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Presented at

The 20th ASA CongressTaipei

by

卜若柏Robert Blohm

http://www.blohm.cnc.netSeptember 27, 2010 2010年 9月 27日

Download at: http://www.blohm.cnc.net/Taipei

Historical Perspective of the Economic Crisis and the Recovery

1. History

Post WWII US economic resurgence after self destruction of Europe and

East Asia.

US had become a huge net exporter in the 1920s & 30s. Militarily weak and

isolationist.

Germany deficit financed itself to military dominance. Hjalmar Schacht &

MEFO bonds.

War indebtedness and decolonization by the UK led to the demise of the British pound as the world reserve

currency which took 20 years to happen.

The Marshall Plan’s capital inflow of US dollars into Europe and Japan to

support Social Democracy as an alternative to Communism widely diffused US dollars worldwide, was

used in part for purchase of US exports and led to the creation of the Eurodollar market and establishment of the dollar as the vehicle currency

for international trade.

European and Japanese economic strength in the 1960s as producers of low cost products began to reduce the

US’s net exporter status.

The Vietnam War and the Great Society drained the US fiscally. The war and welfare economy made the US into a net importer by

the late 1960s. A general loss of faith in economics manifested itself in the US,

Europe and China (following failed economic policies there) by massive protest

movements of youth driven by ideology. Loss of confidence in the US dollar prompted

requests to the US Federal Reserve to exchange it for gold, prompting President

Richard Nixon to take the dollar off the gold standard and eventually to abandon the Bretton Woods system of fixed exchange

rates.

The Nixon Administration opted to expand government spending to

sustain the post Vietnam War economy through recession.

In the early 1970s the Texas Railroad Commission ended the system of production

quotas that had kept the oil price low and stable for decades (and the creators of OPEC

studied that system). The intent was to increase supply and thereby lower the oil

price to boost the economy. The result was that remaining reserves in Texas (the Black Giant) got depleted and the oil price rose. The result of the two dramatic measures,

floating exchange rates and the formation of OPEC, has been 4 decades of volatile commodity prices & exchange rates.

The 2 oil shocks of the 1970s (the first triggered by the Yom Kippur War, the second by the Iranian

Revolution) drove the US into a deeper net importer position. President Nixon imposed wage and price controls, especially of oil prices which only kept oil

consumption high and set the stage for the second oil price shock which was followed by high oil prices and huge inflation and economic stagnation in America.

Capitalism was viewed as on the threshold of destruction as petrodollars had recycled into US-

dollar loans to developing countries, helping to pay their oil imports, but setting stage for the developing world debt crisis of the 1980s as interest rates rose to

break the back of inflation and ultimately raise the value of the US dollar against other currencies as oil prices declined in response to downward demand

adjustment to high oil prices.

2 heros emerged to meet the challenge to the survival of their

respective economies: Ronald Reagan and Deng Xiao Ping.

The impact of the oil shocks in ending Japan’s two decades of 10% annual

economic growth prompted Japanese manufacturing to become ever more

efficient and quality-oriented (partly in implementing the industrial engineering of US statistician W. Edwards Deming whose ideas weren’t so well received in the US). By the early 1980s Japan exceeded the oil

exporting countries as the biggest net capital exporter to the US.

Ronald Reagan took advantage of Japan’s willingness to finance the US deficit to

implement the “supply side” economic recovery plan of Robert Mundell which consisted of a

tight monetary policy of high interest rates to fight inflation as successfully done by Jimmy

Carter’s appointment of Paul Volker to the US Fed, and a loose fiscal policy (the Kemp-Roth tax rate cuts) to stimulate the economy. This

broke the received wisdom of economists called “the funnel” which prescribed that fiscal and monetary policy be simultaneously tight or

loose.

Deng Xiao Ping opened the first 30-year phase of China’s reform &

opening up: rural enterprise was allowed to compete against State

Owned Enterprise, and farm labor was allowed to migrate to export manufacturing platforms of multinational corporations.

Deregulation and marketization enabled economies to reduce

overhead costs through competition in the 1990s: “the Washington

Consensus”. Commodities prices dropped. The Internet Economy

emerged with IT efficiency.

1985 Yen appreciation kept the Japanese economy in the slow growth mode it was thrown into by the 1980s

oil shocks.

The Asian Tiger economies roared as East Asian governments borrowed in

US dollars to develop export industries expected to pay back the loans.

Super-growth proved to be the result of migration from country to city and stopped once that process stopped.

A strong US-dollar US recovery prompted by a weak US-dollar driven emergence from the

post Gulf-War recession and a “peace dividend” following the end of the Cold War, and the completion of urbanization led to the

1997 Asian Financial crisis as East Asian economies struggled to service US dollar debt with weak currencies and as their

super-growth that had attracted massive inbound investment was over. East Asian

economies were forced to internally restructure/marketize their economies away from central planning and “crony capitalism”, the most notable example being the demise of the Korean Chaebols (conglomerates).

