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“A more balanced economy might allow the world to live with a less perfect financial system”

by Brad Setser
July 2, 2009

Mike Dooley and Peter Garber argue (at VoxEU) that the recent crisis has nothing to do with “Bretton Woods 2” — an international monetary system where reserve growth in the “periphery” financed deficits in the center. They write:

“the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries …. [NOT BY] ….”current account imbalances, particularly by net flows of savings from emerging markets to the US,” “easy monetary policy in the US” or “financial innovation. … the idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP, while having no problem with intermediating much larger flows of domestic savings, is astonishing to us.” *

The authors of Box 1.4 of the IMF’s Spring 2009 World Economic Outlook also attribute the current crisis to risk management failures in large financial institutions and weaknesses in the regulation and supervision of such institutions.** The role of imbalances are downplayed, as a “disorderly exit from the dollar has not yet been part of the crisis narrative.”

The last point is hard to refute: the dollar rallied during the most intense phase of the crisis.*** Reserve growth stopped, but that was because private money moved out of the emerging world and into the dollar, yen and swiss franc after the crisis – not because the world’s central banks lost confidence in the dollar. The proximate cause of the most recent phase of the crisis was a collapse in private financial intermediation, not a collapse in key central banks’ willingness to finance US.

But the absence of the kind of dollar collapse that many postulated might bring Bretton Woods 2 to an end doesn’t imply – in my view – that there was no connection between a global system marked by large inflows from the emerging world and the current crisis. The key issue is whether or not the large net flow from the emerging world to the US and Europe created conditions that facilitated, directly or indirectly, the failure of private risk management.

Three potential connections come to mind:

A rise in offshore dollar deposits by central banks provided some of the financing for the growth in banks’ dollar balance sheets. Central bank inflows into offshore money market funds had a similar impact.

The availability of dollar funding allowed banks’ balance sheets to swell, with an associated rise in demand for complex financial products that generated a bit of yield.
This was particularly pronounced with European banks. Thanks to the work of the BIS, we now know that a host of large European institutions funded their dollar book – a book that included a lot of synthetic triple A – in the wholesale market.


The fall in real yields pushed real money to seek higher returns
.

This happened in US money market funds, who increasingly financed European banks taking a punt on risky US securities in order to pick up a bit of yield.

It seems to have happened among fixed income fund managers, many of whom underperformed their benchmarks in 2008 because they loaded up on riskier assets in good times. The Wall Street Journal:

“What went wrong? Most intermediate funds held far fewer of the safest bonds than were inthe index. Worse, as the credit crisis unfolded and prices of risky bonds collapsed, many managers boosted holdings of low-quality debt.”

It also happened in pension funds. Some turned their fixed income portfolio into something like a credit hedge fund (it is hard otherwise to explain say Ontario Teachers’ 2008 fixed income returns). They needed higher yields than on offer in the Treasury or Agency market to meet their future obligations (in the absence of higher contributions).

The life insurers also likely reached for yield, even if one sets aside the special case of AIG’s financial products group.

The flat yield curve encouraged risk taking by special investment vehicles and other leveraged players

Investment vehicles that borrowed short to lend long couldn’t make money buying “safe” long-term assets so long as central bank demand for longer-term debt helped keep the yield curve inverted. Various vehicles could have closed up shop and said, more or less, current market conditions aren’t conducive to our basic strategy. Most though took on more credit risk and increased their leverage to maintain a high return on equity as the yield curve inverted and credit spreads fell.

A host of financial intermediaries were in the same position as they special investment vehicles. The inverted yield curve put pressure on all institutions that borrowed short and lent long. Many though seem to have offset the natural pressure on their profits by expanding their balance sheets and taking more risk. There is a rough correlation between the inverted yield curve and the rise in ABS issuance in the US –

abs-v-yield-curve2

European purchases of US corporate bonds (including ABS) surged along with issuance from 05 to mid 07. Those European purchases collapsed in the middle of 2007. That marked the beginning of the crisis. The surge reflected demand from a mix of European banks that relied on the “wholesale” market for dollar financing and a slew of offshore vehicles, including some sponsored by US banks. My guess is that this demand was also a manifestation of the market impact of a flat yield curve.

I am not sure this provides the kind of theoretical or empirical evidence Dooley and Garber called for, but it could — I hope — provide a couple of hints that help further future research.

Another argument could be added to the list of potential links between the credit crisis and central bank demand for reserve assets, but it is a bit harder to document.

Central bank inflows helped helped create the illusion that a world with large imbalances could be a low volatility world. In the pre-crisis world, a shortfall in private demand for US assets would, generally speaking, be offset by a rise in central bank demand. Low volatility, in turn, meant that high levels of leverage appeared safe.

Dooley and Garber, I suspect, would argue that the stable flow from the periphery to the center from the emerging world’s central banks – i.e. Bretton Woods 2 –meant that it was rational for private players to bet on its continued stability. The rise in volatility during crisis, they would argue, didn’t reflect a fall in the United States access to external funding.

That though strikes as too narrow a view – especially with the benefit of hindsight. Central banks did step up their financing of the US when private flows faltered in 2006, 2007 and the first part of 2008, taking away one source of volatility. But Bretton Woods 2 – at least after 2004, back in the days when the US fiscal deficit was trending down — required intermediaries willing to sell their safe assets to the world’s central banks and use the proceeds to invest in riskier assets. The gap between the increasingly risky assets (as loans backed by inflated housing collateral are more risky than loans backed by more conservatively valued homes) that the US economy was generating and central banks desire for fairly safe assets that had to be filled by private intermediaries. And as we now know, a failure in this process was a potential source of “volatility” inside the system, especially after the source of the US external financing migrated from the government to households.

To be sure, a surge in central bank demand for treasuries and agencies that pushed real rates down and inverted the yield curve didn’t have to lead to $4 trillion or so in (estimated) losses in the financial sector. Bankers didn’t have to take more risk to try to boost returns; they could have sat out the last dance. And even if they didn’t, regulators should have stepped in earlier, limiting the buildup of risk.

At the same time, absent official inflows, a shortfall in (net) private demand for US assets, relative to amount of external financing the US needed so long as US households were running large external deficits, would likely have cut the housing and lending-against-rising home values bubble off at an earlier stage, before it got so large. The recycling of the emerging world’s surplus back into the US regardless of the dollar’s slide or the relative performance of US assets helped allow financial leverage to build, as financiers came to believe that a world with large internal and external deficits was a stable world and thus high levels of leverage were warranted throughout the economy. That is one reason why the IMF, after initially discounting the importance of imbalances, ends up arguing that “a pattern of low interest rates and large inflows into US and European banks” encouraged “a buildup of leverage, a search for yield and the creation of riskier assets.” (see p. 36 of the WEO)

Back in March, the FT’s Krishna Guha — in a box linked to a Gillian Tett missive on “destructive creation” — wrote: “a more balanced economy might allow the world to live with a less perfect financial system”

Very well said.

* Net foreign inflows of 6% of GDP actually were fairly large relative to the US national savings rate (using the NIPA definition of savings), which wasn’t that fair from 12% of US GDP. Roughly a third of all investment – in a macro sense – in the US was financed by foreign not domestic savings.
** The IMF has changed its tune here. The IMF’s 2007 staff report on the US extolled securitization, arguing that it had left the “core” of the US financial system well capitalized.

52 Comments

  • Posted by DJC.

    The financial system is crashing and action must be taken by the US government to convert debt into equity to produce a more stable environment, Nassim Taleb, author of “The Black Swan,” told CNBC Thursday.

    “You may have green shoots, whatever you want to call them, you may have temporary relief, but you are still in a world that’s breaking,” Taleb said on “Squawk Box.”

    Anything that’s fragile like the financial system will eventually crash, he said.

    “We’re in the middle of a crash,” Taleb said. “So if I’m going to forecast something, it is that it’s going to get worse, not better.”

    The government needs to deleverage debt and not try stimulus packages that will inflate assets, he said.

    “What makes me very pessimistic in not seeing any leadership or awareness on parts of government on what has to be done, which is deleverage $40-to-$70 trillion,” Taleb said.

    http://www.cnbc.com/id/31706523

  • Posted by DJC.

    Chinese Vice Foreign Minister Says China Hopes for Forex Diversification from US Dollar

    China hopes for diversification of the international currency system in the future, and it would be “normal” for the issue to be raised for discussion at next week’s Group of Eight summit, Vice Foreign Minister He Yafei said on Thursday.

