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The U.S. and China — The Global Economy’s Odd Couple

Why is the income gap in the United States and China so wide?

March 1, 2005

Why is the income gap in the United States and China so wide?

In dangerous terrain, mountain climbers routinely rope themselves together. That way, if one falls, the other can catch her before she plunges into a crevasse. Or, if the accident comes at the wrong moment, both climbers may fall together.

Today, China and the United States are traversing an exceptionally treacherous financial glacier.

This odd couple — the Republican Bush Administration and the authorities ruling the People’s Republic of China — have come to depend on each other much more than either would probably choose.

To outside observers, the situation may seem paradoxical. Why should the core interests of an elite party cadre numbering only 0.5% of China’s population and those of the party of Abraham Lincoln be so interdependent?
The answer is quite simple — money, jobs and stability.

Since Deng Xiaoping famously declared, “To get rich is glorious,” the Chinese economy has expanded at a breathless pace. But the benefits have been more and more unequally distributed.

The great majority of Chinese still live in rural areas, where they have not only fallen further behind the booming coastal cities, but where out-migration has been severely restricted.

A recent study (pdf) finds that “the distribution [of income] has worsened significantly since 1995, with rising inequality and falling absolute incomes — especially at the bottom end of the income distribution.”

The study attributes most of the recent decline in welfare to collapsing agricultural incomes, “probably brought about by lower farm prices.”

Also, it notes that “increasing non-farm incomes have widened the gaps between those with and without access to non-agricultural opportunities.”

So long as production in the modern industrial belt along China’s coast continues to expand at a fast pace, millions of poor people will find better-paying jobs — even if they are forced to leave their families behind.

The money they send home helps those left behind eke out a bit of economic progress. But hundreds of millions of rural people have yet to get their chance to step onto this colossal “economic escalator”.

Any serious drop in manufacturing production could have serious political consequences. Sporadic rural violence directed against the Communist Party is a harbinger of what might happen if the Chinese masses were deprived of economic hope.

Indeed, a prolonged economic slowdown might make the Chinese leadership’s worst nightmare come true: widespread destabilization.

This is where the United States enters into the Chinese leadership’s equation. Exports are key to maintaining China’s industrial momentum, representing fully one-third of the country’s total output (GDP).

And one-quarter of these exports go to the United States. This means that the economic health of the United States is of vital interest to the Chinese leadership.

If the United States were to suffer an economic crisis, it would threaten not only the Chinese economy — but also China’s internal stability, which China’s rulers consider to be of paramount importance.

U.S. imports from China amounted to $200 billion in 2004, a whopping 30% increase over 2003. That export success also made China the second largest exporter of goods to the United States — behind only Canada, with $256 billion in exports.

And at its current rate of export growth, China will surpass Canada and become the largest supplier of U.S. imports in 2006.
The supply of cheap goods from China on the shelves of retailers like Wal-Mart depends on two key decisions by the Chinese leadership.

First, they need to keep the wages of Chinese industrial workers as low as possible. China has managed to do this, but stresses are showing as demand for higher-skilled workers by Chinese firms increases.

Second, China’s leaders have to keep their country’s currency — the renminbi — from becoming more expensive in dollar terms. That is why the renminbi is kept at a de facto fixed exchange rate of about 8.3 renminbi to one U.S. dollar.

This currency arrangement has helped Chinese goods stay cheap on U.S. shelves.

Incidentally, it has also made Chinese products even cheaper than they were before in Europe, as the renminbi has been depreciating vis-à-vis the euro in concert with the U.S. dollar.

These two decisions by the Chinese leadership — on wages and the exchange rate — are interconnected. Any decision to let the renminbi appreciate against the dollar would raise Chinese wages and incomes measured in foreign currencies — resulting in an overall loss of competitiveness.

One would think that China’s dependence on exports to the United States would give the Americans great leverage over the Chinese.

But fortunately for China’s leaders, the Bush Administration depends at least as much on them as the reverse.

In pursuing a “tax-cut and spend” fiscal policy, the United States has generated budget and trade deficits that normally would be unsustainable.

Throughout the world, private investors are increasingly unwilling to accumulate additional low-interest U.S. Treasury bonds.

