CPDS Home Contact Why Japan can't Deregulate its Financial System Understanding East Asia's Neo-Confucian Systems of Socio-political Economy    Financial Market Instability: A Many Sided Story   Global Financial Crisis: The Second Test (Sovereign Defaults: Stage 2 of the GFC? + Debt Denial: Stage 3 of the GFC? + An Approaching Crisis Competing Thought Cultures  Global Implications of Corruption in China  Globalization has Been Under Siege for Years
Outline +




Global economic growth appears likely to prove unsustainable, because a structural imbalance between aggregate supply and demand and insolvent financial institutions are built into the economic and financial characteristics of major East Asian economies and the global financial system lacks disciplines to correct those imbalances without disruption.  Rather than merely accumulating foreign exchange reserves to prevent currency appreciation (as Western analysts would expect), this seems to have also been used to protect suspect financial institutions that have mobilized national savings to achieve non-commercial / nationalistic economic goals (in much the same way that other societies have financed wars by the sale of war bonds).

The US has compensated for the East Asian demand deficit by providing the main source of global demand growth for a decade but the US has also experienced financial imbalances as a result (a large current account deficit and accumulated debts). And this has only been able to continue because changes to the global financial system in the early 1970s permitted sustained trade deficits to be financed by creating money (rather than balanced with gold reserves).  At the same time, high levels of public spending have been needed to sustain demand in other major economies (eg  China, France, Germany, Italy, Japan) resulting in some cases in public debt levels that are also becoming critical.

Though 'solutions' to its imbalances that the US has officially been seeking (eg revaluation of China's currency, faster growth in Europe) have been inadequate, there may be a serious problem, namely that the communitarian / mercantilist character of some economies in East Asia (especially Japan, [?Korea?] and China) makes them quite different to consumer / profitability driven economies (eg US). In particular:

  • such economies involve 'markets' being managed by social elites under governance arrangements (involving intelligence gathering and networking) that are unfamiliar to Western observers;
  • export production capacity is created which is much greater than aggregate domestic demand [which results in current account surpluses that have been recycled into US assets and demand]; 
  • transactions are coordinated by social relationships - with little regard to financial outcomes. This achieves nationalist goals in terms of building up production capacity - while losses accumulate in financial institutions;
  • such institutions have been protected (by regulation and large foreign reserves) from the need to obtain the international credit rating they would need to borrowing in international financial markets;
  • stimulative fiscal / monetary policies in the US have counter-balanced the growing East Asian demand deficiency and capital surplus for two decades (resulting now in large fiscal imbalances);
  • European countries have had to run large fiscal deficits to achieve sufficient growth to keep unemployment under control.

This pattern cannot be continued indefinitely because:

  • the net effect is to create a potential demand deficit in the global economy - a phenomenon which Keynes saw as a major factor in the Great Depression of the 1930s, and which post WWII macroeconomic management was mainly concerned to guard against;
  • the US now faces large trade imbalances and the need for $US500bn pa capital inflows to sustain growth - which leads to risks such as protectionism or escalating interest rates. Though it is vital to the East Asian economies to continue re-cycling capital into US demand, this can only continue as long as there are US institutions (eg companies, households, government) who are able to absorb it;
  • some East Asian models are unsustainable in the long term (ie they: do not produce economic 'success' in terms of financial outcomes and this must eventually trigger a crisis; could not be used globally as not all countries can have a balance of payments surplus to protect financial institutions with suspect balance sheets; and must eventually fail due to unproductive resource allocation);

China's 'solution' apparently involved slashing its overall current account surplus through shifting from primarily export driven growth to that involving also large-scale domestically-driven urban / infrastructure investment. However as this has also been undertaken with limited regard to investment profitability, the effect has been to further overheat China's economic growth and exacerbate the bad debt problem in its banking system. There is a real risk of a renewed financial dislocation in Asia - centred this time on China.

Many obvious alternative 'solutions' appear unsatisfactory, eg:

  • stimulating domestic / global growth will not reduce the US current account deficit if it originates in structural differences in the goals and character of various major economies;
  • altering exchange rates in Asia (which has been the US's officially-preferred 'solution') can have little impact on current account outcomes - as it is the way that financial systems are arranged internally that leads to the imbalances;
  • reducing the US current account deficit (which equals the difference between national spending and income) by cutting demand to increase US savings would trigger a global recession or worse;
  • a restrictive new tariff regime would overcome current account imbalances - but also suppress global trade and potentially result in an economic recession or worse.
  • significantly increased consumption in East Asian countries with current account surpluses (eg China and perhaps Japan) would erode the pool of foreign reserves that protects their financial institutions from the effect of bad balance sheets - and thus create financial turmoil;

The US Reserve Bank argues that an efficient global financial system will eventually resolve these imbalances - providing protectionist pressures do not arise. This may be the case - as devaluation of $US asset holdings and a decline in US demand resulting from increased interest rates will rapidly increase the exposure of insolvent financial institutions in East Asia and the risk of a (China-centred?) financial dislocation.

