Thu Oct 16th, 2008 at 07:21:38 PM EST
For some reason I cannot quite put my finger on, I am dissatisfied about the exchange between Jerome and Martin Wolf on Bernanke's savings glut theory.
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.
So I read Wolf's piece over a couple of times and then had some discussions with Metatone, Drew and Colman and here's the result.
Let's start by rereading Wolf's October 8 column Asia's Revenge for statements of fact, theory and opinion. Wolf starts with
What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years.
For me, mentions of "the last 30 years" in recent commentary are becoming synonymous with Friedmanomics, the Reagan/Thatcher revolution and the dominance of Market Fundamentalism as an ideology. The tone seems to be, universally, that Reagan's era is over, but depending of where in the ideological spectrum the writer comes from this is seen as either a good or a bad thing. Wolf is smart enough to not go into value judgements. However, what is clear from what he writes is that free movement of capital is a contributing factor to international financial crises
. It has to stop.
Wolf's argument is that reserves accumulated through trade surpluses are lent to trade-deficit countries until they cause a default. The first example is the "recycling of petrodollars":
To trace the parallels - and help in understanding how the present pressing problems can be addressed - one needs to look back to the late 1970s. Petrodollars, the foreign exchange earned by oil exporting countries amid sharp jumps in the crude price, were recycled via western banks to less wealthy emerging economies, principally in Latin America.
This resulted in the first of the big crises of modern times, when Mexico's 1982 announcement of its inability to service its debt brought the money-centre banks of New York and London to their knees.
So far, so good. What makes the current crisis special is that the borrower is the US, and that the Western banks who used to be intermediaries between two sets of foreign countries are now involved not only as intermediares but as borrowers.
So a "large chunk of money has effectively been recycled to a developing economy that exists within the United States' own borders", they [Reinhart and Rogoff, in a paper from last year] point out.
Note the admission that the levels of inequality and lack of mobility within the US are such that it makes sense to say that the US contains a third-world economy within it. But here's where Wolf uses this to say "this is not our fault"
The links between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow.
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.
Now, the fact is that Wolf arguably gets his economic history wrong here:
These latest crises are also related to those that preceded them - particularly the Asian crisis of 1997-98. Only after this shock did emerging economies become massive capital exporters. This pattern was reinforced by China's choice of an export-oriented development path, partly influenced by fear of what had happened to its neighbours during the Asian crisis. It was further entrenched by the recent jumps in the oil price and the consequent explosion in the current account surpluses of oil exporting countries.
According to Stiglitz in Globalization and its Discontents
, not only had China been on its current development path for 20 years already but also the Asian Miracle
pre-1997 was the result of high savings and investment: these countries did not
become creditor countries only after
1997. Stiglitz actually argues that the crisis was caused by the adoption of IMF-inspired capital liberalisation which saw an influx of foreign capital to add to the high domestic savings, which was then quickly reversed crashing the Asian economies and currencies when the IMF voiced misgivings about these economies. Here's what Stiglitz has to say about the development model behind the Asian Miracle:
How, I wondered, if these countries' institutions were so rotten [as the IMF warned], had they done so well for so long? The difference in perspectives, between what I knew about the region and what the IMF and the [US] Treasury alleged, made little sense, until I recalled a debate that had raged over the East Asia Miracle itself. The IMF and the World Bank had almost consciously avoided studying the region, though presumably, because of its success, it would have seemed natural for them to turn to it for lessons for others. It was only under pressure from the Japanese that the World Bank had undertaken the study of economic growth in East Asia (the final report was titled The East Asian Miracle) and then only after the Japanese had offered to pay for it. The reason was obvious: the countries had been successful not only in spite of the fact that they had not followed most of the dictates of the Washington Consensus, but because they had not. Though the experts' findings were toned down in the final published report, the World Bank's Asian Miracle study laid out the important roles that the government had played. These were far from the minimalist roles beloved of the Washington Consensus.
To reiterate, a strong planning effort by the government, capital controls and high savings rates (hence no need to be a debtor country) were features of the East Asian Miracle before about 1994. And then, when Wolf claims that this pattern was reinforced by China's choice of an export-oriented development path, partly influenced by fear of what had happened to its neighbours during the Asian crisis
, it is worh noting that china established its peg of the Yuan at 8 to the dollar in 1996
, and did not change it in response to the Asian Crisis in fact keeping the peg at the same level until 2006.
This, then, means that Wolf is wrong on this
What lay behind the savings glut? The first development was the shift of emerging economies into a large surplus of savings over investment. Within the emerging economies, the big shifts were in Asia and in the oil exporting countries (see chart). By 2007, according to the International Monetary Fund, the aggregate savings surpluses of these two groups of countries had reached around 2 per cent of world output.
