Historical Perspective of the Economic Crisis and the Recovery

1. Historical Perspective of the Economic Crisis and the Recovery Presented at The 20th ASA Congress Taipei by 卜若柏 Robert Blohm http://www.blohm.cnc.net September 27, 2010 2010年9月27日 Download at: http://www.blohm.cnc.net/Taipei

2. 1. History

3. Post WWII US economic resurgence after self destruction of Europe and East Asia.

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

5. Germany deficit financed itself to military dominance. Hjalmar Schacht & MEFO bonds.

6. 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.

7. 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.

8. European and Japanese economic strength in the 1960s as producers of low cost products began to reduce the US’s net exporter status.

9. 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.

10. The Nixon Administration opted to expand government spending to sustain the post Vietnam War economy through recession.

11. 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.

12. 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.

13. 2 heros emerged to meet the challenge to the survival of their respective economies: Ronald Reagan and Deng Xiao Ping.

14. 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.

15. 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.

16. 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.

17. 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.

18. 1985 Yen appreciation kept the Japanese economy in the slow growth mode it was thrown into by the 1980s oil shocks.

19. 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.

20. 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).

21. 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.

22. 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.

23. 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.

24. 2. The 2008 Financial Crisis and Subsequent Great Recession

25. 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.

26. 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”.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 3. The Post Economic Crisis

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.