Musings on the savings-glut theory by Migeru on October 17th, 2008

To paraphrase, Wolf takes a cue form a 2005 speech by Bernanke and blames East Asia's (and especially China's) mercantilist policies for the credit crunch. Jerome replies that wealth capture is not wealth creation. I guess part of my problem is that the two positions are not incompatible, and Jerome 1) doesn't refute that East Asia has been mercantilist; 2) doesn't refute the argument that this is the root cause of the asset bubble now deflating. Even if Wolf were to accept Jerome's contention that the bubble was a Western policy choice, Wolf's argument seems to be that there was no good policy path out of the situation created by China's dollar peg and that deflation and recession were inevitable and Jerome doesn't address that.

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So, the question which Wolf skirts is, without risky monetary policy, lax regulation and irresponsible finance (which, together with finance's oversized share of GDP, is what Jerome calls the Anglo Disease) would the global imbalances have led to a different outcome? Wolf is trying to argue that the Anglo Disease was incidental. Jerome, that it was fundamental.

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In other words, to the best of my understanding, because China was hoarding US dollar reserves (and also as a result of the popping of the dot-com bubble), the US economy was in danger of monetary deflation and therefore the Fed had to run an expansionary monetary policy of real negative interest rates which kicked off the credit bubble. That is, because China was draining money out of the US economy the Fed had to keep printing more. And this would have depressed the US exchange rate with the Yuan until the trade balance became zero except that China had a dollar peg. So we have a situation in which the Chinese dollar peg causes runaway debasement of the dollar as China and the US run to stay in place relative to each other. My problem with this is that I don't find it intuitive at all, and Wolf assumes that it's either well known or bleedingly obvious. But on this hinges the whole argument.

In the comments, Jerome ends up not disagreeing with Wolf on the deflationary effect on the US economy of the Chinese dollar peg.

I wrote again to Martin Wolf, after the initial exchange and after receiving Mig's initial comments on the fact that we did not need to borrow the Chinese surplus. Martin Wolf replied that there would then have been a nasty recession in the US.
I agree with him, but my point is that inflating a bigger bubble to avoid the effects of the previous one only pushes the problem a little further down the road (ie now) and makes it even worse wehn it hits (as we now see).

The problem was not the defict of the US - its was its growing deficit over the past few years. A stable deficit over the years is possible, especially when you own the world currency, but a growing one becomes a Ponzi scheme at some point.

Also, BruceMcF wrote

If the US is engaged in the borrowing, clearly the role of the Chinese here is in accommodating, not in causing, the long term unsustainable GDP growth model. And that accommodating entails finding a mechanism for providing the external finance so that the US could continue to purchase Chinese exports, even though the US was on a growth path that is unsustainable in the long term.

Now, is this recessionary? Compared to what alternative? The Chinese have simply been in no position over the past two decades to dictate to the United States that is must adopt a sustainable GDP growth path. The only choices that it has had have been to either accommodate the growth path, putting off the day of reckoning, or refusing to accommodate the growth path, bringing forward the day of reckoning.

Given their own position of riding a massive demographic transition from the insanely unsustainable  pro-population-explosion policies of Mao to the population-control policies of Deng, instituted in 1979, the Chinese really had no choice but to accommodate.

The only side with actual freedom of action in the bilateral relationship was the United States, and our political elite choose to pursue a financially unsustainable GDP growth path.

(Bruce's argument is much longer and more technical, and well worth a read in full, but that's the conclusion)

By laying out pros and cons we risk inducing people to join the debate, and losing control of a process that only we fully understand. - Alan Greenspan