuals who are down on the US will tell you that the orgy of housing construction in 2004-06 was “consumption,” not investment.  When the same intellectuals are down on China they’ll insist that all the excess housing construction is “investment” not consumption.  The only common thread is that intellectuals like to make things look bleak.  The US “consumes” too much and China “invests” too much.  If that’s your narrative, then just adjust the facts to make it true.  (Not saying Krugman is guilty here, but plenty of intellectuals are.)

HT:  Tyler Cowen

After being criticized by Noah Smith, I foolishly got all defensive.  Meanwhile Noah was laughing all the way to the bank.  Here’s commenter anon/portly:

Think for a second, what is hippie-punching, anyway?  It’s a “stratagem” where you gratuitously attack X to ingratiate yourself with Y, having (in your own mind, at least) caused yourself problems with Y by having displayed the incorrect attitude toward X.

Then consider, what is Noah Smith really up to?  He doesn’t have any examples of SS’s hippie-punching, which could be due either to his lack of knowledge, or his lack of interest, in SS’s views.  Either way it’s hard not to see his real intent here as doing some “Sumner-punching,” i.e. this comment of his was merely a stratagem designed to ingratiate himself with certain readers or fellow bloggers who understand that SS is a Bad Guy and who might be suspicious of NS for some of his past comments where his attitude toward SS (and maybe others, like Tyler Cowen) has not been entirely appropriate.

I believe they call this “irony.”  Whatever it is, it’s as beautiful as any sunset.  Noah Smith is not just a “good guy,” he’s the highest possible expression of academic genius.

Yup.  Krugman did call him a “good guy,” but also warned him not to stray off the reservation.  Smith responded with some “SS-punching” to show he’s loyal to the liberal tribe.

PS.  Even in my initials I’m stuck with a sinister far-right connotation.  Or perhaps the sound of a snake.  Another reason to envy Noah.

Here’s Noah Smith, who for some strange reason Paul Krugman recently labeled a “good guy”:

.  .  . monetarists like Scott Sumner often spend a lot of time “punching hippies” on every issue other than monetary policy, trying to avoid being tarred as hippies themselves for their lack of fear of inflation. (Note to Sumner: This strategem has quite noticeably failed to convince most conservatives to support anything remotely resembling NGDP targeting.)

Yeah.  That’s why I’ve advocated carbon taxes, universal health care, progressive taxes to redistribute income, drug legalization, more immigration, etc. I’m hoping to piss off all those hippies and win over the conservatives.  (Memo to young bloggers–wait until you are at least 50 years old before trying to judge the motives of other bloggers.)

But the second statement is what really set me off.  When I started blogging I had no expectation of having any impact at all.  After all I’m at Bentley (which is a college, not a car.) I still don’t really know how much impact I’ve had, but no one can deny that NGDP targeting has become the hot idea in macro, with lots of supporters on both the left and the right.  I’ve recently done not one but two NGDP targeting papers for the Koch-funded Mercatus Center (the 2nd on NGDP futures is coming out very soon), and you see lots of conservative journalists jumping on the NGDP targeting bandwagon.  I’ve also done pieces for Cato, AEI, the Adam Smith Institute, etc.  Yes, I’ve failed to convince Taylor, Feldstein, and Meltzer, but I’m seeing lots of interest from younger academics.   Noah Smith should check out my email inbox.

It’s clear to me that old monetarism is dying.  It might be replaced by Austrianism, but I believe that bright young conservative academics will find market monetarism to be more appealing.

PS.  Otherwise Noah’s post is mostly right, except he gives the unwashed masses too much credit in focusing on the redistribution effects of stabilization policy.

PPS.  I’ll bet I own more Bob Dylan albums that Noah.

HT:  Saturos.

Noah Smith recently did a post discussing the long period of deflation in Japan, and noted that NK models generally predict that wages and prices should eventually adjust to restore full employment.  Paul Krugman criticized Smith as follows:

No, the only reason deflation “works” in the standard model is that it increases the real money supply, which leads to lower interest rates; in effect, it acts like an expansionary monetary policy.

