The news that China has overtaken Japan as the world’s second-largest economy did not come as a surprise. This is the major geo-political outcome of the Great Recession of the early 21st century — one that carries both economic hope and political fear.
First, the good news: The economic side of the case. China’s response to the world economic crisis is the central reason why the financial turbulence that emanated from the US sub-prime debacle did not completely destroy the world economy and lead to a repeat of the Great Depression of the 1930s.
In a famous analysis of the Great Depression, the economic historian Charles Kindleberger argued that it arose from a failure of world leadership. Great Britain had been the hegemonic power of the 19th century, but its creditor status had been severely eroded by the cost of fighting World War I.
The US had emerged from the war as the world’s largest creditor, but it had a double vulnerability. Its financial system was unstable and prone to panics and its political system was immature and prone to populism and nativism.
In the Depression, according to Kindleberger, the US should have provided an open market to foreign goods. Instead, the Smoot-Hawley Tariff Act closed off US markets and provoked other countries into a spiral of retaliatory trade measures.
US financial institutions should have continued to lend to distressed borrowers, in order to prevent a spiral in which credit rationing forced price reductions and intensified world deflation. Instead, US banks, widely blamed for the international lending boom that preceded the bust, were so intimidated and weakened that the flow of US credit stopped.
After World War II, as a leading figure in developing the Marshall Plan, Kindleberger set about applying these lessons: The US should keep its markets and its flow of funds open to support other countries.
How different the 21st century looks! It is as if China’s leaders were the star pupils in one of Kindleberger’s courses. Throughout the crisis, the Chinese economy continued to grow at an amazing pace, in part as a consequence of massive fiscal stimulus. When anyone wants an example of how effective a Keynesian counter-cyclical strategy can be, internationally as well as domestically, they need look no further than China’s 4 trillion yuan (US$594.5 billion) stimulus of 2008-2009.
Apart from a six-month period after the September 2008 collapse of Lehman Brothers, in which trade finance stopped and the world did look as if it was close to Great Depression circumstances, China and other emerging markets helped those export-oriented industrial economies to recover. The surprising strength of the German economy, with more vigorous growth than at any time in the past 15 years, is due to the dynamism of emerging-market — particularly Chinese — demand, not only for investment goods, engineering products and machine tools, but also for luxury consumer products. Germany’s high-end automobile producers are now operating at full capacity.
China also followed Kindleberger’s financial lessons. For a moment, it looked as if a contagious crisis, driven by fears of government over-indebtedness, would destroy the politically fragile compromise that European countries had carefully constructed over a 50-year period. The turning point in this spring’s euro panic came when big holders of reserve currencies signaled that they saw the need for the euro as an alternative to the increasingly problematic dollar and the equally vulnerable yen. China started to buy EU governments’ bonds and a high-profile Chinese team even went to Greece to buy under-priced real assets.