He implies that the emerging economies shifted into a large surplus of savings over investment after 1997
. In fact these economies were saving heavily through the 1980's and early 90's.
Then, in a sleight of hand that would make The Economist proud, Wolf inserts three charts which have nothing to do with his argument. In fact, if you look at his third chart
you see that there's nothing peculiar about the "emerging Asia" current account balance until after 2004, that is, after the US had been running negative real interest rates for 18 months. Wolf continues:
Despite being a huge oil importer, China emerged as the world's biggest surplus country
and the interesting thing is that it appears from other data
that China had been using the dollar peg to manage its exposure to the price of oil, and that it only dropped the dollar peg in 2005 when the dollar started to come under real pressure from oil prices.
That represented a vast shift of capital - but unlike in the 1970s and early 1980s, it went to some of the world's richest countries. Moreover, the emergence of the surpluses was the result of deliberate policies - shown in the accumulation of official foreign currency reserves and the expansion of the sovereign wealth funds over this period.
Quite reasonably, the energy exporters were transforming one asset - oil - into another - claims on foreigners. Others were recycling current account surpluses and private capital inflows into official capital outflows, keeping exchange rates down and competitiveness up. Some described this new system, of which China was the most important proponent, as "Bretton Woods II", after the pegged adjustable exchange rates set-up that collapsed in the early 1970s. Others called it "export-led growth" or depicted it as a system of self-insurance.
Yet the justification is less important than the consequences. Between January 2000 and April 2007, the stock of global foreign currency reserves rose by $5,200bn. Thus three-quarters of all the foreign currency reserves accumulated since the beginning of time have been piled up in this decade. Inevitably, a high proportion - probably close to two-thirds - of these sums were placed in dollars, thereby supporting the US currency and financing US external deficits.
There are two obvious questions about this. One is, aren't the deficit countries as responsible for the imbalances as the surplus countries? Isn't the emergence of a large US deficit also the result of deliberate US policies? And then the bit that I really don't understand: why do accumulated foreign reserves have to be lent by the surplus countries to the deficit countries, necessarily?
Can't the reserves just sit in the Chinese Central Bank? And why does the US have to borrow from the Chinese? We then come to the key of Bernanke's savings glut argument:
In this world of massive savings surpluses in a range of important countries and weak demand for capital from non-financial corporations, central banks ran easy monetary policies. They did so because they feared the possibility of a shift into deflation. The Fed, in particular, found itself having to offset the contractionary effects of the vast flow of private and, above all, public capital into the US.
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.
So, once we manage to blame the Chinese for Greenspan's 18 months of negative real interest rates around 2003, we can say that
The big global macroeconomic story of this decade was, then, the offsetting emergence of the US and a number of other high-income countries as spenders and borrowers of last resort. Debt-fuelled US households went on an unparalleled spending binge - by dipping into their housing "piggy banks".
Except that the US households didn't go on an "unparalleled" "debt-fuelled" "spending
binge". I would argue with Jerome that there was an "unparalleled debt
binge" fuelled by the desire to maintain a standard of living in the face of declining real incomes. Low interest rates allowed people to tap their home equity (the only piggy bank
they had left as household savings were minimal) for this purpose, leading to a housing bubble.
However, it is still unclear on Jerome's side whether there really was a deflation (and recession) threat from China's drain on the US money supply, and in case there was a threat whether different policies would have resolved it. This is again not intuitive to me, well-known or bleedingly obvious.
Interestingly, Wolf ends with a recommendation that we here might agree with:
So among the most important tasks ahead is to create a system of global finance that allows a more balanced world economy, with excess savings being turned into either high-return investment or consumption by the world's poor, including in capital- exporting countries such as China.
If only they had listened to Keynes at Bretton Woods we would already have an international system designed
to attempt to dampen trade imbalances by imposing penalties both on deficit and
surplus countries. My beef with Wolf is that he resorts to financialisation to achieve this, which may lead to a "more balanced" system but in my opinion not to a more stable system
A part of the answer will be the development of local-currency finance in emerging economies, which would make it easier for them to run current account deficits than proved to be the case in the past three decades.
And then comes the recognition that global capital market liberalization is a strong destabilising force and needs to be reined in
Yet there is a still bigger challenge ahead. The crisis demonstrates that the world has been unable to combine liberalised capital markets with a reasonable degree of financial stability. A particular problem has been the tendency for large net capital flows and associated current account and domestic financial balances to generate huge crises. This is the biggest of them all.
Lessons must be learnt. But those should not just be about the regulation of the financial sector. Nor should they be only about monetary policy. They must be about how liberalised finance can be made to support the global economy rather than destabilise it.
This is no little local difficulty. It raises the deepest questions about the way forward for our integrated world economy. The learning must start now.