What Can We Really Learn From Estonia?

S&P Downgrade of U.S. and Upgrade of Estonia Inspires Misguided Admiration

In the wake of a few recent S&P decisions, fans of budget cuts are practically waving the Estonian flag. They point to Estonia's recent austerity measures and it's Q1 2011 growth as some sort of vindication. "Look, look ... we've got a positive example!" Ah, but if only it were that simple. There's more to Estonia's austerity and growth than meets the eye of the starve the beast crowd who would have us emulate their example. Estonia chose "internal devaluation," including wage cuts. So keep in mind what following the Estonian script would mean: big wage-cuts and a lower standard of living. Who really wants to sign up for that?

But more importantly, one should take a closer look at the impact on the Estonian economy before declaring them a model that everyone should copy. I'd swallow some short-term pain if it made the overall situation better for my country in the long run. But in the case of Estonia, the trouble didn't entirely end with the turn-around from the -13.9% plummeting GDP in 2009 to the 1.8% growth in 2010 and varying more-or-less positive growth forecasts for their future. While Estonia has returned to GDP growth, they're doing so on the backs of their neighbors. The one bright-spot in their economy is exports, which were up 43% from a year earlier in June. (Although June's figures showed a drop from the previous month.) Their unemployment remains high. Their retail sales and non-govt construction are both still down significantly. The domestic market isn't looking so good there. But in Sweden, Russia, and Finland demand is rising. All three of Estonia's biggest foreign markets saw significantly higher GDP growth in 2010 than Estonia. The strong growth continues in Sweden in particular ... plenty to explain why Estonian producers have still had a market in the face of lower internal demand. Having growing trading partners is great. But in the long run it's a poor substitute for steady internal demand. Estonia's internal devaluation has made them even more dependent on their neighbors. Should the growth in Sweden, Finland, and Russia cease or even slow down significantly, Estonia could find itself in deep trouble with no fuel for its economy. That sort of dependence on -- and vulnerability to -- foreign trade partners has lots of drawbacks. Sacrificing domestic demand to gain foreign demand means a weakened domestic economy.

So what can we really learn from Estonia? Mainly that it's good to have trading partners who have money to spend on what you're making. That's not a lever we (or anyone else) can control. It's up to our trading partners to keep their economies moving. Aside from maybe lending the occasional wrench, we can only look to get our own engine revving again. But we can also learn that worrying too much about increasing our exports can cause a nation to become export dependent -- at the mercy of the whims of foreign markets. While that may be nice when those markets are thriving, do we really want to count on them completely and make ourselves export dependent? Wouldn't you rather we fixed our domestic shortage of demand instead of sacrificing what's left of it in the vague hope for an uncertain boost to exports?

Debunking Subramanian: No, China Isn't Bigger

Tom Gjelten of NPR in a piece asking "Is China's Economy Already No. 1?" tells us that "By traditional measures of gross domestic product — the value, in U.S. dollars, of total goods and services produced — the size of the U.S. economy is $14.6 trillion. China's GDP is only $5.7 trillion. But if China's economy is assessed according to its "purchasing power," it may be a different story." He further relates how Arvind Subramanian tells us that by purchasing power, their economy is already larger.

But this isn't just in conflict with tradition. Purchasing power parity (PPP) is mainly useful for assessing living standards because it adjusts for the costs of selected goods within a currency's market area. PPP gives a better sense of how many bowls of rice the average Chinese citizen can buy with their Renminbi vs how many bowls the average American can buy with our Dollar. The strength of PPP comes as a per capita measure on internal purchases. For 2010 the IMF rated per capita PPP of China at 7,518 International Dollars whereas the per capita PPP of the US is 47,123 International Dollars. So we can see that the average American can buy a lot more bowls of rice (or most anything else) in America than the average Chinese citizen can buy in China. By contrast, when they're both touring Germany, if you want some idea what the Chinese citizen can buy there vs what the American can buy there, PPP won't help you as much as GDP because their PPP figures aren't tuned for Germany's market. For international buying, you need to use the actual exchange rates, which means you want the GDP because it is listed using those very same exchange rates that would take effect for international purchases. Anyone (like Subramanian) who'd use PPP as an assessment of "the bigger economy" internationally should generally be considered dubious at best. There are good reasons why it is traditional to use GDP to compare the size of national economies. When you're looking at the ability to purchase outside of your own market, it just doesn't make sense to use a figure tuned to purchasing strictly within your own market.

