Three Dimensions in Dealing with Economic Crisis

Ping Chen’s speech at the conference « The Financial Crisis, the US Economy, and International Security in the New Administration », New York, 14th November 2008.

by Ping Chen

I. Theoretical basis

I would like to discuss three dimensions of the current economic crisis: the economic theory, the economic policy and the changing world order¹. To start with the theory, mainstream economics is illprepared to handle the crisis. If we want to adopt new economic policy, we also need new thinking in economic theory itself, sincepoor policies came from poor theory. As I see it, there are four influential theories that could mislead our analysis.

Number one is the exogenous theory of business cycles, such as the Frisch model noise-driven business cycle. This school believes that the market economy is fundamentally self-stabilizing; any trouble is caused by an external shock. The best thing about the current financial crisis is that people finally seem to realize that the causes of the crisis are to be found within the American economy itself. Since the discovery of economic chaos in 1985, we know that business cycles are driven by endogenous forces. The market economy is inherently unstable – that is the very reason why we need proper regulation and sound management.

Secondly, Friedman’s theory of exogenous money gives an oversimplified account of how to deal with financial crisis. Friedman assumes monetary movement is exogenous, so central banks can do whatever they want. Friedman also claimed expansionary monetary policy alone could have prevented the Great Depression, though there’s no solid empirical evidence to support that theory. It would be very dangerous for Paulson, Bernanke and central bankers around the world to follow Friedman’s theory in dealing with the current crisis. On the contrary: we have solid evidence supporting the Austrian theory of endogenous money and rejecting Friedman. In 1998, China had to confront severe deflation in the aftermath of the Asian financial crisis; it managed to maintain sustained growth mainly by fiscal policy, by large investments in infrastructure.

The third misleading theory is the Lucas theory of micro-foundation and rational expectation. As you know, there is a fundamental debate between the school of micro-foundation and the school of macro-foundation for firms’ behavior. Some people today blame Wall Street greed for the financial crisis. But let me ask you: why did American investors like Goldman Sachs behave much better in China than in the United States? They don’t make their decisions in a vacuum, but in a certain macro-environment; it was American macroeconomic policies and deregulation that encouraged financial speculation and manipulation.

Lucas ignored the “principle of large numbers” according to which the driving force of business cycles comes mainly from financial intermediation and industrial organization, not from households and firms. We have a large number of households and their fluctuations neutralize each other. But we have many fewer giant firms, and their decisions will generate much larger macro fluctuations than those of households or small firms. This means that the financial crisis was caused by failures of major firms in the financial sector. In dealing with failed giant financial firms, you have a tough choice to make: either you break them up into smaller entities, and encourage competition, or you merge them into even bigger ones, and create even more concentration. American government is encouraging big firms like Citigroup and Bank of America to take over weak financial institutions. China made a similar mistake in the 1980s, but changed its policy in the 1990s. You may soon find out that the larger the firm, the more difficult it is to reform. China’s new competitiveness is mainly based on open competition rather than on concentration.

The fourth misleading theory is the Black-Scholes model in option pricing theory. Some people blame rocket scientists² for the meltdown of the derivative market, but few realize that the problem lies in the equilibrium theory of option pricing. We found out in 2005 that the Brownian motion model, the basic model in all derivative trading, is explosive in nature. The collapse of the derivative markets is not just driven by greed; it also resulted from poor models of the stock market. When you don’t know how to evaluate the price of derivatives by empirical data, you have to count on the so-called efficient market model. However, these equilibrium models completely ignored market instability generated by collective behavior. And the Coase theory of transaction costs cast even more doubt on market regulation.

Combined, these four mainstream economics theories created an illusion of a self-stabilizing market, making policy makers ill-prepared for the situation we have today. And yet, since the 1980s we have empirical and analytical support, not just philosophical arguments, to prove they are erroneous. I would specifically mention the “principle of large numbers” used by Schrödinger, the founder of quantum mechanics, applied to micromacro relations in biological structures but ignored by economists like Lucas. Let’s say we have 1,000 banks and merge them in 10 bigger ones. You think that a bigger bank is more efficient or more stable? On the contrary: its aggregate fluctuation will amplify by 10. That’s exactly what has been going on in the United States for the last 20 years, ever since financial deregulation stimulated a wave of mergers and acquisitions.

