(I) Xu Gao's case for stimulus

Chief Economist of Bank of China International tears apart the opposition

Xu Gao, the Chief Economist and Assistant President of Bank of China International Co. Ltd., and an adjunct professor of the National School of Development (NSD) at Peking University, has been featured on The East is Read several times.

On August 19, 2024, Xu published a new essay on his personal WeChat blog 徐高经济观察 Xu Gao Economic Observation. This long essay, essentially making a case for Beijing to adopt stimulus measures, will be rolled out in three parts.

Amid cautious signals from the Chinese government and the widespread belief in saving policy "ammunition," Xu Gao calls for a shift to macroeconomic thinking. He contends the government shouldn't be tethered to the belief that money spent is money lost, as a company might. The government revenue isn't fixed or exhaustible but "endogenous," says he, driven by government spending, which boosts private income, consumption, and investment. Unlike individuals and businesses who see income as beyond their control, the government, following Keynesian principles, can step in when demand falters. By increasing fiscal spending and liquidity, it can generate demand where the private sector won't, matching purchasing power with the willingness to spend.

Xu argues that the real limit on stimulus isn't money supply—it's supply capacity. Rising inflation and trade deficits mean domestic supply can't keep up with demand, making further stimulus risky. But when inflation is low and there's a trade surplus, it signals excess supply, making stimulus "not only feasible but also essential."

All footnotes are by Mr. Xu, who has kindly reviewed our translation.

刺激政策的是非之辩

Stimulus, Right or Wrong?

The consensus on China's economic situation indicates significant pressure and notable risks of demand contraction and sluggish growth. However, there is disagreement on using stimulus to revive growth, with opinions split on its effectiveness, sustainability, and the balance of long- and short-term costs and benefits. As a result, stimulus measures face implementation challenges and are typically introduced only as much as economic pressure demands, akin to "squeezing toothpaste." This causes policies to lag behind changing conditions, significantly diminishing their effectiveness.

To improve the government's ability to manage macroeconomic operations and enhance policy foresight and effectiveness, a thorough analysis of the costs, benefits, and trade-offs of stimulus measures is essential to clarify and address concerns surrounding policy stimulus and then foster a broader consensus. This essay aims to apply macroeconomic thinking to analyze the constraints of stimulus measures in-depth, explore key issues such as the effectiveness and sustainability of policies, and provide a clearer understanding of the pros and cons of stimulus measures.

I. Evaluating Macroeconomic Policies from a Macroeconomic Perspective

Macroeconomic policy assessment cannot be conducted on a policy-by-policy basis but must be evaluated within the context of the broader macro environment. The same policy can yield entirely different outcomes depending on the macroeconomic conditions. In one environment, the benefits of a policy may outweigh its drawbacks, while in another, the detriments could surpass the advantages. Due to complex feedback and transmission mechanisms, the implementation of macroeconomic policies often creates ripple effects, leading to divergent outcomes within the same policy framework. In different macro environments with different feedback and transmission mechanisms, the same policy can produce starkly different results. Evaluating policies without accounting for the macro environment risks repeating the mistake described in the traditional Chinese idiom, "marking the moving boat to locate a sword dropped overboard."

The principle above is not complicated but often obscured by individual experiences in micro life. While everyone lives within the macroeconomy and forms some understanding of economic dynamics based on their own position, these micro-level perspectives, even when widely shared as "common sense," may not fully grasp the operation of the macroeconomy. Using micro-thinking based on personal experience to understand the macroeconomy and evaluate macro policies—whether stimulative or contractionary—can easily result in bias and misunderstanding.

Nobel Prize laureate in Economics, Paul Krugman, neatly addressed this issue in his 2014 article titled "Business vs. Economics,"

"A country is not a company. National economic policy, even in small countries, needs to take into account kinds of feedback that rarely matter in business life. For example, even the biggest corporations sell only a small fraction of what they make to their own workers, whereas even very small countries mostly sell goods and services to themselves."