But (because those imbalances reflect central features of some East Asian economic and financial systems) resolving them will require large changes which in itself may be economically and politically disruptive.

The main focus for reform must be the mercantilist framework in which some economic and financial systems (especially those of Japan and China) are managed and regulated to direct finance to production with little concern for profitability or for the balance between production and consumption. Such reforms need to be focused most specifically on Japan, as China has made more effort to normalize its economy (and is paying the price in an exposure to a very real risk of a financial crisis).

A 'soft' solution to the US's financial imbalances might be assisted by (for example):

  • shifting the foreign exchange holdings of East Asian central banks away from $US - a trend that seemed to be underway by March 2005;
  • institutional reforms to East Asian financial systems to make large scale capital inflow possible;
  • shifting the emphasis of manufacturing investment away from countries that operate communitarian / mercantilist economic policies towards those whose financial institutions do not require protection by large balance of payments surpluses (eg towards destinations such as India or others);
  • structural reforms in Europe to overcome its economic stagnation;
  • a substantial increase in US productivity (perhaps due to technological advances or improved business / economic strategy), providing the gains were diverted into national savings rather than further increasing spending.

However, the world may be on the point of a global 'demand deficit' recession / depression - which might again lead to political conflicts. This would traditionally suggest an emphasis on Keynesian (ie public spending) solutions - but these may also be structurally impossible.

The relationship between the issues explored here and global financial instabilities that emerged in 2007 is developed in Financial Market Instability: A Many Sided Story, while the crisis that ultimately eventuated in 2008 is considered in Global Financial Crisis: The Second Test.

Outlook (Current (2003) situation + Inadequacy of Currency Re-alignment + The Risk)

Economic Outlook

In 2003, strong global economic growth was anticipated - with an expectation that growth would be sustained by US demand.

However the US economy suffers fiscal imbalances (namely large current account deficits and foreign debts) which many observers have seen as a threat to the sustainability of US and thus global growth [1, 2].

In particular, the Bank of International Settlements (the Reserve Bank for Reserve Banks) has expressed concerns about:

  • the risk of deflationary turmoil related to competitive devaluations because of: global dependence on US growth; its financial imbalances; and the lack of international policy coordination [1].  
  • the risks associated with financial imbalances (especially between US and East Asia) and asset booms, and about the lack of political will to address these problems [1, 2]

In 2007 BIS argued that unwinding of financial imbalances is the world's greatest economic risk [1].

Similar concerns about US financial imbalances have been expressed by the IMF [1, 2]. In 2005 it was suggested that global institutions lacked the means to resolve global imbalances and were simply gambling on US-driven growth being able to continue [1].

The situation: In brief it appears that:

The US economy (which is strongly consumer / business-profitability oriented):

  • has provided most (around 65%) of the growth in global demand over the past decade [1]. This growth has been driven (as in Australia) by consumers who have spent more than their incomes because of an asset boom / bubble associated with rapid expansion of credit which has increased community wealth. The credit boom was possible without igniting inflation because cheap imports (mainly from Asia) prevented producers from gaining pricing power. A risky 'asset-driven' (rather than 'income-driven') economy can be identified since the late 1990s - initially based on equities, and then on property (following the bursting of the equities bubble in 2000) [1].
  • is vulnerable to any increases in interest rates or economic shocks that depress asset values because historically high levels of household debt have been accumulated while median household income levels have been falling [1] to buy into a 'bubble' in asset values (ie shares whose P/E ratios still remain above the historical norm - a situation that can only be justified if growth is rapid; and housing).  A self-reinforcing collapse in consumer demand could result if households were obliged to increase savings to strengthen their balance sheets. However it has been suggested that debt / household income levels are such that payment pressures should not become critical [1]
  • has been subjected to a large fiscal and monetary stimulus to re-ignite growth following partial deflation of the 1990s' equity bubble since 2000 (ie by tax cuts whose effect seem likely to be different to the tax cuts of the 1980s [1], and by very low short-term interest rates). There is however concern that this stimulus has mainly led to the emergence of asset bubbles - rather than to real economic activity [1]
  • suffers major financial imbalances - namely a $US500bn pa current account deficit (and foreign debt due to past deficits). This has been increased by government deficit spending associated with the war against terror;
  • requires a large capital inflow to sustain growth - much of which has come from East Asia where it balances the current account surpluses which are built into the structure of the economic / financial system;
  • has attracted capital inflow because (a) the strength and dynamism of its business environment has created very attractive investment opportunities, and (b) funding US demand has been vital to maintaining economic activity and employment in East Asia. It has also had advantages in attracting capital inflow because of the $US's role as the world's reserve currency - advantages which could be lost because of the US's high debts [1, 2];
  • can only finance this deficit as long as some US institutions (business, government, consumers) are willing and able to service additional debt instruments every year [1]
  • has started to experience rises in long term interest rates - presumably because of perceived risks of devaluation as large capital inflow can not be maintained indefinitely. Higher long term interest rates will discourage investment and increase the cost of debt service;
  • reportedly experienced (a) a large fall in capital inflow in September 2003 [1] and (b) a rapid decline in money supply since that time [1] indicating that Fed efforts to stimulate growth by creating easy credit are not working. Falling money supply indicates that either governments, business or households are not borrowing [and while there is no firm data it seems likely that it could be the heavily indebted US consumers who, after supporting global growth for a decade, have now decided to 'take their bat and ball and go home']
  • has a rising sharemarket which seems to anticipate economic recovery. However profitability has increased by cutting costs by sending production off-shore - so there has been little employment growth and this must impede consumer demand [1, 2];
  • had been forecast to experience very strong corporate productivity gain - so as to be able to continue reliance for some time on capital inflow to fund its current account deficits [1]. However it has now
  • has ceased being able to attract capital inflow for investment, and relies on inflow which funds consumption and government spending [1]. Moreover US investors increasingly seek external investment options [1];
  • has been suggested to face great economic difficulties if $US ceases to be the global reserve currency - because $s issued freely in the past would then become demands against US resources [1]

