In an environment of high productivity growth, stability of nominal
variables, such as interest rate and exchange rate, must come first;
economic adjustment should first occur through varying distribution of
productivity gains among labor, capital and consumer.
Overhang of surplus labor distributes productivity gains to consumers.
Chinese productivity benefits western consumers mostly. Until most
Chinese are employed, this would not change. Currency appreciation
would only cause wage deflation in China.
***Inflation is just a scare
The current inflation is due to cost-push and couldn't sustain as wages
are kept down. Inflation expectation cannot be supported in an
environment of surplus labor.
***Deflation is ok
The expansion of labor pool in the global economy due to IT has
increased productivity enormously. Reaching potential growth rate is
not possible without causing financial instability. The stable
equilibrium for the global economy is to have mild deflation that passes
productivity gains to consumers.
Summary and Investment Conclusion
----------------------------------
When Mr. Greenspan talks about productivity, I shudder. Productivity is
a wonderful thing; it improves living standard with the same capital and
labor; but it does not necessarily mean more profits or stronger
currencies.
When NASDAQ was approaching 5,000, Mr. Greenspan volunteered a plausible
explanation that it was a lottery in a high productivity revolution-the
winners would make it so big that it would justify trying even if most
fail. The underlying logic was that productivity would lead to profit.
Mr. Greenspan again volunteered an explanation last week that Chinese
currency-Renminbi or Yuan would appreciate because the Chinese economy
had been registering rapid productivity growth. Mr. Greenspan's
productivity musing probably contributed to the frenzy in the NASDAQ
last time. It may encourage more speculation in the Chinese currency.
Productivity gains distribute among labor, capital or consumer. Where
it goes depends which factor is the scarcest. Historically,
productivity gains mostly went to consumer in lower prices. That
productivity gains show up in higher wage and profit was a recent
phenomenon, only possible in an economy with a fully employed labor
force.
There is not a long-run relationship between productivity and exchange
rate at all. If the equilibrium implies that productivity should
reflect in currency appreciation, wage increase could substitute for it.
If wages are not rising despite of productivity gains, it implies that
currency appreciation would lead to wage deflation.
Exchange rate is irrelevant for an economy with flexible factor markets,
especially one with high productivity gains. Other prices should adjust
quickly in response to any pressure that could cause the currency to
appreciate.
Macro management should view stability rather than reaching growth
potential as a more important goal. The global labor overhang is so
large that it is impossible to reach 'potential growth rate' without
causing financial instability. If macro policies insist on maximizing
growth rate, it would cause massive bubbles as labor overhang keeps
inflation down and monetary stimulus only inflate asset markets.
Who Benefits from Productivity?
-------------------------------
You can visit Chinese productivity at a Wal-Mart near you. Yes, Chinese
economy is becoming more productive. I estimated that China's total
factor productivity ('TFP')-how much more output with the same inputs is
3-4% per annum (see 'Measuring Productivity', February 22, 2002). My
guesstimate is that Chinese wages are rising at half of the labor
productivity, which includes the impact of more capital per worker and
is about twice as much as TFP. Why can't Chinese wages rise at the same
pace as labor productivity, which would capture all the TFP to benefit
Chinese workers?
The problem is that the competition for jobs in China is fiercer than
the competition for goods in the world market. For Chinese to gain jobs
faster than the average pace in the world economy, they must sell their
labor cheap, i.e., giving the TFP to western consumers in lower prices
so that they would buy more Chinese goods, i.e., more Chinese labor.
The relative balance would change only when most Chinese are employed.
When China reaches the tipping, either its currency would appreciate as
in Korea and Taiwan in 1980s or its inflation would be higher than the
world's average as in Hong Kong in 1980s and 90s.
Some people have the brilliant idea to give Chinese workers a raise by
appreciating its currency, since China's labor market would not do it.
Would it work? Would western consumers pay more for Chinese goods if
China's currency were to gs up? I doubt it. China's export price is
determined by the relative balance between the number of Chinese workers
and western consumers. How could manipulating the exchange rate change
this reality? If western consumers refuse to pay more in the case of a
Yuan appreciation, wouldn't it push down wages in China for its labor
market to reach some sort of equilibrium?
Throughout the industrialization of the west, productivity mostly
benefited consumers also; deflation prevailed due to productivity gains.