But Japan has been in a liquidity trap during the whole period Smith looks at. Monetary expansion is ineffective unless it can raise expectations of future inflation. Deflation is definitely not going to help. In fact, by raising the real burden of debt, it makes things worse.

Hmmm, which hippie to punch?

Long time readers know I strongly disagree with Krugman’s view, as I think the standard model uses inflation where NGDP growth is needed.  Thus if nominal wages fall and NGDP doesn’t fall then employment will increase.  Keynesians would argue that falling wages will reduce prices, and this will increase the real burden of debts, or real interest rates.  But the ratio of debt to the price level doesn’t matter, what matters is the ratio of debts to NGDP.  And real interest rates don’t matter, it’s the difference between nominal rates and expected NGDP growth that matters. Hold NGDP stable and falling wages and prices most certainly will restore full employment.

Now I suppose you could argue that falling wages would cause the central bank to reduce NGDP.  But I’ve argued that Krugman and Eggertsson’s model doesn’t fit the Great Depression.  In a follow up post Krugman makes the following comment:

One thing Noah Smith did get right, by the way, is his suggestion that Japanese wages are less sticky than in other advanced countries. There’s a fair bit of evidence to that effect, above all the fact that Japan is pretty much unique in having gone into actual deflation. The point, however, is that this is not a good thing in a country that is in a liquidity trap and suffering from a debt overhang: when it comes to wage and price flexibility, the situation in the economy has developed not necessarily to Japan’s advantage.

That last lines echoes Hirohito’s famous comment, and I suppose its cleverness is supposed to end all debate.  But does it?  Yes, over the past 20 years AD in Japan has fallen by more than in any other developed country in the world, indeed so far as I know by more than in any other developed economy in all of world history over such a long period of time.  That fits Krugman’s claim.  Of course this mind-boggling decline occurred during a period of persistent and large budget deficits, which is awkward for Keynesians.

But what about Krugman’s employment claim?  How’s Japan doing compared to economies where workers riot if you try to cut their wages?  Here are some recent unemployment rates in countries with weak NGDP:

Japan:  4.1% and falling

Greece:  26.9% and rising

Spain:  27.2% and rising

One might argue that wage stickiness has not necessarily worked out to the advantage of Greece and Spain.  Yes, you can throw a million objections at my list (I agree that Japan’s actual rate is probably higher), but none of them will address the point I’m making—Krugman can’t simple throw out a clever line and make everyone assume he’s got the facts on his side.  Let him find his own highly misleading comparison to counter my highly misleading comparison and then we can start a meaningful debate.

PS.  Krugman also makes this remark:

Bruce Bartlett’s latest has some interesting history from the 1930s that just so happens to bear on my mild chiding of Noah Smith (Smith has an answer that, frankly, I don’t understand “” but he’s been such a good guy over time that I’m just going to let this one drop).

Well regardless of whether Smith is a good guy, a bad guy, or just a guy, I’m not going to let this Smith comment slide:

So how can we be looking at a sticky-price story for Japan’s stagnation? Well, we could be looking at a very long series of negative demand shocks. Japan could have just kept getting hit with shock after shock, giving the appearance of a long steady decline. But what were those shocks? If they were global in nature (such as the Asian financial crisis, the tech bubble, etc.), there’s the question of why other countries around the world haven’t mirrored Japan’s deflationary experience. And a long string of negative domestic demand shocks is not in evidence.

This is flat out wrong.  Japan’s NGDP is lower than 20 years ago, that’s the biggest fall in AD I’ve ever seen. The only question is why has Japan suffered such a big adverse demand shock, spread out over 20 years.  And the answer is simple; the BOJ has had an unusually tight monetary policy.  The BOJ has produced 20 years worth of adverse AD shocks.  In both 2000 and 2006 they raised interest rates despite the fact that Japan was experiencing deflation.  In 2006 they cut the monetary base by 20%. I’ve often disagreed with Bernanke, but he’d never do anything THAT crazy.  Indeed Bernanke wrote some powerful pieces criticizing the insanity of BOJ policies as far back as the late 1990s.