European Union economies appear unable to achieve strong growth because of market rigidities - despite the massive public deficits of its largest economies such as Germany, France and Italy [1] - which deficits are constrained under European Monetary Union rules;

Japan, which has the world's second largest economy,

  • has been in recession since around 1990 because of a lack of demand associated with its high savings rate. Demand had previously been generated by a high rate of business investment - but opportunities for this declined significantly after 1990 [1]
  • was expected to achieve 'real' economic growth in 2003 (while nominal recession continues because its rate of deflation is increasing [1]);
  • began in 2003 to print large quantities of yen with which it bought $US, and so kept US interest rates low, supported tax cuts and boosted US consumer and government spending [1];
  • appeared, in early 2004, to have adopted an expansionary macro policy - though problems associated with its banking system and structural reforms have not been resolved [1]. Those problems may make continued growth impossible [1]
  • has been suggested to have no choice but to correct its current account surplus by boosting domestic demand - because of its deflation risk and the high price of constantly buying $USs to prevent the Yen appreciating and undermining exports [1] - and by March 2004 domestic demand was appearing as a factor in its economic growth [1]. 
  • announced in 2006 that it would cease provision of zero interest credit to boost economy. This was predicted by IMF to result in volatility in global financial markets as carry-trades based on low Japanese rates are unwound. [1]

China in particular (see also China's Development: Assessing the Implications):

  • has been experiencing very rapid economic growth; and thus been suggested to have to take a role in leading global growth if the risk of deflation resulting from a reduced role for US demand is to be avoided;
  • is however subject to constraints including: environmental limits; uncertain resource availability; high levels of public investment which debt levels make unsustainable; reliance on (reportedly frequently unprofitable) foreign investment; an apparently deflationary industrial (over) capacity; insolvent financial institutions (which prevent demand being raised to the point where foreign exchange reserves were eroded and it became necessary to borrow externally); and potential political instability
  • has increasingly shifted to a 'market' economy - though those 'markets' (like their Japanese equivalent) are anything but free;
  • has reduced its overall current account surplus by shifting from primarily export driven growth to that driven also by infrastructure / urban investment - with consumer demand as an additional factor [1]. However this has apparently again occurred with little regard to profitability so that the bad debt position of banks has been further worsened;
  • has incorporated other countries in the Asian region within its economic system by increasing imports (eg of components), so its its overall current account surplus was small (eg $US 30bn pa) and subsequently turned into a deficit - though its surplus with the US is > $US 100 bn [1]. Simultaneously a large capital account surplus (generated by foreign investment) has had the effect of rapidly increasing foreign reserves [1];
  • has resisted pressure from the US to revalue its currency - which the US had argued would reduce current and capital account imbalances;
  • has indicated, in early 2004, a desire to reduce exports and capital flow to US [1]; and to end its quarter-century 'growth at all costs' emphasis and focus increasingly on reducing internal inequities [1]
  • has been warned by the US that without much deeper reforms of its economy (towards market mechanisms) it may be unable to sustain fast growth [1]

The large current account surpluses in East Asia have been balanced by capital account outflows (mainly to the US) - as otherwise currency values / domestic inflation would increase. There seems to be a desire to direct this away from US in future because investment there is now seen to be risky given an expectation of future currency devaluation and that interest rates on offer are low.

The global trading environment has been uncertain given:

  • declining international trade  in the less certain environment created by terrorism, the war against terror, tensions in diplomatic relationships [1] and SARS;
  • rising protectionist sentiment in the US [1] because of its trade and financial imbalances, and jobless recovery;
  • the September 2003 breakdown of WTO talks on further multilateral trade liberalization;

Instabilities remain in the global financial system [1] - resulting in periodic crises. In particular:

  • the breakdown of the financial system established at Breton Woods - and the shift away from a gold standard in the early 1970s removed features which automatically corrected trade imbalances - because it meant that such deficits could be financed by creating credit rather than having to be balanced by gold reserves [1, 2];
  • the credit created to finance US current account deficits has led to an escalation of global money supply, and contributed to economic 'bubbles' in countries that run current account surpluses [1]. Moreover derivatives seem to remain a systemic risk [1]
  • the high levels of US foreign debts are leading to a potential loss of status as the world's reserve currency which would destabilize global trade [1]
  • there appears to be a risk of a massive China-centred financial dislocation which would have a global economic impact because of the role China has played in driving growth - especially in Asia;
  • there is a large global excess of savings which has resulted in levels of US current account deficits and debts that cannot be maintained much longer [1] .

