Trading Places: China's Misdirected Consumer Stimulus

China's trade-in stimulus is an oxymoron — it rearrages replacement demand rather than creates a new stimulus to a floundering Chinese economy.

Stimulating household consumption is now the top priority for Chinese policymakers. As well it should be. That was a key conclusion that came out of December’s CCP Central Economic Work Conference, a focus that is well justified by the current state of play in the Chinese economy. The property sector is under protracted downward pressure, export demand is facing a new round of protectionism, and deflationary forces are building — all of which are leaving a struggling Chinese economy in serious need of a new source of growth. With household consumption consistently accounting for less than 40% of Chinese GDP, well below the norms of other major economies, a consumer stimulus appears to be a no-brainer.

Unfortunately, China’s current approach to tapping such an impetus is unlikely to succeed. The main feature of the current pro-consumption policy stimulus is a so-called trade-in campaign — in effect, price concessions (in the form of subsidies or rebates) to replace older goods with newer ones. This program does not create any new net demand. Instead, the goal is “freshen up” the existing stock of consumer durables. Motor vehicles trade-ins were initially featured, soon to be followed by an increasingly wide range of household appliances such as microwave ovens, water purifiers, dishwashers, and rice cookers. While other pro-consumption actions have been announced — wage increases for government workers and increased subsidies for digital purchases for cellphones, tablet computers and smart watches — the durable goods trade-in campaign has received the greatest attention by Beijing policymakers.

This is a familiar script — not just for China but also for other countries. It was tried recently in the United States in the form of an ill-fated cash-for-clunkers program that failed to stimulate sagging US consumer demand in 2009. The concept of the trade-in stimulus is largely an oxymoron — it accelerates replacement demand for relatively long-lived, or durables, goods. It is, at best, a short-term boost — a stimulus that simply brings forward replacement demand that would have occurred in any case at a later point in time as durables either wear out or become obsolete. Yet once that artificially induced stimulus occurs, a payback almost automatically happens, as the normally scheduled replacement demand has been cannibalized by the accelerated trade-in. A trade-in stimulus basically rearranges demand — it provides a short-term boost that, in effect, trades places with future, previously scheduled, replacement demand.

That’s exactly what happened in the US when the Obama Administration attempted this sleight-of-hand in the immediate aftermath of the Global Financial Crisis. As can be seen in the figure below, following a crisis-induced collapse of vehicles sales in late 2008 and the first half of 2009, the cash-for-clunkers incentive was put in place in July 2009 — intended not just to provide an immediate boost to a crisis-impaired US economy but also to replace emissions-intensive vehicles (the clunkers) with more fuel-efficient alternatives. In response, consumer demand for new motor vehicles (autos, light trucks, and utility vehicles, combined), temporarily surged to 1.9% of total consumption in 2Q-2009, but then fell back immediately to 1.6% in the final period of the year and slipped fractionally further in early 2010. While the motor vehicles share of consumption started to inch up following this payback effect, by late 2010, it remained well below that prevailing in the pre-crisis period of late 2007. In short, cash-for-clunker incentives did nothing to stimulate the longer-term path of consumer vehicles demand

This is hardly a surprising result for economists who are steeped in the so-called “stock-adjustment models” of consumer behavior. Back in the Jurassic Era, when I was first exposed to the now seminal work of Hendrik Houthakker and Lester Taylor, I was struck immediately by the elegance of the concept — the basic idea that short-term, exogenous deviations from an optimal stock of consumer durables would quickly fade and then return to that same predetermined path. The keyword in this concept is “exogenous” — a perturbation that is induced by a policy action or another artificial development (i.e., in the case of cars, a safety recall, an unexpected regulatory action, or a technological development). Barring those possibilities, this “gravity model” implies what goes up, quickly comes down. That’s precisely what happened with the cash-for-clunkers experiment in the US.

That’s not to say the optimal stock can’t be influenced by other policy actions or shifting consumer demand fundamentals. Significantly, the stock adjustment framework doesn’t rule out that possibility. But that would require policymakers to take bolder actions to raise the longer-term equilibrium configuration of consumer expenditures on durable goods. That won’t occur through rebates on clunkers (America) or subsidies for accelerated trade-ins of aging durables (China). As seen through the lens of the stock-adjustment model, such actions simply rearrange the time profile of replacement demand for an existing stock of consumer durables.

The case for a net demand stimulus is a different matter altogether. For market-driven economies like the United States with strong consumer cultures, such an outcome would be shaped by familiar factors like personal income, wealth, unemployment, and confidence. If policies lead to improvements in those fundamentals, then there is a credible case for a more optimistic longer-term assessment of overall consumption. The impacts would be especially pronounced for consumer durables if policies boost asset markets; durables consumption has long been found to be especially sensitive to household wealth effects.

By contrast, for non-market economies like China, the story is more complex. As I argued recently, the Chinese consumer culture has been increasingly hobbled by the politics of social engineering that are anchored in the CCP’s increased emphasis on control and stability. At the same time, these political constraints are undoubtedly being compounded by the negative wealth effects stemming from falling home prices associated with China’s wrenching property’s crisis. As such, the outlook for the Chinese consumer stands in sharp contrast to that in the US.

This is more than just a minor wrinkle in my view on China. I have long been in the consumer-led rebalancing camp as the best answer for China’s increasingly serious growth challenges. I have repeatedly stressed the imperatives of social safety net reforms — healthcare, pensions, and hukou reforms — as essential to reduce the fear-driven excesses of precautionary saving that have gripped an ageing, insecure Chinese society. I remain convinced these fundamentals must still be addressed in order to stimulate discretionary consumption. But in the context of China’s current political climate, I now see economic fundamentals as necessary, rather than sufficient, for China’s long-awaited consumer-led rebalancing.

Unsurprisingly, this conclusion is very much at odds with the positive spin that Beijing is putting on its current pro-consumption stimulus, especially the trade-in campaign. But as I have argued above, the stock adjustment framework draws the staying power of such a short-term stimulus into sharp question. It’s not just the inevitable payback effects of the durable goods replacement cycle associated with a trade-in campaign. Nor is it the limited clout of the other pro-consumption initiatives noted above such as rebates for digital purchases or government pay hikes. Until or unless Beijing begins to temper the political constraints on social engineering and unshackle the behavioral spirits of the Chinese people, China’s latest pro-consumption policy efforts are unlikely to gain sustained traction. A misdirected consumer trade-in program is hardly the answer.