China resisted devaluing the RMB and instead took advantage of low energy

prices to actively promote energy intensive industry, while promoting competition in the energy sector by

inviting foreign investment in it.

In the early 2000s the Internet bubble burst and the US was attacked on

9/11/2001. Oil prices began to exceed their long-term average. This undid

deregulation and marketization efforts, and prompted the Enron

collapse. Low interest rates to support the economy prompted a subsequent

real-estate boom.

China stopped further development of commodity market pricing and

imposed regulation of prices to below world market levels to satisfy domestic

consumers and promote exports.

2. The 2008 Financial Crisis and Subsequent Great Recession

Financial crises often arise from lack of supervision and due diligence. This is due to the human tendency toward over-confidence. To give a striking

example, the US government’s Brady Report on the causes of the 1987 stock market crash (in technical ways similar to the 2008 crash) is still not available

on line and is available only by mail. In other words, before and after the 2008 crash, nobody consulted the

Brady Report.

Lack of management oversight of increasingly technical processes gave

too much discretion to experts. Banks gave up their credit oversight role of

credit assessment of the customer and instead lent exclusively on the basis of

collateral and this broke the golden rule of banking, namely “know your

customer”.

The US government in the form of Fannie Mae and Freddie Mac, long the subject of media criticism for unsound finances and management, was a

major force driving excess credit for real estate. Even China’s government played a role in

facilitating the US real-estate bubble, by investing a huge portion of China’s export earnings into Fannie Mae and Freddie Mac bonds, and by “sterilizing” the inflow of cash into China for

speculation or for goods by using existing RMB (rather than printing new RMB) to exchange for

the incoming US dollars. That, together with price controls, prevented price-level rise in China, and stimulated US consumption of Chinese products

whose low price kept US inflation low and justified the artificially low US interest rates which

stimulated the housing bubble.

Meanwhile Chinese consumers facing artificially low prices for commodities consumed too much of them, pushing world prices higher, for example of oil of which China has been responsible for 40% of new purchases, which set

the price for all purchases.

That prompted the US Federal Reserve in early 2008 to suddenly worry about inflation, reverse course and raise US

interest rates. That caused the interest rate on the lowest quality

mortgages to double and trigger the sudden death of the sub-prime

mortgage market.

Economists almost never point out that practically all financial crises are due to mismatching the term of

assets and liabilities, in particular by borrowing short term at normally low interest rates in order to use the funds to buy a long-term asset whose higher return is

fixed for a long period. While financial institutions routinely mismatch assets and liabilities to profit from expected movement in interest rates, the US housing

bubble was the first time consumers were encouraged to do the same thing, but in a highly risky way opposite from normal. They were allowed to borrow only short term at prevailing very low rates, to invest in a home

which is a long-term asset. When interest rates are low you normally borrow long term to lock in the low rate for the future. Otherwise the short-term rate will rise later when you cannot pay for that increase from any

increased return from your long term asset.

Robert Mundell, the father of fixed exchange rates (such as the Euro), believes that a sudden rise in the US dollar followed

by a sudden dramatic fall causes recessions. That prompted the collapse of

Lehman brothers and the immediate financial crisis where Citibank was on the

verge of bankruptcy, and subsequent recession, and the current possible double dip after the Euro suddenly depreciated & then recovered as the dollar depreciated.

The most important single policy consequence of the financial crisis has been revival of the attempt at a global

fixed exchange-rate regime like the Bretton Woods system ended by President Nixon. The call for a world currency, to some day

replace the US dollar as the “vehicle currency” for international trade and

investment, is a version of that attempt, where all surrogate currencies would be

linked in a system of fixed exchange rates to the world currency and would disappear

if eventually no longer used.

The G-20 is also developing sounder uniform operating rules for banks, such as increased capital to more

easily absorb shocks like the financial crisis.

The emergence of the G-20 itself is an important result of the financial crisis

in which emerging developing economies had cash that they were willing to place to assist the IMF and

that challenged developed economies did not have.

3. The Post Economic Crisis

The US dollar will not be replaced as the reserve currency any time soon. The

reserve currency must first be a “vehicle currency” widely used for international

trade and investment, and a vehicle currency is convertible. Convertible means

that there is enough of a supply of the currency outside the country of origin that

is freely exchangeable and exerts supply and demand pressure on the currency independent of direct controls by the

country of origin, except by intervention/participation by that country

in the offshore supply and demand.

While China’s GDP is 12.5% of the world’s, the Hong Kong Monetary

Authority has estimated that a convertible RMB would constitute 3% of world reserve holdings on the basis

of its use in transactions.

In international trade and investment discussions, economists tend to reduce a domestic economy to two components,

consumption and investment, & ignore the third big component, government expenditure.

An economy’s external “balance” is the difference between these three expenditure

categories and income. A country has a positive/surplus balance if its income exceeds

expenditure on those three items and the difference consists of net exports that the country’s extra income is used to lend to

foreigners to buy. A country has a negative/deficit balance if spends on net

imports money that it borrows from abroad.