    G8 sources told Reuters on Wednesday that Beijing had asked for a debate on proposals for a new global reserve currency at the G8 summit and the issue could be referred to briefly in the summit statement.

    China’s central bank last week renewed its call for the creation of a super-sovereign reserve currency to reduce the dollar’s global domination, which it said had worsened the crisis.

    The People’s Bank of China caused a stir with its suggestion, first made in March, that the International Monetary Fund’s Special Drawing Right (SDR) could eventually displace the dollar as the principal reserve currency.
    http://www.cnbc.com/id/31699230

  • Posted by Rien Huizer

    Brad,

    A title like this inmvites moralistic comments. There is no way to ensure that there is a balanced economy. The currently poor will not want to be contained and the currently rich will not want to be put in danger.

    The debate about what caused the current correction seems pointles. People make lists af plausibe causes that may appeal to different tastes (for instance some may like the regulatory failure, others the soft budget constraints.

    First, let’s hope that a correction is what it is, i.e. something that will be over within a decade; I am too historically aware not to see the potential for centuries of stagnation, like Qing China, roman catholic early medieval Europe or Turkey after 1600. All of these were autarchic economic systems, and all previously growing fast, similar to the current world economy. But again, let’s hope that some of the hope of the poor and fear of the rich will create a dynamic that keeps demand alive and growing. If necessary we can fight about distribution afterwards). But no one knows, if one did he would clean out all of us without telling.

    The current crisis may have a million crises. But looking back may be a waste of time, all we will get is ideoly dressed up ad analysis..

  • Posted by Rien Huizer

    Apologies for an excessive number of typos.

    Try again:

    A title like this invites moralistic comments. There is no way to ensure that there is a balanced economy. The currently poor will not want to be contained and the currently rich will not want to be put in danger.

    The debate about what caused the current correction seems pointless. People make lists af plausibe causes that may appeal to different tastes (for instance some may like the regulatory failure, others the soft budget constraints).

    First, let’s hope that a correction is what it is, i.e. something that will be over within a decade; I am too historically aware not to see the potential for centuries of stagnation, like Qing China, roman catholic early medieval Europe or Turkey after 1600. All of these were autarchic economic systems, and all previously growing fast, similar to the current world economy.
    Second, let’s hope that some of the hope of the poor and fear of the rich will create a dynamic that keeps demand alive and growing. If necessary we can fight about distribution afterwards). But no one knows how, if one did he would clean out all of us without telling.

    The current crisis may have a million causes. But looking back may be a waste of time, all we will get is ideology dressed up ad analysis..

  • Posted by Lobo

    Rien Huizer: The current crisis may have a million causes. But looking back may be a waste of time, all we will get is ideology dressed up ad analysis..

    On the contrary, you need to know how and why a machine breaks down in order to fix it.

  • Posted by Rien Huizer

    Lobo,

    This is not a machine than can be fixed. It heals itself or it does not..

  • Posted by bsetser

    Rien — I do think an understanding of causes is important, especially as the world puts in places policies to guide the exit from the current crisis. The int. consensus on this is for more regulation by the US and Europe — which is good, though there is a backlash in the financial sector against the need for regulation now that the worst of the crisis has passed (Thanks largely to the government’s backstop of the liabilities of leveraged institutions in my view). And China has defined the problem in the system as the dollar’s key role denominating global (and chinese financial assets), not say china’s surplus — or its decision to maintain a tight dollar peg. Tis sort of funny that China criticizes US monetary policy for not being focused on maintaining the dollar’s external value while pegging to the dollar and importing us monetary policy. I don’t think there is a comparable focus — setting martin wolf aside — on the need to bring down imbalances. And since policies here can get in the way of market pressures for adjsutment, i think it is important to debate how imbalances and financial sector weaknesses interacted in the run up to the crisis.

  • Posted by FollowTheMoney

    In large part, was, indeed the governance and regulation within large financial supercenters. Individuals could walk into any bank making <50K a year and months later be in contract to buy a million dollar McMansion. They then got additional credit lines on that McMansion and ran up immense debts.

    But of course, all of this was only, at least in my view made possible by AIG. Without AIG banks would never have issued the loans, because they would not have had the insurance if the failed.

    I believe, that in large, it was one giant ponzi scheme funneled through AIG, and it’s false collateral. This is what opened the window, and built the bridge to immense flows of $$$ into the hands of real estate boom and retail consumer frenzy. Banks approved applications left and right, with no 2nd thought of “did AIG really have the insurance if the loans went bust”?

    One giant disaster! Now unfortunately, a number of foreign central banks/governments are buying hundreds of billions in U.S. debt without asking, does the “U.S. have the collateral to back up it’s IOU’s”? We’ve seen what happened with an overextended individual (private) borrowing, pretty soon i guess we’ll find out the end game of immense amounts of government borrowing/intervention…

    It’s one giant mess, and in my view it’s getting worse, not better.

    There are no excuses. Blame consumers, blame regulators, and blame the banks/insurance co’s. Let all 3 who over-extended groups FAIL. It’s not fair for people who lived balance lives, saved, worked hard, and did the right thing to put with this fiasco. Clean out the system, and let’s get this wrapped before we enter 2010.

  • Posted by Michael

    Another salient post Brad, lots to forage for here.

    Some moralistic-idealogue comments;

    There are firms out there that do a respectable job at risk management and managing money but ….

    Problems in many risk management organizations: what skills risk managers have.
    Just because they know what the Central Limit Theorem is does not qualify them for roles in ‘risk management’. Risk management as practiced in most large banks is a joke. It is a joke because
    the vast majority of it is ex-post data analysis without context, ditto for Basel capital requirements.

    Portfolio managers (PMs) are for the most part compensated for acting as the sacrificial anode for career-risk-averse (and pensioner risk-apathetic) pension fund trustees. I moralize that many pension fund trustees got the job for being team players for the organization and want an undemanding job until retirement. Anyone that relies on the CAPM or Fama-French models implicitly side-step market risk, focusing instead on insignificant degrees of out-performance !!!!!! Why do these people fail to acknowledge market risk dominates alpha opportunities ; oh wait … how would those PM pay packages be justified then … oops.

    And you wonder why all the salient forces Brad cites above were not tracked, modeled, analyzed,
    or projected in the name of risk management in an ACCOUNTABLE WAY ?????
    Oops, did I just use ‘accountable’ and ‘risk management’ in the same phrase ?

    So just as we have skewed incentives in healthcare that cause problems, we have skewed incentives
    in the money management business ( the incentives for risk managers in most big banks may not be skewed but simply marginalized by the non-risk management compensation schemes that are skewed ) … sounds like intelligent regulation is needed in both arenas
    and it would not hurt if investors spent some time understanding the real risks and opportunities in investing ; they , the investors, need to be more accountable too !

    Comment on Rien Huizer’s post;
    I find it ironic that someone so dedicated to understanding history rejects attempts to understand it as it happens. It is one thing to acknowledge the difficulty of trying to understand what is going on , it is another to dismiss such attempts …. reminds me of the person that wanted to close the patent office in the US in the early 1900s because he thought everything to be invented already had been.

  • Posted by FollowTheMoney

    @ Michael,

    there’s certainly structural oversight problems. I mean, the people, the regulators in my book are far underpaid.

    Financial firms need to pay regulators and those who over-see the firms actions much larger salaries.

    Don’t quote me on this, but unless regulators get equal bonuses to risk takers this sort of stuff could continue. We just heard in the press a few weeks ago Goldman Sachs employees may receive the “LARGEST” bonuses in the history of the firm in 2009. This is huge, that means that someone is once again taking immense risk/s.

    Things are so bad, I wouldn’t be surprised if loan approval officers working at financial institutions received kickbacks or under the table fees for some individuals who received loans. I mean there was, at least in my view just an immense amount of fraud, and most of it has yet to come to light.

    This is sad, this is the United States of America. This is a great country, alot of people behind closed doors are furious. Alot of people are upset. But average Susie and Joe can’t live in half million dollar California homes, they can’t have 25K in credit card debt, and they can’t buy a new car every 6-12 months.

    This is a rude awakening, we’re going to a structural change, in the long run where 300M Americans will no longer consume an immense portion of the worlds goods/resources.

    We’re going back to sharing cookies with friends, we’re going back to car-pooling, we’re going back to people having gardens in the yard.

    This is big, this is not a typical recession. Structural changes are under way, the dominos are falling. The good news, united states needs this. This is going to create more moral value, more sense of community, more sense of regard for non-materialistic culture.

    In my book, what will witness won’t necessarily be bad. It’s a readjustment.