Richard Duncan provided a good summation of the situation. In brief this suggested that:

  • unilateral US action in 1971 to end the Gold Standard (which had been established under the 1944 Bretton Woods agreement) led to the emergence of a $US Standard that allowed rapid growth of credit, of economies and of foreign reserves that had not previously been possible ;
  • trade imbalances between countries (especially the US's current account deficits), have been mirrored by financial imbalances, and these financial imbalances have had damaging effects by:
    • causing economic booms and busts in countries with trade surpluses - because the trade surplus is initially treated as 'new' money by commercial banks and re-lent many times;
    • creating resource mis-allocation due to asset booms (involving shares and property) in countries with trade deficits (eg US) because central banks in surplus countries have to loan the funds back to stabilize their exchange rates; and
    • leading to deflationary global overcapacity in almost all industries;
  • central banks in countries with trade surpluses have no real alternative to placing funds in $US - thus the US can finance its deficits. However:

  • countries with trade deficits (eg US) can not afford to go on borrowing indefinitely. Thus the factors that have driven rapid global growth and asset appreciation over the past 20 years can not continue as they have;

  • the longer trade imbalances persist the greater will be the risk to the foreign exchange reserves of the reserve banks in surplus countries as the $US devalues, and the longer the credit explosion and financial instability will continue.

Prior to 1971, it should be noted, other countries' preference for holding foreign reserves in $USs had led to increasing US trade deficits, a liquidity crisis for US and a desire by others to convert their $US holdings into gold (see Braithwaite J. and Peter D. 'Bretton Woods: Birth and Breakdown', Global Business Regulation, 2001). 

The US's financial (and trade) imbalances are encouraging US trade authorities to seek seek changes in other's monetary and economic policies (eg revaluation of China's currency, faster growth in Europe) to provide stronger demand growth elsewhere. Others have suggested that a very large $US devaluation is needed - along with substantial changes in economic structure - for the US CAD to be reduced to sustainable levels [1] It was also noted that because China is heavily involved in trade, much of its exports reflect imports from elsewhere, so a revaluation of China currency by 20% might only increase export prices by 4%. Thus rebalancing trade is seen to require primarily balancing demand with supply [1]

However the 'solution' to these imbalances the US has officially been seeking (involving a revaluation of China's currency) would be inadequate (because this can not really affect the current account deficit). As noted above, structural economic change is needed in addition to devaluation, and devaluation alone would not ensure that this would happen.

The Inadequacy of Currency Re-alignment?

In September 2003 China was pressed by the US to float its currency on the basis that the Yuan was undervalued and this was contributing to unsustainable financial imbalances. This pressure may have been a tactic to head off rising protectionist sentiment in US manufacturing industries [1] - though:

  • such a step has been seen as unlikely to overcome fiscal imbalances and as potentially triggering financial turmoil [1, 2, 3];
  • it has been credibly argued that most US manufacturing job losses have had nothing to do with Asian imports [1] - and that all countries (including China) have been tending to lose manufacturing employment [1];

Subsequently the G7 (group of large developed economies) announced an agreement favouring a realignment of currency values (and implicitly a weaker $US) in the expectation that this would reduce the US financial imbalances to a sustainable level [1]. Another informed observer argued that other countries would need to cooperate for deficit to be reduced without seriously disrupting global growth by: allowing $US to devalue; and adopting a more stimulatory monetary policy [1]

However such a re-alignment appears to be problematical and a step towards the competitive devaluation the BIS fears, because:

