This post is a sort of response to a recent post by Tyler Cowen, which was skeptical of whether the “nominal AD” shock model could provide an adequate explanation of our current crisis.  To explore this issue I would like to start by asking what a pure nominal shock would look like.

Let’s suppose that the economy is in equilibrium at the natural rate of unemployment, and suddenly the Fed tightens monetary policy enough to reduce NGDP growth about 8% below trend.  Also assume wages are sticky.  What would happen?   The answer depends on the structure of the economy.  If all output is one all-purpose good, output of that good might fall modestly, and prices might decline as well.  The total decline in real output and prices would be 8%.

Does this look like our current situation?  Obviously not.  Some industries have suffered severe declines while other have hardly been touched.  Does this mean that we need a sectoral explanation of the current recession?  No, rather we need need to account for the existence of capital goods, consumer durables, and services.  And we need to recall that the permanent income hypothesis predicts that during a recession there will be a sharp decline in capital investment and consumer durables, whereas the output of food, clothing, and many services will decline by a relatively small amount.  If you had a sharp but temporary decline in your income, would you cut back more sharply on consumption of food, haircuts, or purchases of new cars?  The answer is obvious.  And that is why a pure nominal shock will produce massive sectoral shifts, even if in the absence of a nominal shock the economy needed no sectoral adjustments at all.

Now let’s return to the original assumption that the nominal shock came out of the blue.  How likely does that seem?  In my view monetary policy shocks are not arbitrarily produced by central bankers, but rather reflect a flawed monetary policy process that puts too much emphasis on interest rates as an “instrument” of policy (actually short run target), and inflation stabilization as the goal.  As you know, I favor using NGDP futures as the “instrument,” and expected NGDP as the goal variable.

The monetary policy process suffers from two flaws.  If there is an autonomous decline in the Wicksellian equilibrium interest rate (the rate consistent with macro equilibrium) and the Fed keeps its target rate constant (as it did throughout much of 2008) then NGDP growth expectations may plummet.  This can cause a recession.

A second problem occurs if there is a severe oil shock during a period when NGDP growth falls below trend.  If the central banks focuses on headline inflation instead of NGDP, they may tighten policy, or refrain from cutting the target rate when needed.  This also occurred in mid-2008.

When both of these errors occur at the same time you can have a severe recession.  Just to be clear, here I am only trying to explain the severe recession that began in mid-2008.  So let’s go back and look at the early stages of the recession, the first half of 2008.  There were three problems:

1.  A sectoral shift out of housing and related activities that had been occurring since mid-2006.  This sort of sectoral shift did not and typically does not cause a recession.

2.  A severe energy shock began to develop in 2007 and worsened in early 2008.  This type of shock will hurt energy intensive industries, but will not generally cause a recession.  Most economists were not predicting any sort of severe recession as of mid-2008, despite the fact that they already knew of the sub-prime fiasco and the $147 oil.

3.  In the first half of 2008 there was a mild AD shock, as NGDP growth slowed from its usual 5% down to below 3%.  Even the combination of all three shocks was not able to produce a major rise in unemployment, nor did most economists expect a major rise in the future, despite the fact that they knew about all three problems.  Let’s just stand back and marvel for a moment at the astounding resilience of the US economy.  It takes three hammer blows and it is still standing.

But then in just a few months it all started to unravel.  The culprit?  Something as seemingly innocuous as a decline in NGDP caused by the sort of flaws in our monetary system described earlier.  In other words these massive real shocks did relatively little damage to our economy (or our financial system for that matter) but as soon as M*V started falling everything fell apart.  What can explain this?  Any principles of macro text can explain what happens when NGDP falls.  I prefer texts like Cowen and Tabarrok, which define AD growth as a given increase in NGDP.  Suppose NGDP growth falls 8% below trend.  Because wages are sticky, relatively few workers will get hourly wage increases 8% below trend.  Instead, three things will happen:  Profits will fall sharply, bonuses will fall sharply, and hours worked will fall sharply.

