The G-20, the group of the world’s largest economies, agreed last week to a US-led initiative called a “Framework for Sustainable and Balanced Growth.” This is an effort to rectify current global imbalances in trade and capital flows, in which the US runs huge trade deficits financed by huge Chinese investments in US Treasuries.
The solution? Chinese consumers should spend more and US citizens should save more. Progress on meeting these objectives will be monitored by the International Monetary Fund, which will periodically issue a global scorecard.
While these are laudable objectives, they will be difficult to achieve. Consumer spending in China constitutes only 36% of its GDP, roughly half of the level in the US. At the same time, the personal savings rate in China is amazingly high — the average savings rate for urban Chinese households rose from 15.4% in 1995 to 22.4% in 2005.
And there are good structural reasons why Chinese households save so much and spend so little. First, China has nothing close to universal healthcare, despite its Communist ideology. So when a medical emergency arises, most Chinese families must pay large sums in cash to get treatment. To persuade Chinese families to consume more and save less, therefore, China must fully meet the healthcare needs of its citizens.
When China announced its initial stimulus package of $585 billion in late 2008, it was largely comprised of infrastructure spending and business incentives. During 2009, China did expand the stimulus package to include $120 billion to improve local healthcare. This is a step in the right direction, though not enough to solve the problem.
Second, if China wants its consumers to spend more and save less, it must substantially improve its Social Security system. China’s modern retirement system, begun in 1997, does not cover most workers in rural areas or in small urban enterprises. In addition, workers can no longer count on their children to support them in old age.
Most problematically, contributions to the current retirement system are made to provincial governments, which must pay out legacy benefits on pre-1997 pensions that were never funded. This is an unviable situation for provincial governments and Chinese workers. Instead, China’s national government should assume all obligations under the pre-1997 legacy pensions.
The challenges are equally daunting on the American side. The good news is that the personal savings rate of American households is rising: from negative 2% in 2005 to positive 6% during 2009. This means roughly $600 billion in incremental savings and reduced spending by consumers.
The bad news is that the US budget deficit is rising more quickly than our personal savings rate. In fiscal year 2008-2009, the US budget deficit will be $1.6 trillion. Over the next decade, the budget deficit is projected to average $1 trillion per year, according to the Brookings Institution.
Will Congress reverse these US budget deficits by letting the Bush tax cuts expire at the end of 2010? In theory, this could raise tax revenues by approximately $1.6 trillion over the next decade. However, only $700 to $800 billion of the Bush tax cuts went to wealthy Americans with annual incomes over $250,000; the other $800 to $900 billion went to middle and working class families. Maintaining low tax rates for these families will be strongly supported by both Democrats and Republicans, so the chances of Congress renewing the majority of the Bush cuts are high.
At the end of the day, the US budget deficits will fall and total US savings will rise only if Congress constrains the growth of public spending. This was done during the 1990s through a bipartisan measure called PAYGO — whereby public spending could not be increased unless it was paid for by other spending decreases and/or tax incentives. As a result of PAYGO and other factors, the US ran a budget surplus in 2000.
Congress could adopt a version of PAYGO to become effective once the economy rebounds (i.e., when GDP grew by at least 2% a year). In fact, the Obama Administration has proposed a form of PAYGO to constrain the growth in budget deficits. However, that proposal is filled with exemptions exceeding over $2 trillion — for Medicare payments to doctors, fixes to the alternative minimum tax and, of course, continuation of the Bush tax cuts for families with incomes below $250,000 per year.
In short, for the G-20 to succeed in correcting global imbalances and achieving sustainable growth, both China and the US would have to adopt bold measures involving significant financial and political issues. When the IMF begins to issue its reports, we will know whether either country has made substantial progress in achieving these worthy objectives. How likely do you think it is that they’ll get good report cards?
Bob Pozen is a senior lecturer at Harvard Business School and the author of Too Big to Save? How to Fix the US Financial System (November 2009)