  • currency re-alignment would not significantly reduce US financial imbalances by altering cost competitiveness [1]. The latter competitiveness is understood to be a weak influence on trade flows because of the greater importance of production capabilities and distribution networks (eg see 'Cheap Pounds Don't Mean Strong Exports', Economist 19/1/86,  p48; and Scott B.  'National Strategy for a Stronger US Competitiveness', Harvard Business Review, Mar-Apr, 1984).  It is also noted that:
    • similar pressure on Japan which resulted in the Plaza Accord and Japan's revaluation in 1985 did not significantly alter US / Japan current account imbalances;
    • at times in history devaluation has been said to have set off a process of decline [1];
    • a current account deficit necessarily equals the difference between national expenditure and income - and this difference is mainly the result of national attitude to savings [1]. Even if an economy became genuinely more competitive relative to another - and thus increases income (eg by more exports) if it simultaneously spends that increased income, its current account outcome will not be improved;
    • a 20% revaluation of the Yuan has been suggested to be likely to result in less than a 10% reduction in the US's trade deficit with China [1];
    • a 20% revaluation of the Yuan would result in only a 4% increase in China's export prices because most components are imported, and priced in $US [1]
  • re-alignment seems to be aimed at encouraging stronger currency values in East Asia relative to $US yet:
    • those currencies are pegged to $US - and in China's case at least pressure to change exchange rates has been resisted. However, the G7 announcement appears to have triggered a flow of capital into regional markets (including 'hot money') (see 'Overshoot of Asian FX seen as threat to recovery', Reuters, 2/10/03; [2]) which may make it hard to resist revaluation;
    • it is widely believed that floating currencies such as China's would cause their value to rise - though it has been suggested that its currency might actually devalue because of (a) the very rapid rise in money supply in China [1] or (b) capital flight given the poor state of its financial institutions [1, 2]. However without capital controls, funds might also flow to consumers rather than to producers. If for any reason current account surpluses are eroded, offshore borrowing might be required and the poor balance sheets of financial institutions could then lead to new Asian financial dislocation (see China as the Engine of the Global Economy?);
  • correction of current account imbalances could occur mainly because:
    • devaluation of $US would effectively write-off a substantial fraction the value of US debts, as these are denominated in $US [1];
    • a devaluing $US would discourage capital inflows which would in turn significantly reduce demand in the US (including its international demand for goods and services that has driven growth in the global economy);  and
    • ending of capital controls in East Asia could allow funds to flow to consumers rather than to producers;
  • in practice the major devaluation of $US could be against the Euro - which would tend to create problems for the export sectors and overall growth of European economies. And there is no reason to expect that the US would then gain preferentially from European demand sufficiently to overcome its current account deficit constraint;
  • with any fall in value of $US, inflation could be imported thus requiring an increase in interest rates which would erode asset values, and thus further reduce demand by affecting consumers' wealth;
  • there could be a risk of a rapid withdrawal of capital (if there is any viable alternative destination for investment capital) which could collapse asset values.

The US Fed argued against pressuring China to revalue its currency because: China would have to revalue eventually to avoid a recession (ie China's Reserve Bank can not indefinitely continue pulling money out of economy to prevent inflation); US job losses are not due to undervalued yuan; and China's trade surplus with US is at expense of other Asian countries  - not of US [1]

See also Getting out of the Economic Quicksand (2011) which points to the inadequacy of attempting through changes to trade regimes to deal with problems that have their origin in distorted financial systems in East Asia

Similarly other 'obvious' methods to reduce US current account deficits would seem inadequate such as (a) eg boosting US savings rate (because trying to force an increase in savings could have very large adverse impacts on global demand) or (b) creating a new tariff regime (because this would suppress global trade and potentially result in an economic recession or worse).

The prospect of competitive devaluation driven by a desire to discourage capital inflow in the face of weak demand and industrial overcapacity is real. Growth could become impossible because of weak final demand - if the consumer-oriented US economy can no longer provide it (because of its financial imbalances) and European and East Asian economies do not want to provide it (and would face structural obstacles in doing so). 

The Risk: Unless the structural imbalances affecting the US and major East Asian economies are overcome, a substantial reduction in US (and thus global) growth seems unavoidable - because it must eventually become impossible to justify the capital inflow needed for the US to maintain a high level of demand, either because:

  • public concern about government deficits causes them to be contained;
  • foreign investors become reluctant to invest in the US - which would would force interest rates higher, and thus in turn:
    • deflate US equity and real estate asset values; and
    • collapse the US consumer spending which has sustained global growth;
  • US institutions (consumers, corporations, governments) find that they can no longer service additional large investments [1].

One observer suggested that a collapse in the value of the $US as a result of failure of capital inflow could lead to a $450bn decline in net external sales and the loss of 20m jobs worldwide - which would lead the world to an outcome similar to the banking collapse that led to the Great Depression [1].

The longer those imbalances remain the greater the risk that something (eg a collapse in the Japanese bond market which made it impossible for Japan to continue funding purchase of US financial assets; or adverse investor sentiment) will interrupt capital inflow to the US.

A reduction in US demand growth seems almost unavoidable either as a result of such an economic event or as a precaution to minimize the potential impact of such an event.

Such a reduction would in turn expose booming industrial investments in China as a 'bubble' and create a new Asian financial contagion (see China as an economic bubble?) because (for example):

  • its economy, and others throughout Asia who provide component inputs to China, are critically dependent on foreign investment - whose ultimate market has been US demand growth;
  • direct investment in China seems typically to have been unprofitable for investors - making it quite similar to the massive 'dot-com' investments of the 1990s which involved rapid business growth rates but no real prospect of profitability;
  • such investment will be exposed as a 'bubble' when US consumption demand stalls / falls and no replacement has emerged elsewhere (as seems unavoidable sooner or later). This would in turn take away the foreign exchange reserves (which China accumulates due to capital inflow) and expose its essentially insolvent financial institutions to the need to seek an international credit rating.

Given the growing incorporation of other countries into China's economic system (effectively creating a Greater Chinese economy), its financial crisis would be bad news all around. 