If that weren't enough, by all accounts other than Subramanian, his assessment of Chinese PPP is bizarrely high. While the IMF, World Bank, and CIA World Factbook all come up with slightly different calculation results from each other, they're only slightly different from each other and way, way below what Subramanian claims. They all list China below the US in PPP by a fairly wide margin.

Then, for icing on the cake, there are the very big problems in China, such as the housing bubble mentioned in Gjelten's article. Their growth is currently on a trajectory to overtake us. But past results do not guarantee future performance. China is likely to generally grow over the coming decades, but they may face some serious stumbles and possible huge crashes as well. And while we're not doing it now, if we were to start revamping our infrastructure and investing more in our own growth, we could actually use our head start to keep our advantage. Not that we necessarily will. But it is a bit premature to say that China's economy will necessarily eclipse our economy at any point in the future. It may. It seems plausible that it will. It isn't guaranteed.

China Doesn't Own Us

Intertwined

With the visit of the Chinese President, Hu JinTao, there's a lot of talk about the amount of our debt that China has financed. Paul R. La Monica, writing for CNNMoney.com, even proclaims "Let's face it. China is kind of like our landlord. Or, if you prefer a more menacing term, our loan shark. We should tread carefully."

The reports of the death of America's financial strength are greatly exaggerated. Yet they're widely believed. According to a Pew poll, nearly half of Americans "see China as the world’s leading economic power." That's a pretty stunning belief when you consider that as of the 2010 IMF figures, the GDP of the US is still higher than that of the next three largest economies combined (14.6 trillion for the U.S.A. vs 14.4 trillion for the combination of China, Japan, and Germany).

So how did a much smaller economy get such a hold over the top mover & shaker? It didn't. According to the Treasury, our total public debt stands a $14.008 trillion. Of that, "intra-governmental holdings" account for about a third at $4.631 trillion. Intra-governmental holdings are the govt writing an IOU to itself from to borrow from all sorts of trust funds and other places where it had money set aside. That portion certainly isn't held by China. The Federal Reserve, various domestic investors (pension funds, mutual funds, etc.), state and local governments, banks, insurance companies, and various other U.S. interests together own large portions of the debt. China only own about $895.6 billion in our debt. Yes, I said "only." That's a large figure to you and me, but it's quite a bit less than is held by our govt lending to itself. It's not all that much more than the amount held by pension funds. It's not all that much more than the amount held by mutual funds. It's not all that much more than the amount held by our state and local governments. It's not all that much more than the amount held by the combination of banks and insurance companies. Lot's of domestic groupings each hold comparable amounts, some more and some less. It's barely more than is held by Japan. It's around 6% of our debt.

At 6% of our debt, that's not ownership. That's not an overwhelming landlord. It's not even a loan shark. Yes, they're a significant lender for us. But they don't have a controlling stake.

Meanwhile, our imports account for about 25% of their exports. And their economy is still largely export driven. If we put strict controls on imports from China it would severely hurt their economy. Strict controls interfering with their exports to the US might well hurt their economy even more than it would hurt ours if they suddenly started dumping our debt. But, of course, they're not about to do that, since much of their cash is tied up in our debt. If they were to sell it quickly, they'd lose a lot of their value from their cash reserves. And where would they put it anyway? The crisis-prone Euro? Not if they've got any sense.

To ice the cake, as David Frum says, it's "a country facing problems as huge as its achievements." They're battling rapid inflation. Their aging workforce situation over the next couple decades may well make our Baby Boomer retirement hurdle look like child's play. And there's been talk of a growing housing bubble in China that may dwarf our Great Recession housing market trouble.

All of this means that China is at least as tied to us as we are to them. They've developed an important relationship with us ... important for both nations. They don't own us.