  • Posted by Brick

    While I pretty much agree on the role the imbalance played I think there are a number of unexplored routes that the imbalance may have had banking behaviour. China’s appetite for agency debt until recently may have played a part in suppressing the yield of other forms of mortgage debt leading to Countrywide’s attitude to lending.
    Whilst most would agree that a rebalancing over time is appropriate, there are still some vested interests which will pull in the opposite direction and others who just want things as they were without understanding the potential cost. How many times can we afford to repeat the mistake of not addressing the imbalance?

  • Posted by WStroupe

    FollowTheMoney said, “This is big, this is not a typical recession. Structural changes are under way, the dominos are falling. The good news, united states needs this. This is going to create more moral value, more sense of community, more sense of regard for non-materialistic culture.”

    “In my book, what will witness won’t necessarily be bad. It’s a readjustment.”

    This readjustment could turn out to be much longer and much more painful a process than is generally assumed. See a pretty good piece on this by Mohamed El-Erian at FT.com: http://www.ft.com/cms/s/0/1e06911c-6719-11de-925f-00144feabdc0.html

    The real problem for the U.S. (and Britain as well as much of the rest of Europe) is the increasingly likely prospect of its economy turning virtually zombie, perhaps for several years, or a decade or even more, while the emerging economies return to pretty decent growth. If this occurs, then it will have profound negative geopolitical implications for the developed economies, and net positive ones for the under-developed economies. This could be MORE than a readjustment, therefore. It might actually constitute a fundamental transformation, wherein the under-developed economies of the world collectively take the global ascendancy away from the developed economies, effectively becoming the new global drivers. If that does happen, then there is the real concomitant possibility that the new ascendants could keep the new descendants down (ie, prevent them from reacquiring their former global position) for some time to come. Conventional wisdom pretty much says No! to this eventuality, but beware conventional wisdom, as Mohamed’s piece warns.

    Are we tending to downplay the real importance and impact of this crisis, assuming it’s an adjustment, when it may be much more than that?

  • Posted by Too Much Fed

    bsetser said: “Rien — I do think an understanding of causes is important, especially as the world puts in places policies to guide the exit from the current crisis.”

    What about stop using debt (future demand) to prevent price deflation from cheap labor and/or productivity growth?

  • Posted by Michael

    Rien,

    I disagree. There is certainly a contrast of focus (trade and financial flows vs. F.I.RE and government mismanagement) in the two sets of analyses; but that does not make either mere ideology. Analyses and disagreement are still in progress regarding the role of trade, financial flows, F.I.RE mismanagement and government mismanagement preceeding and during the Great Depression. For the most part, the extremely preliminary picture that is emerging from current vigorous work is that there was – as Brad has repeatedly emphasized – a synergy between the imbalanced flows and casino F.I.RE with government numbness that made this particular credit and trade contraction exactly what it is. It is increasingly clear that this has been not a “Whodunnit” (though accusations and blame abound) nor an unpredictable “Black Swan”, but rather a “Perfect Storm” of multiple interacting factors that has overwhelmed people in many roles at many levels in many countries.

  • Posted by Cedric Regula

    “the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries …. [NOT BY] ….”

    There are so many things that went wrong this decade that anyone could pick one and be 1/10th right.

    As far as the inverted yield curve that Brad talks about, that didn’t happen until 2006. And we had significant inflation, so there was reason for the Fed to raise short rates and the market should have pushed up the rest of the yield curve. But it didn’t. Now CBs did buy lots of GSE stuff, but they still didn’t go very long dated on treasuries. So to my thinking the treasury should have auctioned a different mix…more long dated to push up the curve. But they took the easy money from the CBs at the short end. So I think they liked the housing bubble as much as everyone else.

    There is a lot of arguing right now about the practicality of regulating all this. The obvious and easy ones to implement are less leverage and more capital. Beyond that it starts to get tricky, but still very necessary.

    The problem is with making changes to the system as it exists in a reasonable amount of time without killing the patient.

    I just made up an ancient Chinese proverb to illustrate my point. “A caterpillar that loses his leg in battle does not die from being unable to run from his enemies, but from bleeding to death.”

  • Posted by Ying

    The relationship between lender and borrower can be analyzed by Greek philosophy. This idea was first originated by Economist Henry CK Liu.

    Hegelian dialectic, usually presented in a three-fold manner, comprising three dialectical stages of development: a thesis, giving rise to its reaction, an antithesis, which contradicts or negates the thesis, and the tension between the two being resolved by means of a synthesis.

    We live a dilemma. On the one hand, individuals and governments are loaded with debt burden which could not possibly be increased especially in recession while all sources of revenues are shrinking. On the other hand, pension funds and private investors reply on the income from debt securities to grow their asset value in the past.

    Ironically, private sector pulled the plug on mortgage debt and low credit worthy debt. The government takes up all the slack in funding these debts. The synthesis probably to reduce overall debt funding. The imbalance exists in domestic funding and high debt level too.

  • Posted by Phillip Huggan

    The title was an argument Bill Clinton forwarded on a talk show last year. He said if the housing money under GWB’s first term had instead been plowed into Green spending there would be “competition of capital”. I didn’t get it at the time, but it is simple portfolio diversification.

  • Posted by FollowTheMoney

    @ wstroupe-

    indeed we shall see decoupling as the traditional west stays in a long and protracted recession. It may take longer than most expect, but shall indeed progress.

    the question is how will the traditional west react to the great rise of the emerging players?

    I can’t imagine it was easy for Michael Jordan to see Kobe Bryant emerge as he was in decline…

    I’m your typical white guy, light brown hair, blue eyes and i have to confess we’ve gotten lazy. I remember in school, while we’re out drinking beers it was alot of the Asians studying hard at the library past midnite, excelling in math and science during the lectures. Attentive, something tells me they want “it” more than we do.
    I guess we are witnessing the great transfer right before our eyes. You either be part of it, or you be left in the dust. It’s a new world, a world where you have to think outside traditional borders.

  • Posted by FollowTheMoney

    Wstroupe-

    Just want to clarify that the decoupling I see won’t be this year or even next, but maybe 2-4 years out.

    in my view, we’re going to see Asian-Centric growth, consumer driven down the line (*NOT IN 2009), and enter recovery faster than the traditional west…. I WOULDN’T be long Asia at these levels. China also has structural problems, and need readjustment. They need to spend, while we need to save.

    It’s very difficult, and unfortunately before we get to more ‘balanced’ atmosphere there’ll be some pretty serious black clouds ahead. Green shoots are about to pass out from lack of sun in 09.

  • Posted by Glen M

    FollowTheMoney,

    It is more than they need to spend and we need to save. Following the current patterns that would merely maintain the status quo. To really address the situation it would be better for us to buy less from them and for them to buy more from us.

  • Posted by Rien Huizer

    Michael,

    Somewhere my insensitive remarks must have hit a few raw nerves. OK.
    First, many of your comments (re risk and portfolio management for instance) resonate, because that is what I have been doing for a long time and it made me pretty cynical about what any of us, individually or collectively, can do to either beat markets or manage the economy. We know a lot about market manipulation, but that is not a legitimate way to make money and I think we learned quite a bit, over time, of how to manage closed economies, or even systems of economies with shared political-economic characteristics. Unfortunately we live in a world with incomplete globalization, where some of the EMs believe that they deserve to be mercantilist, some countries are simply family businesses, and most countries with representative and rotating government have electorates that are prone to prefer mercantilism as well. I know of no mechanism to reduce trade balances except by unilateral action of a dominant actor or an alliance of several actors that creates some form of purpose organization and is able to dominate. A short time agreement (a trade equivalent to the Louvre accord for instance) will not work. The two best ways that I can think of to reduce trade imbalances would be for the US harmonize taxation with most OECD countries ( eg a much higher petrol tax, some form of VAT at the say 15% level, abolition of current state sales taxe, phase out of mortgage interest deductions, etc). That would probably have an overall effect on the balance betwen private consumption and investment). China should simply let the employment share of GNI rise to about 65-70% whilst encouraging a shift from saving by SOEs to saving by households. All the while narrowing the gap between country and urban. And do these things on top of liberalizing the external account
    to OECD levels (in that case maintaining (unfair) FX levels would be much harder and less necessary.

    All of this is easy to design (and people may have different preferences, these happen to be ones I would prefer), based on ideology and self-interest. However, I am pretty sure that a US VAT and high petrol tax are as unlikely as a ban on the private ownership of firearms, and a touch of social democracy in China as unlikely as democracy itself there. So, the sort of things that I would like cannot be executed politically. And whether one is of the neoliberal persuasion or the direct opposite does not matter.