Krugman was critiquing the misconception that macroeconomics can be understood through the lens of a micro-level corporation. Microeconomic entities, whether businesses or individuals, operate within an external economic environment they cannot control and must accept passively. Even for large corporations, their impact on the overall macroeconomy is negligible. As a result, when micro entities make decisions, they neither do not or rather should not consider how their actions might influence the broader economic environment. Corporations, therefore, view their income as an exogenous variable, beyond their control, and determined by the economic environment in which they operate. Consequently, they base their expenditure decisions on their income. This principle is even more applicable to individuals, who have even less influence on the macro environment.

When discussing macroeconomic policy, many people emphasize the policy space, arguing that policymakers should not exhaust their "ammunition." This perspective reflects a microeconomic mindset that mistakenly interprets macroeconomics through the lens of corporations. The subtext is that policy "ammunition" is a finite resource that diminishes with use, so it should be saved; depleting this "ammunition" could hinder the ability to sustain policies and potentially create problems. While this statement may appear sensible, it fundamentally misunderstands the dynamics of macroeconomic systems.

As Paul Krugman noted, "Even very small countries mostly sell goods and services to themselves." This suggests that, in a macroeconomy, expenditure roughly equals income and also influences it, sustaining a feedback effect between the two. Thus, when discussing macroeconomic policy, it is crucial to recognize that a country's economic environment is largely self-determined, making it an endogenous variable that can be adjusted by macro policies.

The government, as the key architect of macroeconomic policy, must recognize that its spending directly impacts private income. Adjustments in government spending influence the level of private sector activity, which, in turn, affects government revenues. For the government, revenue is "endogenous," shaped by its own actions, in sharp contrast to the situation where individuals and businesses view their income as "exogenously given"—beyond their control.

Therefore, the "live within your means" principle, which is sound for microeconomic entities, can be problematic when applied to macroeconomic policy. When the macroeconomy slumps due to insufficient demand, a government that lives within its means and cuts fiscal spending because of falling revenues will further depress private income and spending, risking a revenue decrease. In this way, the pressure of economic contraction will continue to be transmitted and amplified between government spending and income, resulting in a macroeconomic quagmire.

In such situations, the government should not "live within its means" but adopt counter-cyclical measures, increasing private income and stimulating spending by expanding fiscal expenditure, thereby breaking the vicious cycle of economic contraction. For those familiar only with microeconomic principles, even successful businesspeople, this correct policy response may seem counterintuitive or contrary to conventional wisdom. This is why Krugman observed that "business leaders often give remarkably bad economic advice."

Applying macroeconomic thinking to stimulus measures reveals that the same policy can produce different effects depending on different macro environments.

Again, consider fiscal spending as an example.

In a macro environment with insufficient demand and excess supply, involuntary unemployment tends to arise. In such cases, expanding fiscal spending—where the government spends more money to buy goods and services—can help unemployed workers find jobs. When these workers gain employment and income, their spending rises, enabling more unemployed people to find jobs and earn income. Fiscal stimulus, therefore, boosts private sector income and spending, triggers a "multiplier effect", relieves the pressure of insufficient demand, and drives economic growth. More robust private sector activity can also lead to higher tax revenues, enhancing the sustainability of fiscal stimulus measures.

However, in a macro environment with excess demand and insufficient supply, fiscal stimulus can produce different results. By this stage, the economy has likely reached full employment, with workers fully engaged in their tasks. If fiscal spending expands further, workers must shift from their planned tasks to meet the increased demand for goods and services driven by government spending.

In this scenario, fiscal stimulus does not significantly increase the total workload or income of the private sector, but rather redirects labor from private demand to public sector projects, changing the job content. As a result, fiscal stimulus crowds out private demand rather than boosting it, leading to minimal expansion of aggregate demand and limited improvement in overall economic activity. Consequently, government revenues are unlikely to rise significantly, and the fiscal stimulus may add to public debt without delivering substantial economic benefits.¹

Apparently, in macro environments with insufficient and excess demand, fiscal stimulus is beneficial in the former and undesirable in the latter. This example demonstrates that broad generalizations about the effectiveness and necessity of stimulus measures are unhelpful without considering the specific macroeconomic context.