Given the nature of financial systems in the US (where P/E ratios remain well above the levels traditionally regarded as the upper limit) and in key East Asian economies (where many major financial institutions seem insolvent), any financial upset could easily become self-reinforcing.

It will be suggested below that there is a structural problem in resolving current financial imbalances. In particular this involves the mercantilist framework in which some economic and financial systems (eg in Japan and China) are managed and regulated to direct finance to production with little concern for financial outcomes or for balancing domestic production and consumption. This creates a potential global demand deficit, which may not be able to be resolved without massive financial dislocation.

Structural Obstacles (Industry Policy)

Structural Obstacles

It has been pointed out that the large capital surpluses of East Asian economies (who at their early stage of development would traditionally be expected to be capital importers) are as serious in distorting global financial arrangements as are large US deficits [1]. A solution was seen to lie in institutional reforms to East Asian financial systems to make large scale capital inflow possible.

The IMF also argued that more is needed to overcome China's pile up of foreign exchange earnings than changing exchange rates, because there are deep structural issues that contribute to overinvestment, overcapacity and falling prices. [1]

However the problem is not simple.

There are deeply embedded differences between the characteristics of US / Western economies (which are driven by financial return to the owners of capital from meeting consumer demands) and those of East Asian economies with an ancient Chinese cultural heritage (whose goals tend to be communitarian and mercantilist).

An outline of the cultural origin and nature of those critically important differences is attempted in Competing Civilizations which refers to complex differences in: the value placed on abstracts such as ideas, ideals and money; governance systems; economic goals; economic coordination; business funding; and the structure of financial systems.

Some East Asian economies (especially Japan and China) which have achieved strong growth at various times have done so through quasi-mercantilist strategies which have involved:

  • coordination of economic activities by social relationships amongst elites rather than by decentralised initiative in search of favourable financial outcomes;
  • building production capacity for export which is well in excess of domestic consumption, through nationalistic industry policies (which primarily involve accelerating economic learning through intelligence gathering and networking by social elites in various institutional settings);
  • 'buying' market share with limited regard for profitability;
  • financial systems which make funds readily available for production - but limit consumption (partly because limited social welfare systems force individuals to save); 
  • accumulation of large financial losses in financial institutions - which are protect from the need to obtain an international credit rating by accumulated foreign reserves and tight regulation.

Such arrangements are likely to appear inconceivable to Western observers (especially economists) who lack an understanding of (a) social and governance arrangements that allow financial profitability to be viewed as virtually irrelevant while seeking to boost a community's economic power rather than the welfare of consumers and (b) arational / intuitive methods for problem solving which make it possible to run partly-successful industry policies.

Industry Policies

These arrangements are manifest their most mature form in Japan (see Why Japan cannot deregulate its financial system). In particular, Japan:

  • achieves a $100bn+ pa current account surplus;
  • has for a decade seemed to be mired in a deflationary recession associated with (apparently still) unresolved bad debts which threaten the viability of its financial institutions;
  • has relied on high levels of public spending to sustain growth which have left government with debt levels that can not continue rising;
  • has limited ability to stimulate its economy with monetary policy (eg low interest rates) because management methods which do not value profitability mean that there is a lack of companies who have the solvent balance sheets required to qualify as borrowers [1].

It has been reported that Japanese authorities are happy to ignore the risk of foreign exchange losses associated with buying $US assets to maintain an exchange rate that is an effective export subsidy, because such losses are never marked to market [1]

Though China's industry policy practice's do not seem to have been widely studied, they may:

  • involve a modified version of methods which MITI, trading companies, banks and business management used to accelerate Japan's rate of economic 'learning' (ie involving collection of intelligence and networking, to accelerate the creation of market-relevant economic capabilities). In China's case such methods are likely to be:
    • less centralized being undertaken through extended family networks as well as through some state institutions; and thus
    • less disciplined and likely to generate a faster boom / bust cycle.
  • depend on an intuitive style of problem solving, which has an intellectual basis that is not readily understood by Western mindsets (see Transforming the Tortoise). One observer realistically described this as an "ancient Chinese philosophical outlook that makes little distinction between theory and practice" [1]
  • have been used in the creation of massive subsidized industrial capacity - such as that for manufacture of semiconductor chips [1]
  • have been used Asia-wide through China's Diaspora networks (following the Asian financial crisis and establishment of the above Commission) resulting in imports to China that suppressed its net current account surplus and incorporate other economies within China's economic system;
  • are effective (to some extent) because few understand how they work.

These different economic goals and methods seem to be reflected in China's approach to support for nation building in SE Asia - which emphasizes building production capabilities and relationships with little regard to financial outcomes [1]. It is likely that they are also reflected in the apparently wastefulness with which capital is used in China [1] - though Western observers tend to ascribe this merely to the fact that banks fund state-owned institutions who ignore profits. China is seen to have a tendency towards over-investment and boom / bust conditions because banks are state owned, interest rates are held low and capital is provided to state enterprises [1]

The issue goes deeper than this however because there is no Chinese word for 'unprofitable' [1].