What is occurring in China is not unusual. It is the vast pool of
surplus labor that keeps down labor's pricing power and also makes
consumers who are workers price-sensitive. Thus, productivity gains are
competed away by businesses in endless price wars.
Inflation Is Just a Scare
-------------------------
Rising commodity prices and significant inflation in China have fed the
theory of rising inflation. This is incorrect. Inflation is mostly
about income redistribution rather than wage-price spiral. For example,
the rise in grain price in China was merely to change the terms of trade
between urban and rural sectors, caused by a bad harvest and the limited
release of reserves to stabilize the price. From the companies I have
visited, Chinese urban wages rose by probably 4% last year. The people
who received high wages did not have market competition (e.g., civil
servants or state monopoly employees).
There are pockets of inflation in China, mostly in areas related to the
property sector. The release of the state land at below-market prices
has funded the profit in property-related industries, from real estate
agents to commodity producers. It is the 'free money' that is fueling
the pricing power in these industries. As land sales are made more
transparent, this 'free money' machine would also slow.
Other sources of inflation include rising utility prices, healthcare and
education costs. It is hard to see inflation in areas that the
government is not involved. China's inflation is either a tax (e.g.,
education and healthcare) or income redistribution (e.g., grain). As
long as Chinese workers face unlimited competition in the labor market,
sustained inflation based on wage-price spiral is highly unlikely.
Commodity prices are also a tax on Chinese economy. It may cause some
prices to rise. However, companies tend to absorb some of the cost rise
in competitive markets. Only in the speculative property market that
producers could lift raw material prices, because property developers
want to rush through their projects to realize the profits from the
undervalued land and do not mind paying more for raw materials.
'Expectation' has been played up as the mechanism for inflation to surge
beyond cost-push. This is the wrong concept in an economy with vast
amount of surplus labor. For example, soybean price has increased by
50% in the past six months, Chinese consumers were rational to expect
soy sauce price to rise and, hence, tried to buy soy sauce early.
However, would Chinese consumers draw from this the conclusion that
bicycles would become more expensive? Because it is a labor-intensive
product and many workers are competing for the jobs to build bicycles,
Chinese consumers would not rush out to stock up on bicycles when they
see soy sauce price rising. The 'expectation' theory would not cut it
in an environment with vast amount of surplus labor.
Deflation Can Be Ok
-------------------
Inflation fighting is a central goal of modern central banking. But,
inflation is increasingly not a threat. The US economy has experienced
disinflation for two decades. The same trend pushed Japan into
deflation. It is now fashionable to talk about fighting deflation,
i.e., stimulating as much as it takes to prevent CPI from declining.
This is quite wrong, in my view.
When productivity is rising rapidly, it is quite all right for prices to
fall. The technology sector experiences perennial deflation. If more
sectors in an economy resemble the technology sector, what is wrong with
allowing the prices in to fall?
The rising burden of debt service is the main objection against
deflation. But, if productivity rises faster than deflation, the real
burden of debt is not rising for businesses.
Some may argue that one should always increase money supply as long as
inflation isn't a problem. This is also wrong, in my view. In a high
productivity environment, monetary expansion can easily lead to asset
bubbles. This is what occurred in the second half of 1920s and 1990s in
the US. If the Fed does not learn from that lesson, the world could
experience another financial catastrophe.
The global economy is experiencing much higher productivity growth rate,
because information now spreads to developing countries much easier than
before, which makes more people in the developing world with skills to
join the global economy. Thus, the global economy behaves like an
emerging economy that gains productivity from moving labor from
low-productivity rural sector to high-productivity urban sector. In
such an environment, mild deflation in the global economy is the right
equilibrium, in my view. If policymakers try too hard to prevent
productivity-led deflation, the global economy would see more and more
bubbles.
Stability First
---------------
In an environment of high productivity and high employment growth,
exchange rate stability is vital. Adjustments against shocks could be
absorbed via different distributions of productivity among labor,
capital and consumer. Volatile real but stable nominal variables are
the key to rapid economic development, in my view. This is totally
opposite to the philosophy of central banking post-WWII that emphasizes
adjusting interest rate and, hence, exchange rate frequently to balance
between inflation and growth. In a high productivity growth
environment, inflation is not the challenge; asset bubbles are.
I think that China has stumbled onto the right approach for macro
management in the new era of high productivity growth. Mr. Greenspan
likes to talk about productivity. He should consider it in macro
management. And he could learn something from China.
Andy Xie (Hong Kong)
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