Of course, outright opposition to stimulus measures is likely held by a minority. Even without macroeconomic thinking, it is evident that during economic downturns, stimulus tends to produce positive effects in the short term. However, what concerns most people is the sustainability of such measures. Many believe that while stimulus measures may offer positive effects in the short term, they could impose greater economic costs in the long term. In other words, there is widespread concern that, the negatives of stimulus measures may outweigh the positives from a long perspective. This concern is the main reason why many people oppose policies that lead to debt growth, such as larger fiscal deficits and increased bond issuance. The sustainability of stimulus measures will be the focus of the following discussion, starting with the demand-side nature of stimulus.

II. Stimulus Measures are Demand-Side Policies

Any economic activity is the result of the combined influence of supply and demand factors, and macroeconomic operation is no exception. Constraints on macroeconomic growth can arise from either the supply side or the demand side. Consequently, macro policies aimed at promoting growth can target either the supply side (supply-side policies) of the economy or the demand side (demand-side policies). Among the two, only demand can typically be stimulated quickly through policy. As a result, when people refer to stimulus measures, they are usually talking about demand-side policies.

An economy's supply capacity is primarily determined by input factors such as labor, capital, and technology, which are difficult to expand rapidly. These factors can only be gradually increased through sustained accumulation and cannot be significantly accelerated by macroeconomic policies in the short run. Therefore, even when an economy faces supply-side constraints, there is little discussion about stimulating supply directly. This isn't due to a lack of desire to boost production capacity, but because production capacity cannot be rapidly increased through stimulus. If, for instance, macro policies could rapidly stimulate China's high-end "choke point" chip production capacity, there would likely be no domestic opposition to such efforts.

As a result, supply-side macro policies tend to be more structural, focusing on creating an environment that fosters the gradual expansion of input factors and technological progress, thereby promoting their natural development.

When an economy faces insufficient demand, on the other hand, macro policies can be employed to stimulate demand in the short term. To understand why demand can be expanded so quickly through policy, it's important to recognize that "demand" in macroeconomic terms is backed by purchasing power, which refers to "effective demand"—demand that is realized through actual market transactions, not just the spending desires of various economic entities.

A country's total output equals its total income, which essentially represents its total purchasing power. Thus, a country always has enough purchasing power to buy its total output. However, this purchasing power is distributed across different economic entities based on the country's income distribution structure. When combined with the spending preferences of these entities, it forms the country's total effective demand. If there is a problem in the income distribution structure, the resulting effective demand—after accounting for both purchasing power and spending desires—may fall short of the economy's supply capacity, leading to insufficient demand.

In the article "China's Insufficient Domestic Demand Stems from Income Distribution Problems" published on August 29, 2023 [A shortened English version titled "Better Income Distribution Can Create Demand" was published in China Daily on September 11, 2023], I have argued that China's insufficient domestic demand arises from flawed income distribution between the household and corporate sectors. Essentially, the low share of household income in the national total creates a mismatch between purchasing power and the willingness to consume—the household sector faces insufficient purchasing power, while the corporate sector lacks spending desires. In such situations, macro policies can better align purchasing power with spending desires, thereby quickly stimulating effective demand.

Thus, the concept of "insufficient effective demand" forms the theoretical basis for stimulus measures. In 1936, John Maynard Keynes, the founder of modern macroeconomics, introduced this idea in his landmark work The General Theory of Employment, Interest and Money. In Chapter 3 of Book I, titled "The Principle of Effective Demand," Keynes writes:

"The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand... It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away."

The Great Depression of 1929 provided a lesson for Keynes and many of his contemporaries, making them acutely aware of the dangers posed by "insufficient effective demand." This realization led to the development of a macro policy framework centered on demand management. Today's macroeconomics is based on Keynes's insights.

If the economy operated in an optimal state, as envisioned by optimists (where markets function efficiently), purchasing power and the willingness to spend would naturally align, enabling effective demand to match supply capacity. In such a scenario, demand-side stimulus measures would be both unnecessary and ineffective—unnecessary because there would be no issue of insufficient effective demand, and ineffective because, under these conditions, effective demand would already be limited by purchasing power, leaving no room for further expansion. This point will be explored in the following analysis.