What makes macro so endlessly fascinating is that the none of this will appear to have been caused by the factors I describe.  Even in an economy with only one good, no one can “see” a fall in M*V, so it will appear that some other mysterious factor will have caused the recession.  But in an economy with heterogenoeous goods and sticky wages my explanation will seem even more counterintuitive.  Some sectors (especially capital goods) will decline sharply.  Many prices will be relatively sticky, but asset prices will crash.  It will look like the wealth destroyed in the asset price crash and the sectoral shocks are the two prime causes of the recession.  But according to mainstream macro theory both are actually symptoms of falling nominal spending/income.

How could my hypothesis be disproved?  If the Fed pegs the price of NGDP futures and we continue to see events similar to what we observed in late 2008, then I’ll throw in the towel.

Where does policy go from here?  There is one additional problem.  Not only do real shocks such as financial turmoil and/or energy shocks often trigger bad monetary policy, but the resulting recession often leads to bad supply-side responses.  By far the worst example was the NIRA in July 1933.  But even in this recession we have a dramatic lengthening of the duration of unemployment benefits, from 26 weeks to as much as 73 weeks.  (I also recall reading that Obama planned to reverse Clinton’s welfare reform, but I haven’t followed the issue closely.)  In a normal recession workers who have exhausted unemployment benefits are more willing to accept any job at any wage rate.  This increase in labor supply puts downward pressure on wage rates. In the current recession wages have been stickier than in 1921, and thus the unemployment will be more prolonged.  FYI, 1921 was probably the purest nominal shock in American history.  It is worth studying intensively if you want to see what the AS/AD model purports to describe.

[As an aside, many people get confused when some workers accept big wage cuts and still get laid off.  The problem is that if you are in a highly cyclical industry, it is not enough that you accept wage cuts.  Instead, to prevent high unemployment in cyclical industries it is necessary for everyone in the economy to accept big wage cuts, even government workers.  I know people working for high tech firms who haven’t yet had any wage cuts in this recession.  We are far from the sort of wage flexibility required to make nominal shocks neutral, despite all the reports of wage cuts you might have read about.  And wage cuts mean cuts in hourly wage rates, not annual income.]

BTW, I hate the term “aggregate demand” as I have no idea what it means, and when I read other economists I immediately realize they mean something much different than I do.  I prefer to define AD as NGDP, an approach adopted in the new macro text by Cowen and Tabarrok.  But Cowen also recognizes that economists often mean something very different by ‘aggregate demand’ and thus discusses “real AD” shocks in his recent post:

If someone wants to insist that “this is really an AD shock, not a sectoral shift,” I’m not so keen on fighting to keep one term over the other.  I would insist, however, on an issue of substance, namely that not all AD shocks are alike.  If we are going to switch terminology, it could be said that this is a real AD shock and not just a nominal AD shock.  (Though there have been nominal AD shocks too.)  A nominal AD shock can be offset more easily by goosing up some mix of M and V and restoring the previous level of nominal demand.

Thus Tyler Cowen correctly observes that real AD shocks are essentially sectoral shocks.  Thus a fall in wealth may make people shift their consumption away from some goods and towards others.  It doesn’t make people want to work less, but I think both Tyler and I agree that during a transition period it causes frictional or structural unemployment that cannot easily be papered over by printing money.  Where we may disagree a bit is that I think the fall in wealth due to the sub-prime fiasco was not severe enough to cause even a small a recession, and the much bigger fall in wealth after mid-2008 was caused by sharply falling NGDP expectations—i.e. by a nominal shock.

Would reversing this nominal shock be able to reverse all the negative effects I described?  I can’t say for sure.  We have structural problems like extended unemployment benefits that we didn’t have in mid-2008.  But I still think it would do a lot of good.  More NGDP could help because asset prices are highly volatile and forward-looking, while nominal wage rates are very sticky.  A strong increase in 2011 NGDP expectations would sharply raise asset prices, but hardly budge current nominal wages (given 10% unemployment.)  This would boost employment and output.