These characteristics presumably originate in the mercantilist traditions of East Asian economic wisdom - where traders have become rich and influential not by superior ability in making profits, but through superior savings. Similar methods of building economic strength (through savings) have been applied to some national economies (combined with disregard of profitability by state controlled monetary and financial institutions) without considering the consequences of fiscal imbalances for the economic system as a whole.

This has parallels to the mercantile policies in 18th century Europe, where economic activity was controlled by the state as a component of national policy whose goal was to accumulate 'wealth' in the form of gold bullion and to contribute to the defeat of enemies by bankrupting them. Mercantilism was eventually discredited when it was pointed out that the real wealth of nations was not a stock of treasure but an effectively functioning economy. 

The result in many cases has been unbalanced economies (featuring a demand deficit and effectively insolvent financial institutions) and current account deficits in trading partners (eg in the USA). Rather than merely accumulating foreign exchange reserves to prevent currencies appreciating [1], in East Asia this seems to have also been a way of protecting the financial system.

Such methods are unsustainable domestically in the long term (see also Unsustainable Economic Models?) because:

  • the methods used to accelerate economic change and provide business leadership will intrinsically not produce economic 'success' if this is measured in terms of financial outcomes;
  • can be seen to result in a tendency in Japan to over-invest [1];
  • the savings that common people make at substantial sacrifice are lost by elites in the pursuit of economic projects deemed to be in the community interest. There is thus always some risk of (a) capital flight if the financial system is not heavily regulated or (b) political instability - despite the tight social discipline that is imposed;
  • it would be physically impossible for all countries to use such as system as the net balance of payments within the global economy must be zero, so not all can achieve the surplus required to protect insolvent financial systems;
  • in the long term resource allocation from economic strategies that emphasize turnover will tend to be worse than for those that emphasize profitability;
  • there can be no effective means to balance supply and demand without effective price mechanisms and producers who are sensitive to profitability in the use of capital.

These characteristics also appear to account in part for growing problems associated with the operation of the global financial system such as:

  • growing US dependence on Japanese capital inflows in the 1980s, which resulted in the 1987 share-market crash when Japan sold US Treasuries worth $400bn, and interest rates rose rapidly (perhaps as a result of Japan's desire at that time to be 'No 1');
  • a response by the US Fed which involved the creation of credit to prevent financial dislocation from affecting the real economy - which started (a) long period of sustained US and global growth - because even with loose money policy there was no inflation risk because of cheap Asian imports and (b) an asset boom / bubble in the 1990s;
  • difficulties which societies operating under variations of the 'Asian' model have in achieving economic success if this is defined in terms of financial profitability - which ultimately resulted in:
    • Japan's financial problems in the 1990s following the bursting of an asset bubble;
    • the Asian financial crisis of 1997-98   The unsound condition of financial institutions in several countries was exposed when large numbers of international investors followed Japan's initial withdrawal of capital.  Though some countries (eg Japan and China) had maintained a large balance of payments surplus to protect their financial institutions, this was not true for 'Asia' as a whole - which had run a current account deficit in the early 1990s;
  • the subsequently perceived requirement for such countries to maintain large capital reserves to protect financial institutions with poor balance sheets;
  • a growing potential demand deficit in the global economy over the past several decades, which was unrecognized, because of;
  • the parallel growth of fiscal imbalances (ie current account deficits and debts) in the consumer / profitability oriented US economy, which compensated for the demand deficit;
  • the inability of the Louvre Agreement (involving 'stimulation' of the Japanese economy) to correct current account imbalances, because given the way its financial system was organized such action could only have the effect of increasing production, rather than consumption [1];

These differences are also likely to be a contributor to Europe's economic stagnation - despite massive public deficit spending in its major economies.

Overcoming these imbalances would require the emergence of consumer-driven (rather than primarily export-driven) economies in countries such as Japan and China - which in turn would mean that:

  • financial institutions would have to be solvent so as to justify an international credit rating;
  • there would be a need to take corporate profitability seriously;
  • mechanisms to accelerate economic change and provide business leadership would need to be reinvented - which would present huge cultural challenges (and perhaps be inconsistent with the traditional social order).

The World Bank has argued that such a great deal of progress has been made in overcoming such constraints (partly as a result of the Asian financial crisis) but that there is still a long way to go in shifting the framework for decision making and governance [1]. Moreover it remains uncertain whether enough desire to make those changes exists (see also Understanding the Cultural Revolution), and there appears to be a consequent risk of a major new Asian financial dislocation centred on China.