However, the real world is not always optimal, and situations of insufficient effective demand are common. In such cases, demand-side stimulus can act as a feasible and necessary corrective measure for market failure. When effective demand falls short, the government can step in as a direct purchaser in the real economy, expanding its fiscal spending to create effective demand, compensating for the private sector's lack of willingness to spend. Simultaneously, monetary policy can increase liquidity in financial markets, directing more purchasing power to entities with a stronger inclination to consume. By aligning purchasing power with the willingness to spend, these policies can effectively boost effective demand. In the short term, such fiscal and monetary policies stimulate demand, promote economic growth, and improve the overall macro environment.

III. The Real Constraint on Stimulus Measures Lies in Supply Capacity

The real constraint on demand-side stimulus measures for a country lies in its supply capacity. This may go against the gut feeling many people have from their micro experience. When asked what limits a country's ability to implement demand-side stimulus, many might instinctively say currency (money). This partial perspective reflects the constraints faced by micro-entities like businesses or households, for whom spending is limited by the money they possess—once it's gone, no further purchases can be made without more income. However, a country whose currency is created by itself (through the country's financial system) can simply print more money should the currency run short. So the quantity of currency is not the real constraint on stimulus.

The constraint on demand-side stimulus measures is a country's supply capacity. When stimulus measures push domestic demand (consumption plus investment) beyond the country's supply capacity, they hit a hard limit. At this point, further stimulus becomes ineffective, because when domestic demand exceeds domestic supply capacity, demand-pull inflation is triggered. Prices rise rapidly, causing macroeconomic instability.

Of course, to avoid rising inflation, a country can turn to imports to compensate for domestic supply shortages. While this strategy may help control inflation, it inevitably leads to a trade deficit, which increases the country's external debt. After all, foreign countries do not provide goods for free, and the trade deficit must be bought by foreign debts, usually paid in international hard currency (usually the U.S. dollar). Countries other than the United States cannot print dollars when they run out. Once a nation depletes its reserves of hard currency, it risks a balance of payments crisis, which can lead to a sharp depreciation of its domestic currency and a severe blow to the domestic economy. The 1997 Asian Financial Crisis is an example of a balance of payments crisis faced by Southeast Asian countries, with its serious consequences widely recognized.²

Therefore, when a country's demand surpasses its supply capacity, it is bound to face rising inflation or a worsening balance of payments (trade deficit). Either outcome destabilizes the macroeconomy and risks triggering a crisis. With the economy on such a precarious path, demand-side stimulus is naturally no longer a viable option.

To assess whether stimulus measures have hit a bottleneck, it is crucial to monitor two key indicators: inflation and trade balance. Rising inflation and trade deficits signal that domestic supply is insufficient to meet demand, and further stimulus would only intensify inflationary pressures and increase external debt, further destabilizing the macroeconomy. Conversely, when inflation is low (or deflationary) and there is a trade surplus, it indicates that domestic supply exceeds demand. In such cases, stimulus measures are not only feasible but also essential.

A country's supply capacity acts as a constraint on demand-side stimulus measures including fiscal and monetary tools. Let's start with fiscal policy.

An expansionary fiscal policy usually results in a larger fiscal deficit, either through increased government spending or voluntary cuts in revenue (e.g., tax cuts). Fiscal deficits are typically covered by the issuance of national bonds. In other words, if revenue exceeds spending, the government must borrow to pay for the overspending.

When a country faces overcapacity and insufficient effective demand, it indicates that not all of the domestic economy's total income (purchasing power) is being spent, leaving part of it idle. In this situation, society's total purchasing power has not been fully converted into purchases, resulting in effective demand falling short of the economy's full production capacity, which is the source of total purchasing power.

In such circumstances, when the government borrows to expand the fiscal deficit, it effectively taps into this unused purchasing power, channels it through fiscal spending, and converts it into effective demand. This helps to utilize idle production capacity and provide employment opportunities for involuntarily unemployed workers. Therefore, fiscal policy in this context can alleviate the problem of insufficient demand and improve overall economic conditions.

A fiscal deficit inevitably increases government debt. However, in countries with overcapacity, there are already excessive savings (idle purchasing power that has not been converted into purchases) resulting from flawed income distribution. In such cases, the expansion of government debt helps correct these excessive savings, creating "domestic debt" with domestic creditors, ensuring the sustainability of government debt—one party is willing to sell, and the other party is willing the buy.