Every day that goes by my preferred policy response becomes slightly less effective in reducing the problems we currently face.  But oddly a decision to “be irresponsible,” i.e. to have “excessive” NGDP growth in order to catch up to the 5% trend-line, would make it far less likely that NGDP growth expectations would collapse in the next crisis.  This time they collapsed because the markets guessed the Fed would not try to correct its error and return NGDP to the old trend line.  And as each day brings new stories of a Fed itching to tighten policy even as the fiscal authorities are contemplating new stimulus (a policy mix showing our government is approaching  “banana republic” level of incompetence) it becomes more and more evident that the bearish speculators of late 2008 were right—NGDP is going to stay on a new and permanently lower growth track.  There will be no nominal recovery.  And with the lengthened unemployment benefits the real recovery will take longer than normal.

PS.  This was a frustrating decade at times, and ended with me missing my flight home on the last day.  But at least humanity had its best decade ever, at least if you believe economic development and peace makes people happier.  So I guess I shouldn’t grumble.

My new year’s resolution?  How about full RSS feeds?  I have only a vague idea of what they are, but I’m told I should want one.  And that means I want one.

Happy New Year!

In a recent post, Bryan Caplan questioned my faith in markets as the best indicator of the impact of government economic policies:

Forbes provokes Sumner to don the robes of hanging judge for the hypocritical right:

“If Forbes is right, and the markets are made up by a bunch of fools, then why not go with socialism?”

.   .   .

His verdict rings true, but it reminds me of an earlier question that’s still bugging me: Why did financial markets like Nixon’s price controls so much?  What gives, Scott?  Was it just a random error, or what?

When you don’t have strong arguments, it is best to substitute quantity for quality, use some misdirection, and end up with an appeal to religious authority.  I’ll do all three.

I was only 15 when Nixon made his famous August 15th price controls announcement, so I apologize if my memory fails me on a few points.  But here is what I recall:

a.  Nixon installed a “temporary” wage/price freeze, which was to last for 90 days.  It was widely (and correctly) anticipated that this freeze would be followed by a period of looser controls.  It was also anticipated (correctly) that the weaker price controls would be easy for firms to evade.  Wage controls were the real issue, price controls provided political cover.

b.  Nixon pulled an FDR, and did an end run around the Fed by devaluing the dollar against gold by 10%.  This had the effect of devaluing the dollar against many other major currencies.  He also closed the gold window.

c.  He cut taxes.  I don’t recall exactly which ones, but I believe there were income tax cuts and a cut in excise taxes on cars.

1.  My first argument is that it is not clear that the positive stock market response was in reaction to the wage/price controls announcement.  The stimulus to AD was very impressive, and could explain at least part of the response.  Nevertheless, for two reasons I do not want to rely on this excuse.  First, because my hunch is that the stock market did welcome the wage/price controls, or at worst was neutral on them.  Furthermore, the monetary stimulus was probably unwarranted, as NGDP growth was adequate.  So what are some other possible reasons for the market reaction?

2.  Wage/price controls combined with monetary and fiscal stimulus were a very potent mixture, almost sure to benefit the economy in the short run, and boost the odds of Nixon’s re-election.  However the response of the markets was stronger than what one would expected from a mere increase in the probability of Nixon being re-elected.  (The stock market rises about 2% on a 100% increase in the odds of a Republican winning.)  And of course this argument would cut against my view that markets can tell us something about the wisdom of policy initiatives.

3.  At the time, the controls were viewed as a sort of “incomes policy,” a way of shifting the Philips curve to the left and making it easier to reduce inflation.  Some European countries were believed to have had success with this sort of policy, although the record was definitely mixed.  If you believe that nominal wages were above the optimal level in 1971, perhaps due to the strength of unions, then wage controls can actually improve the performance of the economy.  I recall reading that Hitler used wages controls to spur a rapid recovery in Germany after 1933, although I suppose Hitler is not someone I want on my side.  So let’s move on.

