The Twin Problem and China’s Next Steps

The cure can’t be worse than the disease. Really?

One reason why the current economic crisis has foxed policymakers and central bankers all over is the ‘twin problem’ challenge confronting them. The ‘second’ problem is easier to solve. Consumer demand is weak in the economy and the government needs to act as the spender of the last resort to get the demand cycle going. This is done by a fiscal stimulus, easing credit, pumping liquidity and following the general Keynesian approach. Once you do all of the above and not skimp on the size of stimulus, jobs would be created, demand would return and hopefully, the government would recover the cost of the stimulus over the long-term. That takes care of the ‘second’ problem. The ‘first’ problem is that you have a deadly virus that’s killing people. There’s no known cure to it except to avoid it by shutting everything down and staying indoors.

The twin problem for policymakers is this. The more aggressively you try and solve the first problem, the more the second problem exacerbates. The pessimistic estimates of GDP decline in the US for Q2 are coming in 20-25 per cent range with unemployment going up by 15-20 per cent. Other countries might have similar estimates. Another quarter of such performance and the ‘second’ problem will turn unsolvable. The challenge for the policymakers is to find that optimal formulation that brings down economic activity just so much to solve the first problem while not ruining the chance of solving the second problem soon after. This kind of desired Goldilocks zone in formulating a policy in a democratic set up with multiple stakeholders is pretty nigh impossible.

So, right now all different governments are doing is to solve each of the twin problem as if the other one doesn’t exist. On one hand shut the economy down to contain the pandemic while on the other dial up the monetary and fiscal responses like the economy is in a ‘regular’ deep-freeze and there’s no virus on the horizon. In short, the usual problem of the one-handed economist.

To solve for the twin problem simultaneously requires policymaking chops and some plain speaking. I’m loathe to credit Trump with any kind of intellect, but I have long accepted his remarkable ability to change the narrative. “The cure can’t be worse than the disease’ line of his is up there among his best. It is the first time during the crisis a head of state has spoken the unspeakable. Undoubtedly, it is a deeply amoral argument when you look at the lives involved. However, it might force everyone to look for a solution to the twin problem together. Solving for each of them in isolation might give everyone a sense that we are doing something in the present. But we might have dug too deep a hole to come out of in future.

What does China do now?

While the world staggers from the Covid-19 blow, the low hum of Chinese economic engine restarting is getting audible. Most factories are back to work and even the shutdown in Wuhan will lifted on April 8. But here’s a question. Now the Chinese factories are ready to function at their full capacity, where is the demand? Of course, there’s domestic consumption within China. But that’s never enough. The demand from the rest of the world will remain low over the next quarter and there’s a real possibility of gradual relocation of manufacturing capacity and dependence from China to other countries in the medium term. That’s not good news.

Even before this crisis, China was saddled with excess low-value manufacturing capacity that it wanted to shift using the Brick & Road Initiative (BRI) to weaker economies in its neighbourhood. These plants were saddled with huge debts that Chinese banks can’t shake off. Defaults were real possibility. Now that Q1 is a write off and Q2 looking bleak because of global shutdown, things don’t look great on economic front for China. It can kick the can down the road and launch another big stimulus to ride this out. But that will come at the cost of Xi’s dream of high-quality growth.

There are exaggerated views about China cherry-picking assets in Europe now and deepening its footprints there. Regulatory hurdles aside, it will be a huge political risk for any government to be seen letting China take advantage of them when they are down. There’s the other risk of its role in the initial days of pandemic. That’s not come under critical gaze, but it will after things settle down. There’s also the real possibility of Europe and US continue to batten down their hatches for a longer time. Don’t rule out xenophobic impulses about China in these countries.

It will be in China’s interest to temper down the triumphal notes on how they contained the virus while the rest of the world suffers. The need to contrast the effectiveness of their system with the bumbling responses of democracies to their people can wait. China’s economic interests will be best served by it proactively providing all the support they can in helping the world contain this. There’s money to be made and respect to be earned following this course. Besides earning a few real superpower spurs.

Lastly,

There were multiple reports on the high-handed behaviour of police while dealing with people who were out for work today. I guess they could be somewhat more civil but atleast we are enforcing the shutdown with vigour. This government wields the top-down administrative danda with aplomb.

Then we had the FM press conference. And you realised there’s no corresponding danda for the policy space. There, excuse the bad pun, it draws an andaa.  

1 thought on “The Twin Problem and China’s Next Steps

  1. […] good as any framework. So, I applied it quickly to the twin problem challenge that we had discussed here. Voila! It works like a […]

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