    Second, financial system stability can be achieved at the expense of efficiency by constraining entrepreneurial activity and innovation. That would basically mean that external finance would be supplied by cartels of intermediators. That would take way the chance for idiots to entrust their money to crooks who who prey on the naive and shirkers who represent those idiots collectively in pension funds. People would not expect to receive more than the risk free rate minus modest transaction costs. And life time savings plans would reflect that sad reality. Essentially the shape of Western financial systems prior to deregulation in the 1970s. Bans on substitutes, limitative permits for cartel members and some government involvement in pricing. Lots of people like that situation, but it would be quite difficult to push the clock back, especially given the spread of finance-like risk technology to other markets. But like the trade imbalances, it is not so hard to imagine a reasonable financial system and regulation for a single currency and a single country. It is much harder to do that for a world where full of countries where finance varies in economic relevance. For the UK, Singapore and Switzerland (or cities like NY) what constitutes a desirable international financial system is different from what the Chinese or even the Cnadians and Germans would like to see. And there is no reason why the Germans should pay for the externalities (not that I agree with Germany’s official rhetoric about the current crisis though) of system that makes 150K New Yorkers, Londoners etc happy. Most continental European countries were pretty happy with what they had pre 1985 and would have done minor upgrading as technology progressed, But they had to liberalize.

    Anyway, a very lengthy explanation why I think that the problems will not be solved by analysis and design. Nor that it would be easy to separate ideology and analysis in either field. The relevant actors are very much aware of what remedies exist, but they will not individually pay the political price for a collective benefit, not even this time, at least that is what my historical nose tells me. They will rather resort to protectionism.

  • Posted by Rien Huizer

    WS Troupe,

    I think your Mohammed got carried away a bit but he is by no means unworthy of being named after the Prophet. I think that it is eminently possible that the US gets pushed in the same direction as the EU, that is, slow growth.and loss of international economic relevancy. Which will contribute to greater external balance, but not of the desirable kind. Interestingly, that is some of the thinking that was prevalent in the 10 years prior to WW I, especially in Germany re Russia..

  • Posted by Twofish

    bsetser: The key issue is whether or not the large net flow from the emerging world to the US and Europe created conditions that facilitated, directly or indirectly, the failure of private risk management.

    It did and what illustrates that the problem really wasn’t in the emerging world. The *purpose* of a financial system is to take savings and redistribute it efficiently and productively. If the US and Europe had financial systems that took massive amounts of wealth from the developing world and failed to distribute it productively that means that the US and Europe had financial systems that were *fundamentally broken*.

    The US and Europe failed to productively use the assets of the emerging world because they have political and economic systems that were based on flawed and incorrect ideological principles.

    If you can’t get your house in order when people hand you large amounts of cash, then if you have less cash, you are going to be in worse shape.

  • Posted by Twofish

    FollowTheMoney: Things are so bad, I wouldn’t be surprised if loan approval officers working at financial institutions received kickbacks or under the table fees for some individuals who received loans. I mean there was, at least in my view just an immense amount of fraud, and most of it has yet to come to light.

    People are so fixated on under the table and illegal payments that they ignore all of the bad stuff that happens over the table and which is perfectly legal.

    Part of the problem is that loan officers were compensated for making loans. The more loans you made, the more money the bank made, and the more money that you made. If you get paid for making loans, you are going to make loans.

    There’s no need to look for illegal under the table payments, all of the bad stuff was happening over the table while everyone was watching, and all this carping over fraud just misses the big picture.

  • Posted by Rien Huizer

    Twofish,

    What about the argument that those EM should not have been able to export capital but use it for development instead, for instance by importing more equipment. Or alternatively, distribute more and make sure consumers have a higher level of satisfaction? Pse note that that is not necessarily my point of view as to what the EMs should have done (I do not think they have the state capacity to enforce that kind of policy), but for the sake of argument, if those savings had not been there in the first place, the quality of the developed world’s financial system would not have mattered. In addition, the EMs did not suffer too many losses, because the mainly lent to governments or financial firms that were too big to fail. I guess they share the blame. Would you prefer the US having some form of trade restriction that kicks in automatically whenever an EM runs the risk to end up with surplus cash that the EM might foolishly (because it will lead to a crisis due to the weak financial system in the US).

  • Posted by Twofish

    bsetser: Back in March, the FT’s Krishna Guha — in a box linked to a Gillian Tett missive on “destructive creation” — wrote: “a more balanced economy might allow the world to live with a less perfect financial system” Very well said.

    Total nonsense.

    We are not talking about a financial system that was “less than perfect.” We are talking about a financial system was fundamentally unsound and hopelessly broken because it was based on the incorrect idea that markets always know best when they don’t.

    Markets react to low-interest rates by pushing up risk. So fix the damn system so that this doesn’t happen.

    If you have a financial system that cannot deal with an influx of wealth and savings *which is want the whole point of a financial system is for*, then it’s just a matter of time before it blows up in some other way.

    Stop making excuses for systemic incompetence. The faster people stop making excuses and just say “we screwed up” (and I for one will acknowledge that I was part of the problem), they faster we can go to fixing the problem.

  • Posted by Rien Huizer

    Twofish,

    The idea, as you well know is not “that markets know best” . That is ideology. The truth is that it is pointless to fight markets, because regulation breeds abuse. That is not ideology, that is empirically sound political economy. We have markets and democracy because that is the least bad solution.

    We can argue about the particular quality of US etc regulation. There is a lot that can be improved but some day someone like you in an investment bank will find a way to profit, despite or perhaps because of regulation. And in financial markets, your gain is my loss, unless I can put my problem to a government that panders to the electorate (as it should) and blackmail society in making it its problem. We tend to call a situation where soneone successfully blackmails a gvt with a bail out as a result a “systemic crisis” (i.e. the official excuse for bailing me out) There is no other way to run a democratic market economy. You regulate in the awareness that regulation will have weaknesses and unintended consequences, unless you are a perfectionist and then you will implicitly want to severely curtail the market economy (see my earlier post here) and then you are not a democratic market economy (=freedom) but some form of corporate system, where social mobility is limited and a bureaucratic/capitalist elite (sound familiar to a mainlander?) runs the thing.

  • Posted by Twofish

    Huizer: The truth is that it is pointless to fight markets, because regulation breeds abuse.

    That’s simply not true.

    All policies have cost and benefits, which have to be looked at. Not all regulation is anti-market. Often you can have regulation that reinforces markets (court systems for example). Even in situations where you have to fight the market, sometimes the benefits of doing so are better than the costs.

    Huizer: That is not ideology, that is empirically sound political economy. We have markets and democracy because that is the least bad solution.

    Democracy is a marketing term that can mean a thousand different things to a thousand different people. I really like markets, that’s why I work in one. But those “markets uber alles, it’s pointless to do anything about them” is pure ideology and it’s false ideology.

    Huizer: There is a lot that can be improved but some day someone like you in an investment bank will find a way to profit, despite or perhaps because of regulation.

    Precisely, and if you issue a regulation saying that *you will not do this*, then people will find a way around or even using the regulation to make money.

    Huizer: And in financial markets, your gain is my loss,

    That’s not true. In a market situation, we can both gain. Or both lose. The whole idea behind a market is that when we do a trade, we both win, because if either of us lose by a trade, then we just won’t do it.

    Huizer: You regulate in the awareness that regulation will have weaknesses and unintended consequences,

    Sure.

    Huizer: Then you are not a democratic market economy (=freedom) but some form of corporate system, where social mobility is limited and a bureaucratic/capitalist elite (sound familiar to a mainlander?) runs the thing.

    This is the ideology which I think is massively incorrect. If you look at the realities rather than the myths, some of the most socially mobile societies are those with strong state regulation of markets. In situations where you do not have strong state regulation of markets, the market participants will tend to collude to prevent mobility.

    Also, we live in a corporate system. If you want to get rid of a corporate system, then you are talking about an economic system that bears absolutely no resemblance to anything that exists, and I have very strong reasons to think that it just won’t work.

    This markets=freedom bureaucracy=slavery is nonsense ideology.

  • Posted by Twofish

    Huizer: What about the argument that those EM should not have been able to export capital but use it for development instead.

    Wouldn’t have happened. As bad as the US/Europe financial system was in 2003, China’s was in even worse shape. You needed to starve the banks, the SOE’s, and the bureaucracy so that they became more profit focused.

    Yes. I have having a double standard, and this is because in 2005, no one claimed that the Chinese financial system was particularly good, but everyone claimed that the US/Europe system was a model.