4.  Perhaps the wage controls combined with stimulus to AD were seen as a way of shifting income from labor to capital.  I am pretty sure that corporate profits did well for the next two years, although someone should check-double that.  In that case the market response might have been “rational” but again it would not support my argument that markets can tell us something about the wisdom of policy initiatives.

5.  Ex post, the wage/price controls were a significant error, but recall that the markets had no idea what was coming next.  They did not know that after 1973 productivity growth would slow sharply, causing monetary policy (which was excessively focused on real output and unemployment) to go off course and allow inflation to drift much higher.  And of course they had no idea that OPEC would drive energy prices much higher in 1973.  As far as I know, nothing like OPEC had ever been seen, at least at that scale of operation.  I do think that even under the best of assumptions the markets misjudged the Phillips Curve relationship in 1971, as did the vast majority of economists.  Which brings me to one of my strongest arguments.

6.  As far as I can recall most economists supported the wage/price controls.  This is important because this whole debate was motivated not by the question of whether markets are perfect, but rather whether they are better guides to policy effectiveness than the experts.  And in this case the experts were wrong as well.  So even in this 38 year old case, which admittedly looks very bad for EMH people like me, the experts seem to have done no better.

7.  My claim is that one should look at the response of real stock prices.  Usually the price level doesn’t change much from day to day, so a large rise in nominal stock prices translates into a large rise in real stock prices.  And that was also true on August 16, 1971.  But also note that US stock prices in terms of gold and foreign exchange fell sharply, as the 10% dollar devaluation was much bigger than the rise in the Dow (which I seem to recall was around 3% or 4%.) I really don’t have a good answer as to what to do in this sort of situation.  Obviously if the Fed suddenly announced a policy of hyperinflation, the nominal value of stocks would soar.  But that does not mean a policy of hyperinflation would be wise.  Because many prices are sticky in the short run, you have to be careful in interpreting the response of markets to nominal shocks.  Nevertheless, I stand by my previous discussion of market responses to policy in the Great Depression, and also in 2007-09.  I think the markets did correctly point out which monetary policies would be helpful, and which were woefully inadequate.

I suppose I should be flattered that Bryan had to go back 38 years to find an example where the markets clearly seemed to have blown it.  Especially since even in this example the experts did no better.  And I can find many more examples where the “experts” failed us.  I would also note that Bruce Bartlett made a similar comment (in my old blog), so apparently this example has become part of the folk wisdom that economists use when anyone cites market responses to policy to show that the “emperor has no clothes.”  But since when is a single anecdote enough to discredit an economic argument that has the virtue of being consistent with economic theory, especially given that dozens of anecdotes can be found to discredit the counterargument that experts are smarter than markets?

In fairness to Bryan Caplan and Bruce Bartlett, there may be many other such counterexamples, perhaps they simply chose the most famous example.  I admit that I was surprised by the seemingly positive market response to the Obama stimulus package, for instance.   At this point I am tempted to trot out a religious argument.  Recall how when someone mentions a particularly gruesome example of genocide committed by the “good guys” in the Old Testament, Christian fundamentalists will say something like; “The Lord moves in mysterious ways, we are not in position to second guess him.”  Don’t the Catholics also see this sort of  presumption as a sin?  Perhaps the same is true of market responses to policy announcements.  Maybe the markets thought the Obama stimulus package showed that the government was determined to avoid a depression, and that they would do whatever was necessary to boost AD.  Or that it would indirectly make monetary policy more stimulative, by increasing the money multiplier.  The stock market moves in mysterious ways, it is not for us free market believers to question its infinite wisdom.

