Comment on Parallels with Richard Duncan - August 2009

• Links with Duncan's Ideas
• Assessing Duncan's Ideas

PGM suggested that my conclusions about the prospect of a financial crisis in China are based on the ideas put forward by Richard Duncan. 

This is highly unlikely as the basis for his argument is economic, whereas mine is cultural.

Moreover my ideas are based on extensive work on the intellectual basis of East Asian economic models in the 1980s. The probable implications for financial crises of those cultural features were written up firstly in 1997 at the time of the Asian Financial Crisis (eg see 'Understanding the Cultural Revolution - needed in East Asia to succeed under Western financial regimes') and secondly in September 2003 (see Structural Incompatibility Puts Global Growth at Risk). I did not see any of Richard Duncan's work before November 2003.

The example of Duncan's thinking that was referenced is reproduced below {with PGM comments}: [the link to this source did not seem to work]

The United States is the major deficit nation. When exporters from surplus countries bring their dollar earnings home, those dollars enter their domestic banking system and, being exogenous to the system, act just like high powered money.

{PGM: I can't see why this would be so. Those surpluses are exchanged for local currency, so the exporters are receiving local currency & using it to pay their workers. What does Duncan expect - that they don't get paid at all?}

The affect on the economy is just the same as if the central bank of that country had injected high powered money into the banking system: as those export earnings are deposited into commercial banks, they sparked off an explosion of credit creation. That is because when new deposits enter a banking system they are lent and re-lent multiple times given that commercial banks need only set aside a fraction of the credit they extend as reserves.

Take Thailand as an example. Beginning in 1986, loan growth expanded by 25% to 30% a year for the next 10 years. Had Thailand been a closed economy without a large balance of payments surplus, such rapid loan growth would have been impossible. The banks would have very quickly run out of deposits to lend, and the economy would have slowed down very much sooner.

In the event, however, so much foreign capital came into Thailand and was deposited in the Thai banks that the deposits never ran out, and the lending spree went on for more than a decade. By 1990 an asset bubble in property had developed. Every inch of Thailand had gone up in value from 4 to 10 times. Higher property prices provided more collateral backing for yet more loans.

{PGM: There's a need to distinguish between Thailand's export surplus - ie $ earnings entering the country, for conversion to Baht to pay the workers & for company profit & reinvestment - and Hot Money coming in from Foreign Investors. The latter may have been the real problem}

An incredible building boom began. A thousand high rise buildings were added to the skyline. All the building material industries quadrupled their capacity. Corporate profits surged and the stock market shot higher. Every industry had access to cheap credit; and every industry dramatically expanded capacity. The economy rocketed into double digit annual growth.

And, so it was in all the countries that rapidly built up large foreign exchange reserves: credit expansion surged, investment and economic growth accelerated at an extraordinary pace, and asset price bubbles began to form. That was the case in Japan in the 1980s and in Thailand and the other Asia crisis countries in the 1990s. It is also true of China today. Wherever reserve assets ballooned in a short space of time, economic bubbles formed.

{PGM: what of Japan in the 1990s? and the 1970s? The bubble only happened after Plaza & Basle}

Unfortunately, economic bubbles always pop. And when they pop, they leave behind two serious problems.

It will be suggested below that, from a financial system's perspective, you will have trouble winning an argument with Richard Duncan because his understanding seems quite sophisticated.

Three articles by Richard Duncan have been outlined (together with hundreds of others) in various files on my website. Specifically: :

• 'The Dollar Crisis: An Interview with Richard Duncan' (8/11/03) is outlined in the 'Currency' file - together with comments on the desirability of taking a broader approach than Duncan has done (which, as noted below, I also sent him an email about in November 2003);
• 'Asia, its reserves and the coming dollar crisis' (Prudent Bear, 22/5/05) is outlined in the 'Monetary Systems' file. This seems to be the article you drew attention to as an example of his work;
• 'Japan's monetary alchemy may not yield gold' (Financial Times, 02/10/04) is also outlined on my 'Monetary Systems' file.

In September 2003  (ie before I saw any of Duncan's work) a document, Structural Incompatibility Puts Global Growth at Risk, was produced which suggested that trying to understand what was going on from an economic / financial perspective was inadequate. In 2005 I added a reference to the thrust of Duncan's argument (based on his 'Asia, its reserves and the coming dollar crisis' article) because this seemed to be a good example of a sophisticated central banker's perspective.

In November 2003 I emailed Richard Duncan pointing out to him the parallels between his conclusions and mine and the need to consider the cultural dimension of the problem (see Another Dimension of the Dollar Crisis: Causes Consequences and Cures). This was a commentary on his article The Dollar Crisis: An Interview with Richard Duncan (8/11/03). I can't recall whether I received a response, and don't have easy access to my emails from that era.

I can't see anything wrong with Duncan's view that capital surpluses can add to what he calls the 'high powered' money which is the base on which a vastly (eg 10 times) greater amount of credit can be created which would potentially lead to asset bubbles.

You can't beat this by arguing that money is used to pay local suppliers. The foreign currency goes from the local suppliers into the banking system and then to the reserve bank which exchanges it for local currency - and, given a very high savings rate, a lot of this then goes back into the local banking system as the basis for re-lending many times exactly as if it had been added by the surplus country's reserve bank.

Also you can't beat this by saying that it is only 'hot' money that has this effect (and much of this may not wind up in the local banking system anyway). The main problem with 'hot' money is that it can trigger a currency crisis (related to a limited supply of foreign reserves), not because it is particularly significant in adding to the monetary base of the banking system.

The thing that Duncan doesn't seem to mention (though perhaps he does somewhere) is that to avoid the credit-bubble risks associated with current account surpluses, sophisticated reserve banks 'sterilize' the incoming funds (ie get them out of the national banking system) by investing them elsewhere (the US was the favoured destination) - though this then creates problems for the surplus country in managing those investments without losses, and for the country which receives the surpluses because it added to the 'high powered' money in their banking system as the basis for a credit bubble there (which is the basis for Bernanke's complaints about 'savings gluts'). A recent Japanese account of this is summarised on my website.

I'm not quite sure what you mean by the after effects of the Plaza Accord and 'Basel'. You need to elaborate more on their possible significance.

I can't recall what happened in Japan in the 1970s in relation to this particular issue - though in that era Japan's financial institutions were directing funds only into industrial capacity which had no real prospect of generating a bubble - as Japan's share-markets are not serious means of earning profits or gaining control of businesses. It was only in the 1980s when investment started flowing into property that a bubble could develop.  In the 1990s however Japan was thoroughly into the sterilization business with its purchases of US Treasury's and 'carry trades'.

As I have implied above, Richard Duncan's ideas seem pretty good in understanding the situation from a central banker's perspective. This addresses the problems that arise from unbalanced trade, and particularly from persistent  current account surpluses.

My ideas are quite different - having to do with the fact that East Asian economic models have to incorporate current account surpluses because of reliance on neo-Confucian social relationships to coordinate economic activities (rather than profit seeking by enterprises) and the resulting poor balance sheets in both businesses and financial institutions.

I am saying that East Asia's economic models requires doing something. Duncan says that doing that thing has nasty consequences for themselves and others.  I also go further by suggesting that:

• in the post-GFC environment the East Asian economic models will probably prove unsustainable, because no one is going to be able / willing to put up with those nasty consequences;
• Japan would have been well aware of the limitations of its economic model since about 1990 (because it understood the cultural issues that others didn't), and the fact that it was not mentioned raises questions about what game it is playing (see Focusing on Japan and the Global Financial Crisis and Unrecognised Clash of Financial Systems).