East Asia’s surpluses with deficit countries like the US are not simply due to too much

consumption in the US and too much investment in Asia. They are due in large

part to the size of government expenditure. Imbalances become

unsustainable when the role of government in their creation becomes too

large.

The more direct solution is to reduce the role of government rather than explicitly “target” consumption and investment. If

government has been promoting investment in China, then reducing

government’s roll could see consumption rise naturally. In the US, government

spending has displaced investment, while US consumers did adjust to the financial

crisis immediately by reducing consumption which is not necessarily good

for the economy.

The Tea Party movement is a revolution in US politics that aims to dramatically reduce the role of government in the US economy by growing the economy and investment

through reduction in tax rates that eventually lead to higher overall tax

revenue and reduction in the US government deficit as occurred in the early

years of the second president Bush. The Tea Party is aligned with China’s interest in

protecting its investment in US Treasury bonds by assuring sounder US government finances on the basis of economic growth.

The financial crisis has had the unfortunate effect of being cited as a failure of capitalism by those wanting

more state interventionism in their economy. Market crashes and

recoveries are included in capitalism rather than being a failure of

capitalism(‘s promise). It’s a fact of human existence that failures happen

quickly, almost immediately, while recoveries take time.

China in the past 8 years has moved toward state capitalism with less emphasis

on the “socialist market economy”, especially since the financial crisis.

Government led investment provided a temporary basis for growth during the

crisis. China faces the choice of performing the next stage of reform-and-opening-up in the form of decontrolling the Chinese economy, or declaring a New Paradigm.

Predictions that the New Paradigm will shape a new world economy may be as

exaggerated as the hubris expressed at the peak of Japan’s economy in the late 1980s,

and manifested in the short-lived 1987 stock market crash that the Brady Report attributed in part to massive selling of US

Treasuries by Japanese institutions. Instead, because Japan has still not

sufficiently reformed internally, Japan fell into irrelevance.

Mainland Chinese companies don’t know very well how to manage global business

enterprises and those businesses are overlaid by a Party Secretary structure appropriate to domestic enterprises.

Japanese companies had extreme difficulty expanding abroad partly because of cultural refusal to confide in foreign

managers. But the Japanese auto industry has been a resounding success of global expansion, to the point that one of the companies has a foreign CEO and uses English in all internal communication.

Chinese are excellent portfolio investors and small business operators

with history’s greatest diaspora of capable people, primarily business

owners and professionals. Portfolio investment may be the only feasible

way for China to finance its huge trade surpluses by investing into the

importing country’s economy rather than in its government.

China’s export driven, capital control model is unsustainable because there is a natural limit

on reserve accumulation by a single country of government securities by another single

country. Both countries ultimately give up sovereignty to one another and that only drives up political tension in both countries. China’s Central Bank has financed America’s War on

Terror while China’s Foreign Ministry might not agree. Americans who perceive China is

influencing US government policy through its investment in US Treasuries could become opposed to importing goods from China.

The IMF has been concerned by increased imbalances between countries that lead to

overall huge reserve accumulations that are destabilizing by the very ability to use them to manipulate currencies’ values. That growth in imbalances and overall

accumulations lends urgency to the need to reform the world exchange rate

mechanism into something resembling the old Bretton Woods fixed exchange rate

structure.

China faces serious internal governance issues: financial reform of the currency and banking, wage increases, and commodity

price increases to world market level. China’s banks practice collateral-based

lending (as the US did before it led to the sub-prime crisis) not credit-analysis based lending. There is no true money market in

China whereby banks manage the economy’s daily cash float and dispense

cash to borrowers as needed. Instead loan proceeds are disbursed immediately and the property market is used by borrowers

as a parking lot for excess cash.

The property market wildly appreciates because it is serving the

multiple purposes of missing markets. Property is bought not for use as much

as for appreciation. Meanwhile the increasing unaffordability of housing to the middle class is creating wage

pressure.

China’s resource for future growth is general decontrol of the economy and the movement of the manufacturing

economy to the interior. China’s demographic clock during which it can achieve this may run out in 20 years,

as population growth stops in ten years and migration from rural to

urban completes in 20 years.

Inflation is not price increases, nor a valid reason to resist wage and price increases. Wage and price increases

matched by productivity increases are not inflationary. Such increases in China are necessary and structural,

not inflationary.

The result of too slow reform is US pressure to appreciate the RMB. Better to

increase wages and prices in China than the RMB, or than tariffs on Chinese goods

by the US (which the WTO could rule against but the whole process takes a very

long time while US actions can exact immediate damage). RMB appreciation

would have the effect of diversifying China’s investment in US Treasuries among potentially several East Asian countries, a politically more palatable

alternative.

So, I predict that as much as the financial crisis can be used to make a case for the end of capitalism, a case can be made for the end of socialism. We may ultimately see enormous government divestiture of

assets in Europe and America (if not in China), in other words privatizations, a

return to marketization. Even Cuba is firing a tenth of its government employees

despite a push toward socialism by a few commodity exporting countries with excess

cash to dispose of.