Global Rebalancing and the Depression

On his China Financial Markets Blog, Michael Pettis draws a parallel between the global imbalances of the depression and those today, with the US of the 1920's in surplus the country role played by China today:

In the 1920s excess and rising capacity in the US could be exported, mostly to Europe, while massive foreign bond issues floated by foreign countries in New York permitted countries to run large deficits, but as the US continued investing in and increasing capacity without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process, and it was not just the stock market that fell – bond markets collapsed and bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for all but the most credit-worthy foreigners to continue raising money, and by effectively cutting off funding for the current account deficit countries, it eliminated their ability to absorb excess US capacity.

The drop in foreign demand forced the US either massively to increase domestic demand or massively to cut back domestic production. The fact that another consequence of the financial crisis was a collapse of parts of the domestic banking system, leading to banking panics and cash hoarding, meant, as it often does in a global crisis, that the US had to adjust to a drop in demand both domestically and from abroad. But instead of expanding aggressively, as Keynes demanded, FDR expanded cautiously, and in 1937 even decided to put the fiscal house back in order by cutting fiscal spending, thereby stopping the recovery dead in its tracks.

In this situation, Pettis believes that the surplus countries - most especially China - need to generate additional demand. The recently announced Chinese stimulus package seems like a good step in this direction, but he sees some counter-productive moves as well:

...I worry that the global problem has never been a lack of US demand – it has been lack of Asian demand. The US has already provided a greater share of global demand than is healthy for either the US or, as we have clearly seen, for the world.

A massive fiscal expansion by the US would certainly boost global demand, but it would do so at the expense of increasing US indebtedness by far more than it increases demand for US goods (much of the expansion in demand would simply be exported to countries that continue to suffer from overcapacity) and of course it would not solve the global overcapacity problem. It might even exacerbate it. The best that one could hope for, if the US took the lead in fiscal expansion, is that Asian countries make heroic efforts to shift their economies as quickly as possible from export dependence to domestic demand dependence, but I have already argued that with the best will in the world this will be a long and difficult process, and I am not sure anyway that most countries have the political will to force the shift. China, for example, is raising export rebates and talking about depreciating the currency – hardly the actions of a country working hard to reduce global overcapacity.

Hm... under the circumstances, I think we might want to try the "massive fiscal expansion" and worry about imbalances later. There is no sign that the US Treasury will have any trouble borrowing as much as it wants.