commentary

(Policy and Markets Magazine)

February 1, 2007

Which Economy Will Run Into Trouble First: The US or China?

by William H. Overholt

Both the US and Chinese economies are highly diversified, highly globalized, competitive economies run by institutions and leaders who are usually capable of reacting proactively to potential problems. Both have excesses, of course. The US housing price rise and the Chinese investment boom of recent years have both been unsustainable. Highly stimulative US monetary and fiscal policies have created an overbought housing market, accumulating government debt, and outsize trade deficits.

China's semi-socialist banking system and repressed interest rates lead to a spectacular waste of capital. Huge rural-urban migration, rapid decline of manufacturing employment, and rapid influx of new graduates into the workforce create the potential for tsunami-like unemployment problems and social instability if the leadership falters. But managements in both Washington and Beijing recognize the issues and know what measures are required to deal with them. On current paths, under current global economic conditions, both will experience bumps, but neither is likely to experience serious trouble.

What could change this? The risks are parallel. China requires heroic leadership to keep its financial problems, social stresses and unemployment risks under control, but the heroic leadership of Zhu Rongji has been replaced by a more institutionalized, in some ways more mature, but also more bureaucratic and less heroic, leadership. Chinese society is suffering from reform fatigue.

The US economy does not require heroic leadership, but it does require effective presidential leadership, and the political weakness of the current administration shifts the balance of influence toward an interest group-driven and increasingly protectionist Congress.

The key risk is that weaker, more interest group-driven governments in both capitals could succumb to a vicious circle of protectionist demands that would, possibly quite quickly, deprive both countries of the enormous benefits that steady globalization has provided. This risk comes at a time when the open global economy is especially vulnerable, following the Doha failure, the French-Dutch rejection of the European Constitution, the US downgrading of multinational liberalization in favor of politically driven FTAs, the collapse of liberalization initiatives with Latin America, and others.

The problem would almost certainly begin in Washington; indeed we saw a small version when a patronage-driven political storm overwhelmed the proposed CNOOC-Unocal deal and Beijing followed shortly thereafter by tightening its own rules on foreign investment. If some such sequence were to lead to a slow-motion avalanche of protectionist measures, the negative reaction of world financial markets could be spectacular. Protectionists would then almost certainly react in a way that would worsen the problems rather than ameliorate them.

The key risk is not that one would collapse, but that both would simultaneously get into trouble.

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William H. Overholt is Director of the RAND Center for Asia Pacific Policy at the RAND Corporation, a nonprofit research organization.

This commentary originally appeared in Policy and Markets Magazine on February 1, 2007. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.