However, the return on capital is also currently quite low, as indicated by interest rates. Again, deflationary forces due to Chinese economic integration have allowed central bankers to keep interest rates low while maintaining price stability. Here the effects are not so clear cut, as increased demand for commodities leads to price increases, while decreased labor costs lead to deflation. Insofar as the latter effects are dominant (and the current trend corresponds to "good deflation"), central bankers would be making a mistake keeping interest rates so low. In effect, they are flooding the world with cheap capital, reducing the return on capital and producing serious misallocation of resources (housing bubbles).
China's impact on the world economy can best be understood as what economists call a “positive supply-side shock”. Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets.
The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits.
In America, Europe and Japan, the pace of growth in real wages has been unusually weak in recent years. Indeed, measured by the growth in income from employment, this is America's weakest recovery for decades. According to Stephen Roach, an economist at Morgan Stanley, American private-sector workers' total compensation (wages plus benefits) has risen by only 11% in real terms since November 2001, the trough of the recession, compared with an average gain of 17% over the equivalent period of the five previous recoveries (see chart 3). In most developed countries, average real wages have lagged well behind productivity gains.
The entry of China's vast army of cheap workers into the international system of production and trade has reduced the bargaining power of workers in developed economies. Although the absolute number of jobs outsourced from developed countries to China remains small, the threat that firms could produce offshore helps to keep a lid on wages. In most developed countries, wages as a proportion of total national income are currently close to their lowest level for decades.
The flip side is that profits are grabbing a bigger slice of the cake (see chart 4). Last year, America's after-tax profits rose to their highest as a proportion of GDP for 75 years; the shares of profit in the euro area and Japan are also close to their highest for at least 25 years. This is exactly what economic theory would predict. China's emergence into the world economy has made labour relatively abundant and capital relatively scarce, and so the relative return to capital has risen. It is ironic that western capitalists can thank the world's biggest communist country for their good fortune.
China's main impact on the world economy is to change relative prices and incomes. Not only are the prices of the goods that China exports falling; the prices of the goods that it imports are rising, notably oil and other raw materials. China is already the world's biggest consumer of many commodities, such as aluminium, steel, copper and coal, and the second-biggest consumer of oil, so changes in Chinese demand have a big impact on world prices.
China has accounted for one-third of the increase in global oil demand since 2000 and so must bear some of the blame for higher oil prices. Likewise, if China's economy stumbles, then so will oil prices. However, with China's oil consumption per person still only one-fifteenth of that in America, it is inevitable that China's energy demands will grow over the years in step with its income.
There is currently only one car for every 70 people in China, against one car for every two Americans. That implies a huge increase in oil demand, which could keep prices high for the foreseeable future, because of scarce global spare capacity. China's consumption per person of raw materials, such as copper and aluminium, is also still low, so rising demand will continue to support commodity prices.
Overall, the upward pressure that Chinese imports of raw materials have put on the prices of oil and other commodities has been more than offset by the downward pressure of Chinese manufactured exports. As a result, another important aspect of the China effect is low inflation.
Central bankers like to take all the credit for the defeat of inflation, but China has given them a big helping hand in recent years. China's ability to produce more cheaply has pushed down the prices of many goods worldwide, as well as restraining wage pressures in developed economies. For instance, the average prices of shoes and clothing in America have fallen by 10% over the past ten years—a drop of 35% in real terms.
A study by Dresdner Kleinwort Wasserstein reckons that China has knocked almost a full percentage-point off America's inflation rate in recent years. The recent 2% revaluation of the yuan will probably be absorbed by Chinese manufacturers trimming their profit margins and so will not be passed on into export prices. But Americans calling for a 25-30% revaluation may come to regret it: the result would almost certainly be faster inflation.
As it is, China's reduction of inflationary pressures has allowed central banks to hold interest rates lower than they otherwise would be. Three and a half years into its recovery, America's real short-term interest rates are only 0.7%, almost two percentage-points below their average at the equivalent stage in previous recoveries since 1960. This is good news for borrowers, but some economists worry that the entry of China and other emerging countries into the global economy may have affected monetary policy in ways that central banks do not fully understand.
In its latest annual report, the Bank for International Settlements (BIS) asks whether it is really desirable to maintain positive inflation rates when China is boosting the world's productive potential so dramatically and thus reducing the prices of so many goods. In other words, are central banks targeting too high a rate of inflation now that China has joined the global market economy?
During the late 19th-century era of rapid globalisation, falling average prices were quite common. This “good deflation”, which was accompanied by robust growth, is very different to the bad deflation experienced in the 1930s depression. Today, we would again have had “good deflation”—but central banks have instead held interest rates low in order to meet their inflation targets. The BIS frets that this has encouraged excessive credit growth.
This echoes a fierce debate in the 1920s. At that time, a similar jump in the world's productive potential (then caused by technology-driven productivity growth) was reducing manufacturing costs. Some economists suggested that, in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.
The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.
Not only has China's disinflationary impact caused low short-term interest rates, but China is also partly responsible for the low level of long-term bond yields. To keep its exchange rate pegged to the dollar, China was the biggest buyer of American Treasury bonds over the past year. In the first six months of 2005, its foreign-exchange reserves increased by more than $100 billion, to $711 billion, of which about three-quarters are in dollars. This has also kept capital costs artificially low.