    And even if it would have been a good thing for China to export less capital, unless you come up with a mechanism that would provide incentives for it to do so, this is a pretty useless conversation. If you can wish for the impossible, then wish for aliens to land and fix everything.

    Huizer: If those savings had not been there in the first place, the quality of the developed world’s financial system would not have mattered.

    My point is that this isn’t true. Suppose China did exist and the US wasn’t getting massive amounts of excess wealth. I argue that the systemic flaws in the US financial system *still* would have led to problems. Look at Japan/1990 and US/1980. In the first case the country was exporting massive amounts of capital, and in the second case the US was rather capital neutral.

    Huizer: Would you prefer the US having some form of trade restriction that kicks in automatically whenever an EM runs the risk to end up with surplus cash that the EM might foolishly (because it will lead to a crisis due to the weak financial system in the US).

    My point is that this would not have mattered. What happnened in the US was asset inflation followed by a bubble and a burst. Suppose China hadn’t lent the US money. The Fed could and still likely would have printed large amounts of money. Wouldn’t that have led to inflation? But we *did* have massive asset inflation.

    Also it’s very difficult (almost impossible) to have automatic mechanisms in finance. You have to remember that you are dealing with people and not robots, and any sort of economic proposal that you put into effect will have interest groups that will keep in in force after the original rationale disappears. So I really distrust trade barriers to deal with macroeconomic issues because the incentives don’t work well.

    Markets are useful because they can create automatic impersonal mechanism, so if you want China to change the RMB value, you have to figure out some impersonal mechanism to create it, and no one was able to figure one out.

  • Posted by Twofish

    Huizer: The debate about what caused the current correction seems pointless.

    No it’s not. People are making up new rules as we speak, and those rules depend on what people think went wrong. It’s a controversial argument, but it’s certainly not pointless.

    Huizer: centuries of stagnation, like Qing China, roman catholic early medieval Europe or Turkey after 1600. All of these were autarchic economic systems, and all previously growing fast, similar to the current world economy.

    No.

    1) Even during the industrial revolution, the average GDP growth rate in England was about 3%/year. The type of growth rates we have seen in China and India are one’s that are totally unprecedented in the history of the world.

    2) Qing China was not a stagnant economy, and the notion that it was a myth that (mostly British) colonists made up to justify colonialism. As of 1750, China was in the middle of a historically unprecedented commercial and economic revolution (see Kenneth Pommeranz). This revolution led to forces that overwhelmed the old order, and weakened China to foreign invasion. The big problem was that the central government did not have a decent taxation system which could channel economic growth for national needs.

    Huizer: The current crisis may have a million causes. But looking back may be a waste of time, all we will get is ideology dressed up ad analysis..

    This false since you can use various empircal and deductive methods to separate truth from falsehood. I predict that if I do X then Y will happen. Y doesn’t happen, well I guess X wasn’t right.

    Ideologies are empircally testable, as Deng Xiaoping (quoting a 18th century Chinese philosopher) pointed out, we can seek truth from facts.

  • Posted by Twofish

    Huizer: I don’t think there is a comparable focus — setting martin wolf aside — on the need to bring down imbalances.

    That’s because no one can think of a mechanism for doing it.

    Huizer: Second, financial system stability can be achieved at the expense of efficiency by constraining entrepreneurial activity and innovation.

    There’s nothing in any proposal that I’ve seen so far that threatens to do that. Most people that do entrepreneurial activity get their startup money from friends and family or through groups of private equity investors that go outside the banking system. Funding risky startups from banks is a stunningly bad idea.

    Huizer: People would not expect to receive more than the risk free rate minus modest transaction costs. And life time savings plans would reflect that sad reality.

    Which I don’t think is necessarily a bad thing. You end up with very bad things happening when people figure that the best way of investing is to put money in the stock market rather than to save so that they can start their own business or take some extra college costs.

    Huizer: Essentially the shape of Western financial systems prior to deregulation in the 1970s.

    And Western financial systems in the 1970′s were put in place because of the crash in the 1930′s. The other thing to remember is that what caused deregulation was inflation which made the system untenable.

    Huizer: That would take way the chance for idiots to entrust their money to crooks who who prey on the naive and shirkers who represent those idiots collectively in pension funds.

    Which is different than the current system how? The only way you avoid these sorts of problems is if you start your own business or let money to people you know personally. Once you start either lending or borrowing money from people you don’t personally know, then things get very messy.

    The thing about finance is that people lie. They sometimes even believe their own lies.

    Huizer: The relevant actors are very much aware of what remedies exist, but they will not individually pay the political price for a collective benefit.

    Which is a common problem in politics, but if there really is a collective benefit then you can usually figure out a way of changing the game so that people benefit individually. The fun part of politics and economics is trying to figure out creative ways of getting things done.

    Also I don’t think that the relevant players really know what remedies exist.

  • Posted by Twofish

    The other thing is that markets are part of the innovation cycle, but they are only one part. A huge amount of innovation and entrepreneur-ship is state sponsored. Look at MIT or Stanford.

    One other ideology that I think is non-sense is private good/public bad. Look at MIT or Harvard for example, a huge fraction of their budgets come from either research grants or student loans. Entrepreneurship is something in which governments have a very important role.

  • Posted by Rien Huizer

    Twofish,

    Thanks for the elaborate post and extensive identification of my ability to err. There is much too much to reply to, but I think overall, this is a fair illustration of the difficulty that faces people trying to create an international consensus. My ideology (sorry, I adopted one here, because it looked like it would bring out a few comments, and it did) of pro-laissez faire born out of disbelief that things can be governed for the better, is not at all uncommon. What I like about your comments is that it appears to be based on some kind of optimistic mondernist paradigm that believes/hopes that bureaucrats can do a better job than they usually do, if the used the right prescriptions (and technology perhaps?).
    Re stagnation periods, granted, I know that there was a pretty strong rise in population during the Ching, so something must have been growing economically as well.
    But rapid growth as we have seen during the past century is not unique, but quite rare. And not much is known about the on/off switch.

    Finally (it is getting late here):

    Twofish: “Also I don’t think that the relevant players really know what remedies exist.”

    I am abolutely sure they do (ask any academic specialist on bank regulation whether the decision makers read the academic literature, of course they or their staffs do), they even know a range of remedies, their risks (unintended consequences), costs and benefits. But making it work in a strategic (in economic terms)setting is very difficult, and western politicians are risk averse (probably more than EM ones). Very few people back in 2000 or so believed that Basle II was a brilliant idea. Many expected it to become a greater mess than Basle I. But something that was a compromise between effectiveness for one industry (banking), anti-protectionism and advocates of a cross-industry level playing field was the best the international regulation community (that had to do something, it was felt) could AGREE on (not COME UP WITH). And the optimists among the regulators and regulated believed that certain aspects of the scheme could be tweaked to make regulation really effective (some still do) and others did not expect that their freedom would harm the rest of the world and a third group probably did and lined their pockets as fast as they could. All the while there was at least one excellent alternative that might even have worked for the shadow bankers.

    In centralized or authoritarian systems it is easy to implement the things that technocrats want, but in democracies or the current anarchic international environment, it is pretty hard. Perhaps not a complete waste of time, but close.

  • Posted by Rien Huizer

    Twofish,

    Just forgot, Any comments about my suggestions for China (like raising the employment share and capital account (essentially non trade FX) liberalisation? ) in order to reduce the trade imbalance?

  • Posted by edos

    you guys sounds interesting , but i dont know where you are all driving at. A little bit specific please.

  • Posted by jonathan

    A basic idea in tort law is proximate cause and the amazing case behind that is Palsgraf v Long Island Railroad. The facts were that a guy running for a train was carrying a wrapped package. He was late and the guards helped push and pull him up into the moving car. He dropped the package, which exploded when it landed – it contained fireworks. The explosion knocked some scales down on Mrs. Palsgraf. She sued the railroad and the great Justice Cardozo wrote the opinion that laid out how duty and actions come together to determine proximate cause. Look it up. Great reading.

    The point is that one may look at regulation and say yes that is clearly a direct cause. The most we can really say is “a” not “the.” We can also look at secrecy or non-reporting laws, which are a version of regulation, and say they are a cause. We can also look at sources of funds because without those funds the damage is limited, etc. and can say that this is a cause.