I would also add that Charles Kindleberger’s theory about the Great Depression is much more relevant to understand our situation than Milton Friedman’s. Friedman believed that the Great Depression was trigged by one single event: the death of New York Fed Governor, Mr. Strong, which left a vacuum in the Fed’s monetary policy. Charles Kindleberger pointed out that the world depression was caused by the collapse of a globalization based upon British leadership. The three world powers after World War I – the United Kingdom, the United States, and France – were kicking ball among themselves and eventually provoked a collapse of the whole global system. We have a similar problem today, since the United States has lost its world leadership by excessive military expansion and excessive consumption. The world-order has changed since the 1980: unless the United States, Europe, and China coordinate their efforts, we may face another global depression.

II. Political analyse of the crisis

Before discussing policy issues,we need to address the problem at hand from a global perspective. There are three questions to be asked:

First, what vision do we have of the American economy? Should we treat it as a closed system or as an open system? People used to think that only small countries need to ask this question, not the United States. But we can no longer ignore the interaction between the American economy and globalization.

Second, what is the international background to the current crisis? Bernanke once suggested that American imbalance was rooted not in its excessive consumption but in China’s excessive savings. I have a different view on this. The U.S. is much more powerful than China and the other Asian economies combined. Its financial power is still dominating the international financial order. But what we see today is the result of President Reagan’s contradictory economic policy in the 1980s: on the one hand, Reagan launched a tremendous military expansion; on the other, he made substantial tax cuts and deregulated the financial sector. The budget deficit that resulted was financed by growing public debt, which drove up both interest rates and the dollar and ruined the competitiveness of American manufacturing industry. As we know, the response to this was outsourcing, first to Japan and East Asia. The U.S. pushed the Japanese to appreciate the yen, but that did not solve its trade deficit. Instead, it threw the manufacturing industry out from Japan and the “Asian tigers” into mainland China. Ever since, the U.S. keeps putting pressure on the Chinese government to appreciate its currency, but this time with no success.

The fundamental problem of the U.S. is that the financial sector has replaced the industrial sector in the “driving seat” of its economy. You cannot cure that disease by playing currency games or monetary games. Since the 1970s, no matter how exchange rate fluctuated, America has a persistent trade deficit, while Germany and Japan have persistent trade surpluses. It has nothing to do with exchange rates but with American foreign policy. The United States has strong technology and abundant resources, but you continue to waste immense resources on military spending and financial speculation. What you need is a fundamental change in your economic structure and in your foreign policy.

As for China, of course it has suffered from the American foreign policy, but it has also benefited from it. Let me explain this.

During the Asian crisis, China did not follow the American recommendation to devalue its currency. Both before and during that crisis, mainstream American economists had one single policy recommendation to offer Latin America, Hong Kong and China: dollarization, dollarization, and dollarization! Remember that most Chinese reformers tried very hard to learn market economy from American textbooks. They all considered the American Treasury Bill as a risk-free investment compared to risky stocks and corporate bonds. So the Chinese government decided to target China’s exchange rate to the dollar and buy American Treasury bills. They thought that this was the best way to preserve the value of Chinese savings, or at least a much better way than to invest them in China’s own enterprises. However, once China had chosen that road, American Treasure bills turned out to be a trap. And in that situation, China has fewer options than Japan and European countries in the currency game, because of the asymmetric policy adopted by the United States. When the dollar goes up, Japanese or Europeans can buy American assets, but China cannot, blocked as it is by the American security policy. At the same time, American banks and firms are invited to be strategic partners for China’s state-owned firms. Do you think China is blind and will sell their security interests to American firms?

Still, I would claim that this asymmetric trade policy has in fact done more good to China than to the United States. It did not resolve the American deficit problem, but it did accelerate the economic integration of East Asia. How did that happen? If world trade was free and based on rules of symmetry, China would be buying much more American technology than it actually does. But since the United States does not allow exporting high-tech products to China, China can only import second-hand technology. However, the U.S. does export high-tech to Japan and other East Asian countries, and this difference in trade policy has created a tremendous arbitrage opportunity for these countries. It is not by accident that since the 1970s, China has persistent trade deficits with its neighbors: first with Japan, then with Korea and other South-East Asian countries. In fact, these deficits are quite comparable to China’s trade surplus with the United States. And what does it mean? It means that the U.S. is giving away a huge trade opportunity to China’s neighbors.