Returning to reality (now that I have offended Protestants, Catholics and Jews), I suppose in the end my best defense of 1971 would be the following.  The markets correctly saw that 1972 was going to be a very good year.  I first heard of Arthur Laffer when he used the stock market to forecast NGDP growth in 1972; most other economists used econometric models.  Laffer forecast higher nominal growth that the others, and was right.  My hunch is that the stock market correctly understood that the stimulus would lead to higher NGDP over the next few years, which would justify higher nominal stock prices.  In addition, the wage controls would weaken the power of unions and allow this higher nominal growth to show up in higher profits.  They correctly understood that firms could evade the price controls and in any case most firms were monopolistic competitors and would like like nothing better than to have a slightly smaller price increase, but a much bigger market.  Ex post the market was wrong.  Nixon’s policy failed for all sorts of reasons; a misunderstanding of the Phillips Curve, a mistaken belief that the sort of incomes policies that were workable in small consensual societies like Austria could work in the US, bad luck with OPEC and crop failures, etc.  But I don’t think the market reaction was quite as irrational as it might seem in retrospect.  And again, most economists made similar mistakes at that time.

So how about the following:  We will not use market responses to directly evaluate whether a particular policy is good or bad.  Rather we will use markets to answer technical questions, such as how much inflation or NGDP growth we are likely to get next year and the year after.  Right now the TIPS market says we can expect just over 1% inflation for the next few years.  The political and economic right says inflation is a much bigger problem than unemployment.  Let’s revisit this question in two years and see who was right.

A recent post by Tyler Cowen discusses one possible reason why the Fed has refrained from setting a higher inflation target, despite the fact that many economists believe that doing so could boost AD.  The argument is that higher near-term inflation expectations would raise short term nominal rates, and cut into bank profits that are now earned by borrowing short at very low rates and lending long at higher rates.

I can’t say whether Tyler Cowen is correct that worry about bank profits may be a factor discouraging the major central banks from doing additional monetary stimulus.  But I haven’t seen any better explanations for their seemingly perverse behavior.  And I should add that Tyler has mixed feelings about the desirability of such a policy:

I also regard this as a somewhat gruesome hypothesis.  It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

I’d say it’s even worse—it isn’t even clear that this strategy would help the banking industry. I believe this “finance view” misses the most important factor influencing bank profits–the state of the macroeconomy.  Earlier this year the IMF lowered its estimate of the worldwide losses to banks from $4 trillion to $3.4 trillion.  The explanation was a slightly better than expected recovery in the world economy after March 2009.  The fact that a modestly better than expected macroeconomic outlook could shave $600 billion off expected banking losses is just one indication of how devastating the worldwide drop in AD was during late 2008 and early 2009.  It sharply reduced all sorts of asset values and severely damaged the financial system.  Indeed the damage was much worse than that from the earlier sub-prime fiasco.

If the sharp drop in AD had not occurred, i.e. if inflation had continued at its normal 2% to 3%, then the banking system would have survived the sub-prime crisis is much better shape.  Yes, banks may gain, ceteris paribus, from lower short-term nominal rates.  But in this case ceteris isn’t paribus.  The very thing that drove nominal rates to near-zero levels is the same thing that caused the bulk of the financial crisis.  And reversing that fall in AD would be a huge boon to the banking industry, even if nominal rates were higher as a result.  Put simply, in most cases when X is bad for an industry, then “opposite of X” is good for that industry.

[BTW, interest rates are often more closely related to the level of NGDP relative to trend, than the rate of change in NGDP.  So interest rates might remain fairly low even with a vigorous recovery in spending, at least until the economy got closer to full employment.  This pattern occurred in the 1930s.]

Here is a quotation from a recent article in Forbes:

China’s mercantilist trade policy is another contributor to its asset bubble. By artificially depressing the value of its currency and making it difficult for locals to invest abroad, China has forced an artificially large amount of capital to chase after domestic investments, inflating property and stock prices. It’s the same scenario China pursued in late 2007, before its stock market lost two-thirds of its value, but that era was characterized by monetary restraint compared with today.

“It’s a pure debt game,” says Andy Xie, an economist who advises private investors and sees the current bubble as “much worse than previous ones.”