Oddly, Smith’s slip on this point doesn’t detract for the rest of the post, which is very good (Tyler Cowen also liked it.)  I’ve also argued that demand and supply shocks might become “entangled,” but whereas I focused on the persistent effects of AD on employment, Smith focuses on the possible impact on long term productivity.  I have to admit that his focus makes more sense for Japan.

PPS.  On second thought, Smith is a friend of Miles Kimball, so he can’t really be a bad guy. But he needs to be more polite to conservatives.  Noah, there’s a reason Krugman likes you–think about it.

Yichuan Wang has an excellent new post discussing parallels between the QE of 1932 (and tapering of 1932) with the QE of today.  Here’s the conclusion:

To get back on track, the Fed must commit to keeping rates low until the price (or nominal GDP) level is back to trend. On the other hand, if the Fed were to raise interest rates now, this would collapse expected inflation, lowering the Wicksellian curve and knocking the economy into a low output, low interest rates environment. So even if you think the low rates environment is causing financial distortions, the only way to get higher rates in the future and to solve the apparent financial distortions of low interest rates is, ironically, to promise to keeping short rates low now.

The financial stability view gets off track because it ignores general equilibrium effects. In partial equilibrium analysis, when there’s an excess stock of something, such as bank reserves, the natural response is to cut supply. But this is misleading analogy for bank reserves, because an excess supply of bank reserves actually represents an excess demand for money. Therefore the proper response is to maintain lower rates and not prematurely tighten.

Therefore the real bills/financial stability doctrine fails for three reasons. First, it identifies excess reserves as the result of reduced borrowing that the Fed cannot control, whereas the excess reserves actually are symptoms of an excess demand for money that easier monetary policy can address. Second, this misdiagnosis means we are left thinking the Fed is powerless, whereas the Fed can pin down the price level through forward guidance. Third, it ignores the general equilibrium relationship between money and goods. By prematurely raising rates, this actually depresses interest rates in the long run and worsens the excess demand for money. Bottom line? Worrying too much about financial stability concerns can exacerbate the business cycle and actually prolong a period of low rates. Instead, the Fed should keep its eyes on the real economic prize, and keep financial decisions separate from its monetary ones.

Evan Soltas has a follow-up to his study of the relationship between stock prices and bond yields, which suggested that in recent weeks the rise in long term bond yields has been caused by expectations of tighter money.  In his new post he shows that most bond dealers believe the spike in long term bond yields is due to expectations of tighter money.  He seems to have the strongest arguments of anyone I’ve seen in the blogosphere, and he is undoubtedly at least partly correct.  And yet I have a few nagging doubts:

1.  Since May 1 the stock market has risen strongly, and 5 year TIPS spreads have stayed at about 2% (after dipping lower in the interim.)

2.  Tighter money should reduce TIPS spreads and stock prices.

How can these facts be reconciled?  Consider the following:

1. Expectations of tighter money have had a dramatic impact on markets on certain days, such as the period from June 18 to June 21, when 5 year yields spiked from 1.07% to 1.42% and 5 years TIPS spiked even more, from -0.77% to -0.24%.  That means TIPS spreads fell from 1.84% to 1.66%.  Stocks also fell sharply over that three day stretch.   So why are TIPS spreads back close to 2%, as they were in early May?  And why are stocks far above the levels of early May?

Perhaps yields have been affected by two factors:

1.  Expectations of tightening have boosted yields during certain highly visible periods, and this depressed stocks and TIPS spreads.  This is what the dealers noticed.

2.  Expectations of faster growth have been gradually raising stock prices, TIPS spreads, and bond yields on the other days, the days when there is no hawkish news out of the Fed.

Perhaps those who follow the markets more closely than I do can tell me if these two hypotheses can explain most of the stylized facts.

PS.  I’m still quite puzzled by all this, as I don’t see much evidence of faster growth.  The next 12 months of macro data will tell us a lot about what has been going on over the past few months in the markets.