Economy

Paul Krugman: Are We Heading to a Global Economic Catastrophe?

We don't have much of a Plan B if China's recession is contagious.

Photo Credit: via YouTube

Paul Krugman does his best to analyze the current economic crisis and venture a guess about whether it will trigger a worldwide economic catastophe in Friday's column.

It's one of those good news/bad news column, and he confesses that he worries. His analysis in a nutshell:

The good news is that the numbers, as I read them, don’t seem big enough. The bad news is that I could be wrong, because global contagion often seems to end up being worse than hard numbers say it should. And the worse news is that if China does deliver a bad shock to the rest of the world, we are remarkably unready to deal with the consequences.

To catch up readers who have not been paying close attention, Krugman explains the background: 

The basic problem is that China’s economic model, which involves very high saving and very low consumption, was only sustainable as long as the country could grow extremely fast, justifying high investment. This in turn was possible when China had vast reserves of underemployed rural labor. But that’s no longer true, and China now faces the tricky task of transitioning to much lower growth without stumbling into recession.

A reasonable strategy would have been to buy time with credit expansion and infrastructure spending while reforming the economy in ways that put more purchasing power into families’ hands. Unfortunately, China pursued only the first half of that strategy, buying time and then squandering it. The result has been rapidly rising debt, much of it owed to poorly regulated “shadow banks,” and a threat of financial meltdown.

So the Chinese situation looks fairly grim — and new numbers have reinforced fears of a hard landing, leading not just to a plunge in Chinese stocks but to sharp declines in stock prices worldwide.

There are those, like George Soros, who are predicting doom and gloom, but Krugman is not among them. He just does not think the numbers are there in catastophic proportions. China is big—it accounts for a quarter of world manufacturing, for instance—but the world is truly huge. The closed nature of China's govenment and the fact that is isn't especially open to foreign investors might contain the damage. In the financial crash of 2008, Krugman points out, European banks had tons of exposure to the U.S. stock market plunge.

Still Krugman worries, because these things can be psychologically contagious. Bad news in one major economy can spread. Even worse, we would have no plan to deal with another shock, he points out. The Fed and European Central Bank have minimal capabilities. "And while fiscal policy — essentially, spending more to offset the effects of China spending less — would surely work," he writes, ruefully, "How many people believe that Republicans would be receptive to a new Obama stimulus plan, or that German politicians would look kindly on a proposal for bigger deficits in Europe?"