Look to Japanese experience for a costly lesson in rebalancing
Japan has undergone exactly the kind of rebalancing after 1990 that many expect from China today.
This does not mean China will have as difficult a process as Japan did, but it is worth looking at Japan's history to understand the different ways in which rebalancing can occur.
For Japan in the 1980s and China today, high investment rates and even higher savings rates meant economic growth was heavily dependent on investment and net exports, and not nearly dependent enough on domestic private consumption. Rebalancing meant private consumption had to become a larger source of growth for the economy.
Japan's initial response to the 1987 stock market crash in the United States, which brought with it a sharp contraction in the US trade deficit, was to counteract the trade effect by increasing investment from an already high 28 per cent to nearly 33 per cent three years later. This kept economic growth rates high for two more years but almost certainly at the cost of exacerbating the underlying imbalance in Japan's economy.
Higher investment was likely also to mean more misallocated investment and higher debt levels, and these ultimately had to be paid for directly or indirectly by Japanese households. But increasing the future burden on households would also necessarily prevent household consumption from surging. In fact this was what happened. Consumption growth declined after 1990.
The process of rebalancing nonetheless required that household consumption rise as a share of Japan's gross domestic product.
So did Japan rebalance? It did. Broadly speaking, there are two ways it could have taken place. The good way would have involved a surge in household consumption, which would have pulled domestic economic growth with it, even as Japan weaned itself from a dependence on investment and net exports.
But there is a less benign way rebalancing can take place. Consumption can grow slowly while the economy stagnates. Household consumption will still rise as a share of GDP, which will grow even more slowly.
Japan was forced into the second path. Household consumption growth declined, partly for demographic reasons and partly because policies put into place in the 1970s and 1980s to generate high growth at the expense of household consumption were reinforced by Japan's response to the 1987 crash, which included extremely low interest rates and an undervalued currency.
For 20 years, consumption grew slowly, by between 1 and 2 per cent annually. But GDP grew at barely positive rates during the past two decades. For some analysts, this suggests that Japan did not rebalance - Japanese households did not ride to rescue the economy with a surge in consumption.
But this interpretation is wrong. In fact Japan did rebalance its economy to an important extent. Household consumption grew at a faster rate than did GDP, and household savings declined, from about 10 per cent in 1990 to about 2 per cent more recently. The problem is the rebalancing occurred through a sharp slowdown in GDP growth rather than a surge in household consumption.
Could Japan have chosen the former path? Perhaps it could have, but this would probably have required a higher social cost in the short term. Among other things, it would have been necessary immediately to write down excess capacity, bad loans and overinvestment and to move the financial system quickly towards allocating capital for the best economic use. But this would also have almost certainly entailed a sharp rise in unemployment in the short term.
Japan's experience parallels the histories of other countries that have gone through a similar rebalancing, including the US in the 1930s. Moving a large economy away from an excess reliance on exports or investment is never easy. But highly unbalanced economies will eventually rebalance, like it or not.
Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie Endowment