    There are several classifications of cause, ranging from the links in a causal chain (mechanical) to duty. One can say the regulators are clearly within the scope of duty and failure to regulate should have had forseeable consequences and thus their actions are a proximate cause. Action by sovereign nations accumulating funds are likely not within any scope of duty – outside of reporting information. They are a cause, no doubt about that, but the way economists write about this material – less you than others – tends to lump the kinds of cause together (except when doing statistical work that can isolate a degree of cause).

  • Posted by chaingangcharlie

    Somewhat off topic , but..

    A while back, I facetiously suggested Obama should maybe sell a couple or three aircraft carriers to the PRC. ( Hey everybody benefits, right ?)

    Well imagine my surprise on finding this today – “Obama will provide the blueprints for the B-2 stealth bomber to China in exchange for $50 billion in debt relief.”

    http://zerohedge.blogspot.com/2009/06/obama-selling-military-secrets-to-china.html

  • Posted by bill j

    “Huizer: What about the argument that those EM should not have been able to export capital but use it for development instead.”

    Just to add to 2fish, China did use massive quantities of capital for development.
    Its not a typical criticism of China that it has under invested in fixed assets! China has after all increased its FAI from around 2000 $409bn to an anticipated 2009 $2.2 trillion. And at the same time recapitalised their banks and so on.
    There are however, finite limits to the amount of capital an economy like China, with a massive rural non-capitalist subsistence farmer sector can absorb and that’s not considering the impact of raw materials shortages, inflation etc.
    For me its perfectly clear that notwithstanding this huge level of investment, surplus profits were generated on a historically unprecedented scale. These had to be put somewhere. The where they were put was the US and the West, driving down interest rates and creating the necessary precondition for the sub-prime bubble, securitisation debacle instead.
    But a condition is necessary but not sufficient. It also required the gamblers of the Western banking system to play their part.

  • Posted by Twofish

    Huizer: . What I like about your comments is that it appears to be based on some kind of optimistic mondernist paradigm that believes/hopes that bureaucrats can do a better job than they usually do.

    I don’t think so. I’ve just observed that when people talk about stupid bureaucrats and efficient markets, they miss the fact that markets are often dominated by institutions which are themselves huge bureaucracies. If you go into any large corporation, you’ll find yourself in a massive bureaucratic which has all the trappings of a centrally planned state. I just fail to see why people assume that state bureaucracies are doomed to be incompetent whereas corporate bureaucracies are necessarily wise and all knowing.

    Also, if you work in a bank, there is a huge amount of internal regulation. They are just not going to give you the keys to the vaults, the passwords to all of the accounts and leave you alone. Everything you do is signed and countersigned, and there is a huge amount of cross-checking and internal controls. I don’t see how adding one more person from the government to the mix is going to be the end of the world.

    Huizer: I am abolutely sure they do (ask any academic specialist on bank regulation whether the decision makers read the academic literature, of course they or their staffs do),

    I really don’t think so, because 99% of the academic literature involves stuff that is utterly useless to policy makers. Academia and academic publishing has become somewhat of a game to get tenure, and I’ve found very little worth reading in the literature, and people I’ve heard that make policy seem to see things the same way.

    I’ve really been shocked myself at how little some people in academia know about banking and finance, and it is interesting that academia has played essentially no role that I can see in getting us out of the crisis. The theories that people are using to deal with this mess come out of econ 101.

    Huizer: All the while there was at least one excellent alternative that might even have worked for the shadow bankers.

    I sort of doubt it.

    Huizer: In centralized or authoritarian systems it is easy to implement the things that technocrats want.

    It’s actually not. Centralized authoritarian systems also have internal politics. Also one thing that centralized, authoritarian systems have difficulty dealing with is the fact that people sometimes want different things. Certainly, I don’t see policy getting implemented in China any faster than I see it being implemented in the United States.

    Huizer: In democracies or the current anarchic international environment, it is pretty hard.

    It’s actually less hard than it may seem. All you have to do is have someone who is a salesman/actor communicate to people why a policy is good for them. We call them politicians.

    Just like there are corporate bureaucrats, there are also corporate politicians, and you really need people with sales ability and political problem solving skills to get things done.

  • Posted by Twofish

    Huizer: Just forgot, Any comments about my suggestions for China (like raising the employment share and capital account (essentially non trade FX) liberalisation? ) in order to reduce the trade imbalance?

    Raising the employment share seems like a “wish” and not a “policy.” Hu Jintao can’t just say “increase employment’s share of the GNP” and just have it happen. If you can think of something that Hu Jintao can write in a memo, then we can discuss that.

    Also, this is an interesting irony I’ve noted. Hu Jintao can’t order employment share of GNP to be increased. Mao could, but that probably was a bad thing. So you have economists talk about how China should move to a market economy and rule of law, and then turn around and say “China must decrease investment” as if we were back in the command economy days.

    As far as capital market liberalization of FX. I don’t see that happening in the next five to ten years. The dangers associated with getting it wrong are so great and the benefits associated with getting it right are so modest, that it has to be done slowly.

  • Posted by Twofish

    bill j writes: There are however, finite limits to the amount of capital an economy like China, with a massive rural non-capitalist subsistence farmer sector can absorb and that’s not considering the impact of raw materials shortages, inflation etc.

    China doesn’t have a subsistence farmer sector, and hasn’t had one for about five hundred years (at least since the single-whip reform of the Ming dynasty in 1500 when farmers started paying taxes in silver rather than in labor or agricultural goods).

    The farmers are all cash based, and the peasant economy has been “capitalist” for hundreds of years. If you understand what how savings works with farmers, this might give you a better idea of why the system is what it is. Suppose you are a farmer and you want to start a beauty salon or dim-sum stand. What do you do? Well, you save money so that you can start your own small business. While you are saving your money, you just want to park it somewhere so that it doesn’t disappear. That’s were the state banks come in.

    So what can the state banks do with the money? They could invest it in loss-making SOE’s. Really, really bad idea.

    So they just need to park the money somewhere so that it doesn’t disappear when the farmer wants it back. Enter agency bonds and US treasuries. Note here that China didn’t invest in subprime or real estate.

    Now what then happened was that investment banks took cheap money and invested it in riskier things. This wasn’t inevitable. At the same time the US government let US banks invest in stupid things, the Chinese government was forbidding Chinese banks from investing in stupid things. You might say that well China is different, except that Chinese officials were cracking down on bad lending following the advice of Western bankers.

    There was this massive disconnect in which Western bankers were going to China telling the Chinese government (who was listening) not to do exactly the sort of things that they were doing in the United States and Europe.

    One other thing. People have this weird idea that money naturally flows from the rich to the poor. The natural flow of money is from the poor to the rich. Trying this experiment. Some homeless person knocks on your door and asks to borrow $1000. He promises that he will double your money.

    Now Bill Gates or Donald Trump knocks on your door and makes the same offer.

    Who are you going to lend to? Seems pretty obvious who you will lend your money to. Poor people tend to lend money to rich people, since rich people have better credit than poor people.

    Yet I keep reading all these academic papers which are totally bewildered why money “flows uphill.” If you are Donald Trump, there is no shortage of people willing to lend you money. If you are some poor homeless person (or Chinese peasant), then you are going to have to save your pennies, because no one is going to lend you a dollar.

  • Posted by Rien Huizer

    Bill J,

    In my view, raising living standards (hospitals, schools etc) plus consumption are part of development too. I agree that China has done quite a bit in building infrastructure, especially to support industrial production.

  • Posted by bill j

    “China doesn’t have a subsistence farmer sector, and hasn’t had one for about five hundred years (at least since the single-whip reform of the Ming dynasty in 1500 when farmers started paying taxes in silver rather than in labor or agricultural goods).

    The farmers are all cash based, and the peasant economy has been “capitalist” for hundreds of years.”

    Far enough if you’re talking about the surplus product and perhaps I should have been clearer but subsistence farmers will consume a large proportion of the output they produce i.e. they will grow food and eat it without it going through the market. That proportion of output, which I’m guessing is a pretty significant proportion of their production, is not “capitalist” inasmuch as it is is not exchanged on a market. Its rather like when you do the housework at home, rather than getting a cleaner in except it applies to around 500 million people.
    Obviously as agricultural productivity increases the size of the surplus rises and so does the integration of farmers into the circuit of capital, as indeed does the social differentiation of the countryside with relatively richer capitalist farmers employing rural workers.
    The point about the development of capitalism in China is that through separating farmers from the soil they create a consumer who is completely dependent for the market for all their needs and through transforming them into workers from farmers their level of productivity is radically increased.

  • Posted by Twofish

    bill j: Subsistence farmers will consume a large proportion of the output they produce i.e. they will grow food and eat it without it going through the market.