And that’s where the Chinese come in. China’s authorities are playing a pivotal role in helping the U.S. government to finance its enormous fiscal and balance of payments deficits.

The United States is the only major economic “bloc” to run huge and persistent trade deficits with China. And in return for all the goods China is shipping to the United States, the Chinese authorities are accumulating billions of dollars worth of U.S.
Treasury bonds each year.

China’s hoard of foreign exchange reserves exceeds $600 billion, held mainly in dollars. In 2004 alone, China’s foreign exchange reserves increased by around 50%.

Buying such a huge amount of American IOUs is not without risk for the Chinese economy. For one thing, the dollar’s fall against the euro and most other currencies means a loss of value of China’s foreign exchange assets.

If China’s central bank had sold dollars and bought euros instead, for example, reserves would not have lost value.

And if the renminbi were to rise against the U.S. dollar, China’s stock of dollar-denominated bonds would suffer a further capital loss — reflecting the fact that the Chinese central bank is one of only a few institutions in the world willing to accumulate them today.

What is more, each dollar that winds up in the coffers of China’s central bank has been traded by a firm or person — mainly Chinese exporters — for 8.3 renminbi.

This local currency is added to the money supply. To contain inflationary pressures, the Chinese authorities are forced to mop up liquidity by selling government bonds or to curb domestic demand using other difficult and often unpleasant measures.

In short, China’s leadership is going to considerable lengths to supply the U.S. population with cheap goods and to help finance U.S. deficits, so that U.S. imports will continue to enable China’s industries to absorb enough rural poor to avoid “disorder” in the rural areas.

The United States and the Chinese rulers each are enabling the other to pursue their risky economic and social policies.

But increasingly, it is not only the Chinese leadership that depends on this arrangement to smooth over its rapidly growing income inequality and preserve domestic stabilty.

The United States is at least equally dependent on China in this regard. Already, the U.S. income gap is closer to Argentina’s than Germany’s.

And in spite of the most unequal income distribution of any rich country, the Bush Administration is determined to enact taxation and spending policies that will further increase U.S. income inequality.

The United States has set out on a path to cut taxes most at the highest income levels, while reducing its “social safety net.”

U.S. health care, education, pension, income-supplement and other benefit programs are already far less generous than those in Europe, but the administration has been moving to curtail them sharply.

Together with tax reductions for the wealthiest Americans, these cuts in social transfer payments have widened the gap between the rich and the poor to almost Chinese proportions (see chart below).

Income Inequality in 16 Countries

Data Source: UN Human Development Report 2004

Never afraid to take risks, the White House seems determined to “starve the beast” (government) of tax revenue and use this as the excuse for cutting back the social safety net to levels not seen in the United States for two generations.

But for such policies to be politically tolerated, two salient economic dangers must be avoided. First, lower-income Americans must continue to be able to buy cheap consumer goods in order to maintain their “buy-in” to the Bush Administration’s economic policies.

Cheap Chinese imports are particularly important here, because imports from European and other countries whose currencies have appreciated against the dollar are putting significant upward pressure on U.S. prices. The same goes for petroleum imports.

Second, and above all, the treacherous macroeconomic ice the U.S. economy is crossing cannot be allowed to give way, as that would send markets tumbling.

It is clear, therefore, that far from being paradoxical, the Republican administration’s embrace of China’s leadership is absolutely necessary.

Continued willingness on the part of the Chinese to fill Wal-Mart’s shelves in exchange for IOUs of uncertain value keeps the U.S. economy steaming ahead — in turn providing vital draft power for China’s economic growth.

How long will this heightened mutual dependence last? It could last a long time, no matter how odd this climbing team may appear.

The governments of the United States and China each have committed themselves to a path of increasing income inequality and consequent potential political backlash. Each is helping the other as it pursues these policies.

What might end this teamwork? Is there a point at which these unlikely partners can decouple? There is. The time will come when China will need the United States far less than it does today.

With its own internal economic strength and the growing weight of the rest of Asia, China may be able to decouple from the United States and send the bulk of its exports elsewhere. At that point, they would also stop accumulating U.S. Treasury bonds — letting the dollar go where markets will sweep it.

Let us hope that this odd partnership — built on commitment to growth and acceptance of inequality — can soften gradually in both countries, with neither dragging the other down the economic slopes.