But what are the actual results of this policy? After the Asian financial crisis, all these countries realized that China is a more reliable partner in international trade, since it did not devalue its currency in spite of the crisis. They also realized that their economies greatly benefited from China’s rapid growth. So, geopolitically speaking, these countries, once China’s opponents, became its close friends and their economies became more and more integrated into the Chinese economy.

East Asia is today the third largest economic zone in the world, with stable exchange rates to the dollar, which also helps to stabilize the dollar. If U.S. policy makers realize that this is a base for closer economic cooperation, I would say that our future is bright. But if they consider it as a challenge rather than an opportunity, it would signal troubling future ahead.

This is the geopolitical heritage of the Reagan revolution and the American imbalance. If the U.S. was able to maintain its financial power in spite of increasing deficits, it was because China’s exchange rate policy was targeting the dollar as an anchor. So far, both the Chinese and the Americans are happy about the past but worry about the future. Unlike their Asian partners, China did not get any credit from American policy makers; instead, they only get China bashing. American leaders should focus on winning people’s trust more than financial profits.

III. China’s saving rate

Now my third question, the one about China’s high savings rate. Why do the poor countries end up subsidizing the rich ones? My opinion is that China’s high saving rate results in part from the monopolistic power of international companies that dominate China’s domestic market. More than half of China’s exports come from plants owned by foreign firms, and most export channels are controlled by firms like Wal-Mart. Chinese companies and the Chinese government have no pricing power in international markets. For any Chinese product sold in the United States, Chinese companies get 2 to 5 percent of the sale value. As the result China’s domestic market is more open and more competitive than the United States, Japan, or any other country in Asia and Europe. If we look for instance at China’s car industry, we see that the market is not dominated by the “big three” as in the U.S.; you have more than a hundred companies competing with each other. Their profit margins are very thin compared to giant foreign firms – in order to survive, they have to upgrade their technology by self-financed investment, and this gives very high saving rate in Chinese firms.

Since China launched its reforms some 30 years ago, its annual growth rate in residential income and consumption has been about 7 and 6 percent. China’s high saving puzzle cannot be explained by households but by firm behavior. If we look at the composition of China’s immense bank deposits, residential deposits represent some 50%, more than 30% coming from firms. China’s interest rate in the domestic market is also much higher than what U.S. Treasury Bills offer. In rural industry, gray interest rates may reach more than 30- 40%. Clearly, strong market competition leads to strong competition in technology investment among all industries and firms. The Chinese government has very limited means to cool down the investment book since public investments are much smaller than the private ones; in addition, regional governments have strong incentives to promote manufacturing industry.

I would guess that if the U.S. government adopts new anti-trust laws and breaks up monopolistic firms as it did with AT&T, American industries would become more competitive and American households would behave more like Chinese households, investing in education and technology rather than big homes and cars. In the end, you would see more balanced trade in the world market.

When Bernanke points out China’s high saving rate, rather than the low saving rate in the U.S., as a possible source of financial instability, you have to reply by posing a more fundamental question about the driving force of growth. It should be consumption or new technology or new industry. American policy for economic stimulus in developed countries is about encouraging consumption, especially about buying new houses and new cars. But can you recommend the same measures in the case of developing countries, saying “if we spend more money you drive up your economy”? You must consider this question from the point of view of the international competition. Let’s say that one country spends most of the money on consumption, while another country spends more on innovation. Which country do you think will win the international competition? That’s a very simple question, is it not? No matter what natural resources and property rights we take into account. You don’t need a grand theory, common sense will do to answer this simple question.

Finally, I would like to discuss some policy issues. I have lived in the United States for 28 years now. I consider myself as a student of American and European civilization. I learned a great deal from Americans. But the time has come for Americans to ask themselves if they can learn something from other people, from the Europeans, from the Japanese, from the Chinese or the Brazilians. I have some suggestions for my American friends, based on China’s experience in economic reform.