However, if the country is in a situation of insufficient supply and excessive demand, fiscal deficits will become difficult to sustain for two key reasons. First, increased fiscal spending will directly fuel inflation, getting it out of control. Second, with the private sector already fully converting its purchasing power into spending, there are no accumulated excessive savings. This forces the government to rely on borrowing from foreign creditors. Foreign debt, especially when it must be repaid in international hard currency, imposes a tight constraint. Accumulating too much foreign debt increases the risk of a balance of payments crisis. Therefore, under conditions of insufficient production capacity, fiscal stimulus destabilizes the economy and renders it unsustainable.

Now, let's focus on monetary policy.

Monetary expansion manifests as a faster increase in the monetary aggregates. However, it is crucial to clarify that in a modern monetary system, while a country's financial system can create "nominal money" from nothing, the "real purchasing power" of that money is not something the financial system—including the central bank—can generate. Real purchasing power can only be determined by the actual performance of the real economy. In other words, a country's financial system can print money, but whether that money can buy things is not up to the system.

In the article titled "The Fallacy of Excessive Money Printing Should be Put to Rest," published on September 15, 2021, I argued that the consistently faster growth of China's nominal money supply compared to nominal GDP growth, along with the continuous rise in the M2/GDP ratio, is primarily due to China's high savings rate. A significant portion of savings from the real economy accumulates in the financial system as bank deposits (calculated in the money supply), driving the long-term faster growth of nominal money supply relative to nominal GDP.

In countries with excessive supply and insufficient demand, the real purchasing power that corresponds to the nominal money supply has not been fully converted into spending, leading to effective demand being lower than the country's supply capacity. In such cases, increasing the monetary supply can stimulate spending by economic entities whose purchasing power has been constrained, thereby expanding effective demand and using idle production capacity. Additionally, since the purchasing power of the existing money supply has not been fully utilized, an increase in the money supply will not trigger higher inflation, allowing loose monetary policy to be sustained.³

In contrast, in countries with insufficient supply and excessive demand, the existing nominal money supply has already been fully converted into effective demand (hence the excess demand). At this point, if more money is issued, the purchases that this additional money produces will exacerbate the supply shortage in the economy, leading to heightened inflation and economic instability.

Both fiscal and monetary policies can only effectively stimulate the economy when excess supply exists. In such situations, stimulus measures can ease demand constraints that limit economic growth, expand output, and improve the economic outlook. Furthermore, at this stage, stimulus measures will not trigger negative side effects like inflation, instability, or a worsening balance of payments. However, when the economy is running short of capacity, demand-driven stimulus measures will intensify the pressure of supply shortages, worsening inflation or the balance of payments, causing the drawbacks to outweigh the benefits.

1. In fact, even when the economy is operating at full capacity, fiscal stimulus can still expand aggregate demand to some extent. This is because workers, already working at full capacity, can produce more output by working overtime. However, this would inevitably require paying higher wages, which would continue to drive up inflation and put the economy on a path toward unchecked inflation. This essay disregards this short-term effect because, even with this consideration, the conclusion remains the same: in a macro environment with excess demand, the drawbacks of fiscal stimulus outweigh the benefits.

2. As the issuer of the international reserve currency, the United States can borrow foreign debt in its own currency (the U.S. dollar). This makes the U.S. the only country capable of running large and sustained trade deficits without triggering a balance of payments crisis—because it can always print money to repay its foreign debt. Between 2000 and 2023, the U.S. accumulated a staggering $13 trillion current account deficit. This is the "exorbitant privilege" that the U.S. derives from the dollar. However, this privilege is not available to countries outside the U.S.

3. Under the modern fiat currency system, while nominal money can be created out of thin air by central banks and commercial banks, its real purchasing power is determined by the real economy. When analyzing monetary and financial phenomena, it is essential to pierce the currency veil and focus on the functioning of the real economy behind it. However, the task of thoroughly explaining the connection between monetary finance and the real economy is beyond the scope of this article and will only be briefly mentioned here. The author plans to write a separate article to analyze this important issue in the future.

Xu Gao says China must not delay stimulus to its economy