In late November China’s ruling Politburo declared that the nation’s monetary and fiscal promiscuity will continue into 2010. The markets, predictably, were overjoyed. Economists who see parallels to the Russian and Brazilian financial crises a dozen years ago are less sanguine.

Let’s see if we can figure out Forbes’ agenda.  The 2007 policies of mercantilism blew up a big bubble.  And according to Forbes this somehow explains the sharp rise and fall of Chinese stock prices.  And what about the fact that stocks also rose and fell sharply in countries that did not pursue mercantilist policies?  No answer.  And why didn’t stocks stay high?  After all, they are still pursuing those policies, aren’t they?  Again, no answer.

And how about those “Economists who see parallels to the Russian and Brazilian financial crises a dozen years ago?”  Would those be the same economists who (as a whole) failed to predict the Russian and Brazilian crisis (and almost every other economic crisis in world history?)  To its credit, Forbes does admit that the record of economists is something less than perfect:

China naysayers have been wrong before. Gordon Chang, author of the 2001 book The Coming Collapse of China, has warned–wrongly, so far–that doom lies around the corner. Cushioning China’s economy is its high growth rate, an estimated $260 billion (but declining) annual current account surplus and, at $2.3 trillion, the world’s biggest foreign exchange reserve.

But the statement that really jumped out at me was “The markets, predictably, were overjoyed,” from the first passage I quoted.  Note how the statement is dripping with sarcasm.  You’d think it was uttered by someone like Paul Krugman.  But no, it was Forbes magazine, the self-styled “capitalist tool.”  With friends like Forbes capitalism hardly needs enemies.  If Forbes is right, and the markets are made up by a bunch of fools, then why not go with socialism?

Here’s what I think is really going on.  The right has a political agenda.  When the stock market agrees with that agenda, the Wall Street Journal and Forbes love to cite its response to policy initiatives.  For instance, in an earlier post I mentioned how the markets were strongly opposed to Smoot-Hawley, and seemed to favor NAFTA.  But when markets don’t agree with the right’s deflationary agenda, suddenly the markets are just as unreliable as a Marxist economist.

You might wonder how I can claim that conservatives favor deflation?  Well look at the sentence that preceded Forbes sarcastic dismissal of markets:

In late November China’s ruling Politburo declared that the nation’s monetary and fiscal promiscuity will continue into 2010.

That’s right, even though China has been in the grip of deflation over the past 12 months, Forbes characterizes their monetary policy as “promiscuous.”  If it were Playboy magazine that might be a compliment, but in context I am pretty sure Forbes is saying monetary policy is much too expansionary.

Of course this should be no surprise, as the right also thought monetary stimulus was excessive in the early 1930s, even as prices fell sharply.  In contrast, those foolish stock investors greeted FDR’s devaluation of the dollar with a huge rally.  And of course many voices on the right, some in Forbes itself, have leveled a steady drumbeat of criticism against the supposedly excessive monetary stimulus of the Bernanke Fed over the past 18 months.  And again, the markets don’t agree, rather they think that even more monetary stimulus would be helpful.  So what does the right do when the markets bring them the message that deflation is not helpful to capitalism, and instead just opens the door to left wing demagogues?  They don’t rethink their views.  Instead they blame the messenger.

BTW, I have no opinion on where Chinese stock or housing prices are headed.  China has always had dramatic ups and downs in its markets, and will continue to do so.  China’s overall economy will continue to grow rapidly, with occasional sharp recessions, as in 1990.  And just as in every previous recession and bear market, the majority of economists (including me) will fail to see it coming.  And as for “overbuilding,” Forbes ain’t seen nothing yet.  Over the next 30 years China will construct a mind-boggling amount of new residential and commercial buildings.  The comparisons with Japan circa 1990 are just plain silly.