    I don’t think that accurately describes Chinese agriculture. Chinese farmers specialize in a few crops, and while they consume some of that crop, most of the gets sold in the market through cash transactions. I grow rice, you raise pigs, I sell my rice and buy pork from you.

    Also the term “peasant” gives you this mistaken impression of unsophisticated rustics, when every Chinese farmer that I’ve ever met has been using chemical fertilizer and pesticides and have a wealth of information about irrigation techniques, crop strains, market prices. Most of them have cell phones, DVD players, and television sets. When the price of oil rises or falls then everything changes.

    bill j: Obviously as agricultural productivity increases the size of the surplus rises and so does the integration of farmers into the circuit of capital, as indeed does the social differentiation of the countryside with relatively richer capitalist farmers employing rural workers.

    That’s not how Chinese agriculture works. If you have residency in a rural area, then by law you are entitled to a plot of land that you can farm, so it make no sense to be employed by someone else if you can get your own land for free from the state. Once you get that plot of land from the state, you get to decide what to plant and what to farm, and this effectively makes farmers entrepreneurs. This system has proved wildly successful in many ways, and it’s an example of using socialism to promote capitalism.

    Also the problem with increasing productivity is demand. Basically the amount of demand for agricultural products is capped, and since the supply of labor is large, the market pushes things toward low-productivity/high-labor solutions rather than high-productivity/high-capital solutions.

    bill j: The point about the development of capitalism in China is that through separating farmers from the soil they create a consumer who is completely dependent for the market for all their needs and through transforming them into workers from farmers their level of productivity is radically increased.

    Two problems:

    1) What happens if the market fails? The really good thing about the Chinese system of agriculture is that it provides a social safety net. The worst case scenario is that you end up back on the farm, farming the plot of land that the state gives you. If you don’t have that as a backup, you end up with huge numbers of farmers in the cities with nothing better to do that to riot.

    Also by having a social baseline, it allows farmers to take financial risks. While one person is in the fields farming, someone else is starting a beauty salon, doing textile piecework, or going off to the cities to work in a factory. All these other things are high-risk/high-reward activities.

    Finally, if you increase agricultural productivity too quickly, then you end up with huge unemployment. Basically, you want to increase agricultural productivity only to the degree to which you have enough industrial jobs to absorb surplus labor.

    This is the type of economic problem that central planning is hideously bad at. What happens is that you miscalculate the rate at which agricultural productivity is growing in which case tens of millions of people starve to death, or you underestimate agricultural productivity, in which case end up with lots of surplus workers that you put in factories that aren’t producing anything.

    The genius of the market economy is that you give the farmer a set of economic choices, and they have them decide which one makes them the most money. They can go to work in a factory, farm the plot of land, or start their own service based business. Also, if you have the household as the basic unit of production, you can distribute labor between all three to maximize income, and given the structural characteristics of the Chinese economy, that moves *away* from high-capital/high-productivity improvements in agriculture, since you have lots of people. If you have a productivity improvement that is low capital (chemical pesticides) then people will take it, but if you have high capital productivity improvements (tractors) then the return on investment isn’t worth it. Also, low-capital doesn’t mean low-technology. Cell phones, for example.

    But one thing that about this is that you have to be careful about the term “peasant” since this gives the incorrect idea that you have uneducated, rustic, peasants unconnected with the world economy and living life exactly like it’s been lived for thousands of years.

    The “Chinese peasant” is a pretty shrewd and sophisticated businessman is very tightly connected with the world economy, and has been for the last five hundred years, and they are going to make better economic decisions than some central planner a thousand miles away that doesn’t know one end of a pig from another.

    Also, the fact that the Chinese economy works *against* high capital solutions explains why the industrial revolution happened in England and not in China. In China, it’s never been particularly profitable to invest large amounts of money in manufacturing, because there are lots of people. In England, you had the Americas which could absorb excess population.

    It’s actually remarkable because what has happened in the last few years is a massive *de-industrialization* of manufacturing. High productivity machines are getting replaced by low-productivity people. It’s basically the industrial revolution in reverse which explains why China never had a local industrial revolution in the first place.

    A lot of the “fantasies” that people have about third world peasant are basically to justify colonialism. These peasants are stupid and backward, and it’s the “white man’s burden” to lift them up.

    You still see this in World Bank and IMF reports, and I’ve never detected in these reports the realization that “Hey, maybe Chinese farmers know more about Chinese agriculture than we do?” I’ve been to lots of conferences on Chinese economic development, and I’ve heard lots of people *talk* about Chinese farmers, but I’ve never seen one there.

    Except that the peasant’s aren’t so stupid and backward. The English in 1830, had this image of using advanced machinery to dominate Chinese textile markets, but if you have a shirt today, chances are that it says made in China and not made in England.

    In southern China you’ve had a huge network of social relations and markets that has existed for several hundred years. Once you tap those social networks and use them for light manufacturing and finance, then boom, the world changes.

    One other interesting note is the connection between textiles and finance. It turns out that places with strong textile industries always turn out to be major centers of finance (NYC, North Carolina, London, Italy, Pearl River delta). I think the reason why is that both textiles and finance require crucially on very complex and sophisticated social networks, so if you have the networks that can be used to make clothes, you pretty soon have a banking network.

  • Posted by Twofish

    One very important thing about China and why savings rates are so high, is that if you look at the budget of the average Chinese household, you’ll find one huge item missing. Rent.

    All Chinese rural dwellers, and most city dwellers don’t pay rent or mortgages. In the case of people in the countryside, all dwellings and land are owned by the state, and rural dwellers get their houses and land rent-free. In the case of urban dwellers, most people got their own housing when the SOE’s were closed. Migrants from the interior typically live in company provided housing.

  • Posted by bill j

    Interesting points.
    If you take the English example of the 1830s then the transition from agriculture to land was much easier as large landlords had already expropriated the small farmers.
    As these landlords moved towards cash crops, wool, wheat, mining, they drove the peasants off the land into the factories and yes abroad. This was a pretty unpleasant and very bloody process, the Irish famine of the 1840s was deliberately manufactured food was exported throughout the period, to drive the rural poor off the land and into English factories.
    I wasn’t making a point about central planning vs the market in agriculture per se, certainly as you point out the transition towards market relations from the 1970s onwards, enabling farmers to retain a proportion of their earnings massively increased output and living standards compared with what had gone before.
    This is to be expected before the widespread mechanisation of farm production and combination of small holdings into latifundia.
    And as you say the ability of farmers to return to the land and subsist off their output is a massive safety net. BTW I wasn’t implying that farmers decisions whether to consume or sell the output implied anything about their ability to assess what is in their best interests.
    A good friend of mine is the daughter of some Ethiopian susbsistence farmers, who she said, sold on average $2 a month of onions at the local market, everything else they consumed, housing, clothes, food, furniture etc. they produced themselves.
    While the situation is very different in China, the ability of farmers to opt out of market relations limits the ability of the economy to absorb the massive amounts of capital produced by it, notwithstanding your corrections to my crude overstatement.

  • Posted by Twofish

    bill j: As these landlords moved towards cash crops, wool, wheat, mining, they drove the peasants off the land into the factories and yes abroad.

    I think one could argue that the same thing was happening in China in the 19th and early 20th century. However, what you ended up with was a lot of angry peasants and a communist revolution.

    bill j: Certainly as you point out the transition towards market relations from the 1970s onwards, enabling farmers to retain a proportion of their earnings massively increased output and living standards compared with what had gone before.

    But it’s important here to point out exactly what did happen before. In the 1950′s and 1960′s, the government got this idea of turning farms into agricultural factories, where farmers would be scientifically managed workers. By combining plots into communes, you could then get productivity increases by mechanization and low level industrialization.

    It turned out to be a total disaster that left about 50 million people dead. In 1978, the government instituted the household responsibility system, which caused productivity to dramatically increase.

    bill j: And as you say the ability of farmers to return to the land and subsist off their output is a massive safety net.

    But the important thing here is that I don’t think that farmers in China could be “subsistence farmers” in the way that you use the term. Chinese agriculture is extremely dependent on modern technology in which farmers need cash to buy seed, fertilizer, and pesticide. There’s no way that I can see that a Chinese farmer could detach himself from the markets and survive.

    Chinese agriculture is extremely intensive because you are trying to support a population of 1.2 billion people off a tiny amount of arable land. I don’t see how you can get to that level of intensity without some sort of extensive social network whether market based or administrative.

    bill j: A good friend of mine is the daughter of some Ethiopian susbsistence farmers, who she said, sold on average $2 a month of onions at the local market, everything else they consumed, housing, clothes, food, furniture etc. they produced themselves.