Mutual understanding is the most important thing in building mutual trust in international affairs. As I see it, China has no intention to even trying to replace Americans or Europeans as world leaders. Chinese philosophy teaches that you lead when you are modest and you lag behind when you are arrogant. China did achieve some prominent things during the Tang dynasty in the 7th and 8th centuries, and the Ming dynasty in the 15-16th century, and Chinese people understand very well that the rise and fall of great nations are historical events that are beyond the human will.

We all know China’s economic problems were more severe than yours. So what lessons can we learn from China’s reform? I would suggest: growth first, reforms and redistribution second. If you have a shrinking economy, you have little space for institutional reform. A lot of people say we have to increase our pension funds, save this save that. Where will the money come from? You should identify growth opportunity first, then you may convince people to make sacrifices for a better future. Investing in infrastructure, in green technology, and attracting foreign investment are better measures than layoffs and bankruptcies.

Second, the United States must change its consumption-driven growth to export-led growth. What can you export? Exporting Treasury bills or inflation is a destabilizing strategy, both for the U.S. and for the world economy. But you can export, let’s say, the all-electrical car of General Motors. In fact some of your products may not sell well in the United States but very well in China and Asia, where the population density is much higher and traveling distance much shorter. And then, the most competitive U.S. firms are universities. Many Chinese families, including poor farmers, want to send their children to American universities to learn. You may accept more Chinese students by developing partnerships with Chinese provinces or cities. They may invest in the American educational system and infrastructure, and you may help China develop better education.

Third, cross-investments will develop mutual trust and cultural exchange around the world. You might ask: why would Americans need Chinese investments? China asked the same question before. Financially speaking, in the 1980s and the 1990s we did need foreign investment, but in the 21st century the situation is different, because of our large domestic saving. However, China still accepts large foreign investment if it brings in new technology, new management, new marketing channels. China’s open door policy is open for longterm investors, not for short-term speculators. True, Americans have better technologies than the Chinese. However, a lot of patents and technologies controlled by large firms are rarely used. If Chinese firms are so eager to open business in the U.S. it is mainly to improve their business image, not so much for the profits. They consider America as a world stage. Operating in the U.S. market symbolizes a transition from local business to an international business. On the other hand, if American companies open to Chinese investment, they may find new markets for existing technologies. To build a long-term partnership and change cold war thinking we need national governments acting as political insurance for mutual investment.

Forth, competition policy is more essential than financial consolidation. In almost every American crisis, you observe a wave of mergers and acquisitions leading to concentration, which is the root of the current financial crisis. For example, since AIG is the largest insurance company; as soon as it gets into difficulties it enacts a chain reaction that affects the macroeconomic level. I suggest that you break monopoly firms into smaller competing firms, so that you can diversify risk and encourage innovation. If you let Citigroup take over Merrill Lynch and Bank of America take over another big bank, then you’ll just see more troubles ahead. I learned this lesson from transition economies: Russia privatized its state monopolies without breaking them into competing companies; while China split state monopolies without privatizing them. You can see the result today.

Fifth, flexible exchange rates are inherently unstable for globalization. Fixed or relatively stable exchange rates are essential for effective fiscal policies and the international division of labor. Uncoordinated monetary policies conducted by the United States, the European Union and Asian countries may trigger a wave of competitive devaluations, which will hurt most and destabilize countries without enough foreign reserves. The new international financial order can only be achieved if major world economies build a common system of stable exchange rates and coordinate their macroeconomic policies and trade policies. Then other countries could create a basket of major currencies to achieve a relatively stable exchange rate.

In other words, we need a new Bretton Woods System, not based on a single currency, the dollar. This will be done only if the three major financial powers (the United States, Europe, and China), create mutual trust and a long-term partnership, without any of them acting as a self-appointed world police or judge. In other words,we need a new vision of the world order, a vision that will help us to build sustainable globalization. Without this vision, we may see three regional markets emerge and divide the world between them.

¹ The text has been reviewed and modified by the author after the conference.

² Quantitative analysts employed by investment banks and hedge funds (sometimes also by commercial banks, insurance companies and management consultancies) to design and implement complex models that allow financial firms to price and trade securities.

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