After writing this post I came across two other stories that I thought were worth mentioning.  Today’s Wall Street Journal had a scary story about the current debt binge in China.  But it also contained a couple odd paragraphs that seemed to undercut their argument:

China’s banks used to be, in effect, lending arms of the government. That led to an enormous pile of nonperforming loans that, by the late 1990s, rendered most state banks technically insolvent. In response, Beijing stripped nearly $200 billion of rotten debt off the banks’ books and injected tens of billions of dollars more in capital. It also pushed the banks to adopt risk-based lending systems, an effort that made major progress in recent years.

But with the economic downturn last year, Beijing told banks to open the credit floodgates. About a quarter of new loans in the first nine months of the year went into infrastructure, but riskier manufacturing and property investments accounted for about 5% each.

So the previous loan fiasco of the late 1990s led to a $200 billion dollar bailout, and was followed by an enormous economic boom.  Is that so bad?  And will this debt binge be any different?  One other question for any China experts reading this: Are those 5% figures misprints?  Most of the bubble fears seem related to manufacturing overcapacity and a possible housing bubble.  Almost no one thinks China doesn’t need more infrastructure.

Take a look at this link I found on marginalrevolution.  In 1994 I took a train to Wuhan—it wasn’t a pleasant trip.  They just opened a new 700 mile line between Wuhan and Guangzhou—three hours by train and nearly the distance between NYC and Chicago.    Check out all the train stations pictured.  Almost every single one is located in an inland city, the ones that American journalists are always telling us are missing out on the great coastal boom.  Actually, many of those inland provinces are now growing faster than coastal provinces, and will continue to do so (albeit from a lower base.)

PS.  Speaking of China, I got a lot of grief for arguing that the Chinese weak yuan policy helped China recover after March 2009, and that this also helped the world economy.  This year’s Chinese trade surplus fell sharply from $295b to $198b, but mostly due to lower Chinese exports.  Check out Bloomberg’s prediction for 2010, and the forces that will drive the Chinese trade surplus still lower:

Bloomberg) “” China’s trade surplus may slide 19 percent in 2010 as imports surge because of growing domestic demand, Bank of America-Merrill Lynch said.

The amount will narrow to $160 billion from an estimated $198 billion this year, Lu Ting, a Hong Kong-based economist for Merrill, said in an interview today.

A smaller surplus may reduce friction between China, which is poised to become the world’s biggest exporter, and its major trading partners, the commerce ministry said Dec. 16. Disputes with the U.S. or Europe span shoes, tires, screws and the Obama administration’s complaint this week that Chinese plans to foster “indigenous innovation” are erecting a trade barrier.

“The key factor in the narrowing of the surplus will be the increase in imports, driven by rising domestic demand,” Lu said. In 2010, imports may climb 16 percent, outpacing a 9 percent gain in exports, he added, forecasting an economic expansion of 10.1 percent.

Another 16% increase in imports as China continues its “mercantilist” policies.

And then there is this story from today’s Wall Street Journal:

Could a solution to Japan’s economic malaise be just across the East China Sea? While China is a growing rival to Japan, it also looks like one of the best routes to lift Japan out of its malaise.

Already, in 2009, China has displaced the U.S. as the largest overall buyer of Japanese goods, including its top exports: machinery, and electronic goods and parts. It now accounts for nearly one-fifth of Japan’s exports by value.

Being more closely tied to fast-growing China is certainly a welcome development for Japan’s export-reliant economy, which shrank to 2004 levels in the recent financial crisis. Some uncommonly upbeat reports from Japan reflect the shift. Exports to China jumped almost 8% in November from a year earlier, the first increase since September 2008. Those to the U.S., meanwhile, fell by about the same percentage.

UBS estimated earlier this year that a 10% increase in exports to China would add about 0.2 percentage point to Japan’s annual economic growth. Marginal? Not for an economy that has averaged only a bit more than 1% annual growth in the past decade.

To summarize, I keep hammering away at two big China myths.  The weak yuan does not hurt the world economy, and thus shouldn’t be discouraged.  And China is not a bubble.  China may contain all sorts of bubbles (certain property sectors, SOE investment) but China isn’t a bubble.  It is a huge growth story that is slowly but surely getting better governance.

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