    And China hasn’t been like that for several hundred years. This may be one big reason (and perhaps the big reason) that Walmart is importing stuff from China and not Ethiopia.

    One thing that I’ve noted is that people tend to lump all societies together as “developing economies” and the more I learn about economies, the less I think that’s a good idea. What works in China may not work in Ethiopia and vice versa.

    One big difference between China and other places, is that Chinese agriculture has always relied very heavily on irrigation and flood control systems which in turn rely very heavily on a state bureaucracy. That’s why China exists in the first place.

    bill j: While the situation is very different in China, the ability of farmers to opt out of market relations limits the ability of the economy to absorb the massive amounts of capital produced by it.

    I don’t think that farmers in China can opt out of market relations even if they wanted to. In the end, they have to buy fertilizer and pesticide.

    I think the main barriers to capital absorption are institutional. If you show up at a bank with $1 trillion dollars, it’s very, very difficult to make sure that this money would actually be used to do something useful rather in some banker’s pocket.

    Look at Russia or most African countries. Massive amounts of wealth being generated and squandered. Or the United States. Getting back to the original point, I do think that all that Chinese money could have been used for something more useful than real estate projects.

    When people actually tried to pump money into rural areas in the 1980′s what you ended up as a massive credit boom/credit bust that still hasn’t been totally fixed.

  • Posted by Rien Huizer

    Twofish,

    Thanks for very informative posts on the economics of rural China. Probably many people thinking about development do not realize that the East Asian countries were not primitive subsistance farming communities but instead have had high levels of socialization for often longer than Western Europe. Also people miss that the gap between emerging Europe and “cruising” East Asia only opened up around the early 1800s (meaning for instance that Japan needed only a short spurt to industrialize in the late 1800s). If we look beyond the damage done by overpopulation (relative to farm technology), civil war, impacts of external war (Japan) and especially if we are aware of the rapid industrialization of Manchukuo in the 1930s, it becomes clear that the Chinese rural person was never a typical LDC person.

    However, I spent some time thinking about your statement:

    Raising the employment share seems like a “wish” and not a “policy.” Hu Jintao can’t just say “increase employment’s share of the GNP” and just have it happen. If you can think of something that Hu Jintao can write in a memo, then we can discuss that.

    Also, this is an interesting irony I’ve noted. Hu Jintao can’t order employment share of GNP to be increased. Mao could, but that probably was a bad thing. So you have economists talk about how China should move to a market economy and rule of law, and then turn around and say “China must decrease investment” as if we were back in the command economy days.”

    You make it look like Mao could have done something (and maybe he would have do the wrong thing?) and Hu cannot (but if he could he would do the right thing?)

    Of course no one can manadate the employment share to go up, but there are many policies that would lead to that outcome and I would be surprised if they were out of reach for China’s state capacity.

    In this respect I am curious as to what will be the outcome of the long-awaited IMF consultation annex country report (latest may 2006, and previously basically an annual event). I would not be surpised if the IMF would come up with policies that could have a higher employment share (the basis for a sustainable higher share of houshold consumption). Many ways to do that. Crude ones (minimum wage), market ones (labor deregulation, retail trade and zoning), politically incorrect ones like trade union deregultion and frameworks for collective bargaining.

    With an economy where FDIs produce and consume 50-60% of imports and exports whilst employing only 3% of the labor force there seems to be considerable scope for social policy without ruining international competitiveness.
    THis could be done without liberalizing the external account (no doubt one of the bones of contention with the IMF) and might start locally, thanks to the hukou system.

    Plenty of options but no desire or need?

  • Posted by bill j

    OK perhaps saying opt out of market relations is the wrong expression, but the point remains that unlike workers in a city farmers have the option of living off their output.
    I’m assuming as well that there is a difference in the integration of farming into the market between the East and West, South and North, in the less developed parts of China, unless you can tell me different, I’m guessing that the proportion of a farmers output consumed by them, i.e. non-market production, will be higher than in the more advanced areas, more closely tied into production for the cities.
    And finally what about Hu Jintao’s proposed land reforms, not on the scale of Vietnam where outright privatisation is proposed or something pretty much like it, but enabling farmers to borrow against their holdings etc. Won’t that have the effect of consolidating land holdings, increasing class differentiation in the countryside, accelerating the separation of farmers from the land etc.?

  • Posted by Michael

    comment to Rein Huizer’s reply ;

    OK; I see; you see institutional constraints & inertia thwarting any balanced growth initiatives
    regardless of what might come from debate and analysis.
    I think your observations are valid concerns.

  • Posted by Twofish

    Huizer: You make it look like Mao could have done something (and maybe he would have do the wrong thing?) and Hu cannot (but if he could he would do the right thing?)

    In a command economy, the state can order changes in what workers get paid. The trouble is that without market information, they can’t get the right number and this causes problems. The other problem with command economies (which is usually insufficiently mentioned) is that if the state controls your employment, they pretty much control everything else in your life.

    Huizer: I would not be surpised if the IMF would come up with policies that could have a higher employment share (the basis for a sustainable higher share of houshold consumption). Many ways to do that. Crude ones (minimum wage), market ones (labor deregulation, retail trade and zoning), politically incorrect ones like trade union deregultion and frameworks for collective bargaining.

    Perhaps but I don’t see the real point. Since Chinese GDP is rapidly growing, I really don’t understand this fixation with increasing consumption growth and employment share. You increase GDP which increases investment which increases GDP which increases investment. Repeat for fifty years until you have a first world economy.

    The whole reason that the PRC government is trying to increase GDP growth is that they want to avoid making decisions about how to cut the pie by making the pie bigger.

    bill j: I’m assuming as well that there is a difference in the integration of farming into the market between the East and West, South and North, in the less developed parts of China, unless you can tell me different, I’m guessing that the proportion of a farmers output consumed by them, i.e. non-market production, will be higher than in the more advanced areas, more closely tied into production for the cities.

    I’m sure there are regional differences, but I don’t know of any place except maybe in extremely isolated places in Western China, where the farmers aren’t very tightly integrated in the markets. Also what goes for “rural” in China is very different than in the US, since most “rural” areas in China have very high population densities.

    bill j: And finally what about Hu Jintao’s proposed land reforms, not on the scale of Vietnam where outright privatisation is proposed or something pretty much like it, but enabling farmers to borrow against their holdings etc. Won’t that have the effect of consolidating land holdings, increasing class differentiation in the countryside, accelerating the separation of farmers from the land etc.?

    Yes, which is why it is unlikely to happen especially after the recent financial meltdown.

    Suppose a farmer borrows large sums of money against their land, and they can’t pay it back. What happens to the farmer, and what happens to the bank that loans money to the farmer, and were did the bank get the money to loan out in the first place?

    I don’t see why it’s important to separate farmers from the land. I don’t know of any farmer that seriously thinks or wants their kids to do farming, and most of them seem to see their job as to accumulate enough capital so that their kids can to go high school and college and get office jobs.

    If a farmer can do something more profitable than farming, then presumably they would be doing it. The fact that someone is farming means presumably that they can’t find something that will make more money.

  • Posted by Rien Huizer

    Twofish

    Since Brad is away, we might as well try to figure out what we mean.

    Re:
    “Perhaps but I don’t see the real point. Since Chinese GDP is rapidly growing, I really don’t understand this fixation with increasing consumption growth and employment share. You increase GDP which increases investment which increases GDP which increases investment. Repeat for fifty years until you have a first world economy.

    The whole reason that the PRC government is trying to increase GDP growth is that they want to avoid making decisions about how to cut the pie by making the pie bigger.”

    If that is the case, then they have a problem because governments that ignore distribution tend to have not enough friends. Unless you believe that in China (with its high literacy, internet ccess etc) people will accept growth in income and wealth that does not give them anything except a national statistic without friction, I guess you are wrong.

    States like China (benevolent, paternalistic authoritarian systems) depend on unopposed (and unopposed at low cost in terms of repression etc) single party government for their long term prosperity. I completely agree that China would not grow as fast if it had a vigorous “Asian” democracy and a highly disruptive civil society. I am not saying that growth is more important than democracy.

    But the government has to make sure that people do not see it as something they learned in the 1950s: a class enemy..

    Just kidding. But I still believe that income distribution is an issue that will grow in importance, especially when so much wealth is in the hands (but not their pocket yet, this is a civilization, not Russia, it takes more time) of SOE managers. Comrades as they used to be called.

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