By Kenneth Rogoff

Given the highly vulnerable state of the US and European economies, what would happen to global growth if the Chinese juggernaut also started sputtering? Few investors or policymakers seem to be seriously contemplating this scenario.

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.

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For China’s rulers through the ages, stability has been the chief objective.

The same is true for the Communist party today. For the current government, however, economic stability matters most of all. Yet observers of the Chinese economy, both at home and abroad, now worry that what looms ever closer is instability in its most dangerous guise – that of inflation. Are they right to do so? Probably not, is the answer.

Consumer price inflation did hit 6.5 per cent year-on-year in August, the highest rate in 11 years, largely because of a 49 per cent surge in meat and poultry prices. One much-respected Chinese economist remarked last month that "we have entered a very delicate stage of our development". He is convinced, moreover, that true inflation is far higher than what he regards as the government’s over-optimistic figures.

Albert Keidel of the Carnegie Endowment for International Peace takes a similarly alarmist view. He writes that "China’s economy today looks much as it did before the inflationary catastrophes of 1988-1989 and 1993-96". The first of these episodes contributed hugely to the protests that culminated in Tiananmen Square in Beijing in 1989. The second ended up with inflation at more than 20 per cent, the sacking of the governor of the central bank and a big jump in interest rates.

Mr Keidel makes three points: first, while the price increases have indeed been limited to food, these remain of large importance to Chinese consumers, particularly to the urban Chinese; second, inflation is already visible in the data on nominal gross domestic product, which is growing at between 6 and 7 per cent a year faster than the government’s estimates of real GDP; and, finally, real interest rates on deposits are negative, which is likely to encourage the Chinese to spend at least a part of their huge holdings.

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What is the most important high-level dialogue in international economics? The answer is not the discussion among the finance ministers of the Group of Seven high-income countries. It is the “strategic dialogue” between China and the US. This is not because the latter will produce answers, but because it asks the right question. The biggest challenge in international economic policymaking is the incorporation of China. This, to his credit, Hank Paulson, the US Treasury secretary, has recognised. But his bilateral approach will fail. The G7 should, instead, be replaced by a multilateral body that can address such issues more effectively.

To understand the challenge, we must appreciate what makes China’s impact special. Experts often describe today’s globalisation as the “second globalisation”, to distinguish it from the “first globalisation” between 1870 and 1914. In the earlier era the rising economic power was the US and the UK was by far the world’s most important exporter of capital. But China is now emerging as both the world’s most dynamic economy and its largest source of capital. This helps explain a signal feature of our era: the combination of rapid growth with low real interest rates.

The Great Wall is China’s most celebrated tourist attraction. As China’s impact on the world and its rulers’ desire to control the world’s impact on China grow, it appears as an enduring and disturbing metaphor. From the Great Wall, aimed at the “barbarians” of the Steppes, to today’s Great Firewall, aimed at free flows of information, China’s rulers have wished to keep their people separate.

Yet how far can China remain inside the world and outside it, embrace the west’s market economy, while rejecting its political ideas?

This is a history with potent lessons: of the ability of this greatest of agrarian empires to mobilise human resources; of its indifference to human life; of its desire to “define, enclose and exclude” – to define what was civilised, enclose what was Chinese and exclude what was foreign; and, not least, of its imperviousness to lessons of failure.

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What exchange rate regime should China adopt? The answer must be: one that supports stable growth at home and, given China’s growing role in the world, also abroad. The government has already decided to shift towards greater reliance on consumption. In doing so it has willed the end. Now it must will the means.

Nicholas Lardy of the Washington-based Institute for International Economics spells out the case for such a shift in a thought-provoking new paper*. This represents just one of the host of contributions made by the Institute to the greater understanding of international economic policy issues over the past quarter of a century. I do not agree with everything it has published. That is hardly surprising. But the world would have been far worse informed and less stimulated without it. Happy birthday, IIE!

Mr Lardy’s contribution is a superb example. All, he argues, is not as healthy in the economy as headline statistics suggest. Between 2001 and 2005, investment generated a little more than half of the expansion in aggregate demand. More recently, the current account surplus has exploded from 1.3 per cent of gross domestic product in 2001 to 7.2 per cent last year and a forecast of 9.1 per cent this year. As a result, net exports of goods and services generated a quarter of additional demand last year and will generate another fifth this year. The current Chinese economic expansion is evidently both investment- and export-led.

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free – click ‘Comments’ below.