Reform would probably need to be focused mainly on Japan as:

  • China has made some attempts to normalize its financial system, and is putting itself at risk of a financial crisis as a result;
  • Japan seems to have been going to extra-ordinary lengths to prevent change (eg creation of large quantities of credit that are made available to US consumers to maintain East Asian current account surpluses [1]);

As an apparent alternative to such changes, proposals have emerged for the creation of

  • an Asian Monetary Fund in parallel with the IMF which would presumably operate in terms of 'Asian values' and make funds available in the event of a prospective withdrawal of capital by investors (see East Asian Economic Paradigm). The AMF concept (which was first raised at the time of the 1997 Asian financial crisis) seems to be re-emerging [1];
  • a 'Confucian Union' for East Asia which would be based on a (so called) 'worker caste system' which is a future better alternative to the 'merchant caste system' in which capital has been the source of power. It is seen as superior because it would be run by bureaucrats / technocrats whose productivity 'merchants / capitalist' otherwise constrain  [1

Such proposals reflect a profoundly different way of organising societies and economies. Western societies are government by abstract ideas / values, and economies are coordinated by money (symbolic wealth). Such abstracts carry little weight in East Asia and the economic emphasis is on maximizing 'real' rather than 'symbolic' wealth.

As outlined above, this difference leads to unsustainable financial imbalances. While major cultural and institutional changes in East Asia would be one way to restore balance, East Asian societies might pursue an alternative vision (ie trying to gain a globally dominant position, so that balance could be achieved through economic coordination by relationships amongst neo-Confucian social elites).

Policy Coordination


The Second Failure of Globalization? suggests that coordinating trade and financial policies to overcome such constraints will be difficult because, whilst the differences between the character of Western economic systems and those in East Asia are particularly significant (see above), there are also differences amongst Western systems of political economy.

It was the sum of these differences which presumably made it difficult to gain agreement about changes to global arrangements that might have eliminated the the political and economic dysfunctions in the Middle East that have bred terrorism by Islamist extremists - and in turn led to:

  • the adoption of unilateral 'solutions' by the US, which appear unlikely to be effective; and
  • a fracturing of long-established alliances.

However unless these obstacles are overcome there is going to be a serious financial dislocation somewhere - and probably sooner rather than later. 

A demand-deficit recession / depression like that in the 1930s is not impossible, and neither is the shift to totalitarian and militaristic governments which that economic dislocation induced.

Options (Will Incompatibilities Resolve Themselves Naturally)


Any attempt to develop a solution must start by placing the problem in context and recognizing that:

  • different peoples come from different starting points, and there is no proof as yet which economic and governance models are likely to be most effective ultimately for individual nations or the global community generally;
  • humanity faces many difficult spiritual, social and environmental challenges (which are not seriously considered here) in addition to the need to ensure economic prosperity;
  • there can be no solution for any one, unless there is a solution for all.  

Because of the structural differences involved, it is not possible to create conditions in which growth could be sustainable merely by stimulating domestic growth in the US and hoping that this will lead to enough demand elsewhere to overcome the US's financial (cash flow) imbalances.

In 2000 the US established a US-China Economic and Security Review Commission, and in October 2003 the Commission expressed concern about China's mercantilist policies and specifically about the effect of its exchange rate and industry policies which were seen as contrary to the rule of free and fair trade - and called for a US policy response. Others have called for measures which reduce the trade imbalance [1] (eg a tougher tariff regime [1])

Some have been concerned that this could lead to destructive US protectionism.

The adoption of some form of mercantilist strategy by the US (ie constricting imports and boosting exports by various protective measures) would overcome its financial (cash flow) imbalances - but it would do so by stifling domestic and global growth and would ultimately prove self defeating. Likewise options related to manipulating exchange rates seem likely to be ineffectual (see above)

In particular the US Federal Reserve takes the view that fiscal imbalances will resolve themselves - providing a flexible international financial system develops and no one resorts to protectionism [1, 2, 3].

Will Incompatibilities Resolve Themselves Naturally

The relaxed approach which the US Fed (and to a lesser extent) the US administration have taken to the US current account deficit (CAD) may be justified by assuming that:

  • the US economy does not really have a CAD problem. It has a CAD because others (eg in East Asia) have a very high rate of savings and invest in US institutions which allows US national spending to exceed its national income. But the moment they cease doing so the US CAD would disappear (though perhaps not smoothly) because the CAD is more a function of external capital inflows, than of the US economy itself. When the demand deficit disappears, or others become more attractive to investment (or US organizations cease to be able to make productive use of additional capital) it will flow elsewhere - and the US's CAD will evaporate. A shift of the foreign exchange holdings of Asian central banks away from $US was apparent in the second half of 2003 [1]; 
  • US business is better able than any other to extract profits from global economic growth, and thus will (a) strengthen the US tax base eventually so as to allow government deficits to be reversed and (b) be attractive to inflow of foreign capital;
  • there is currently no viable alternative to the $US as a global currency - and thus no real risk of a $US currency crisis because:
    • US asset values have increased far more than debt levels - resulting in a huge increase in net wealth and thus no serious difficulties in servicing debts;
    • no alternate destinations for East Asian savings seem to be available [1].
    • there is no realistic currency alternative. The currencies of major East Asian economies are not viable alternatives as a reserve currency because of the balance sheet problems in their financial institutions. Large investments into the euro-zone would cripple European economies which are already struggling (by further strengthening the euro) unless those inflows were neutralized by the European Central Banks buying a similar amount of $US assets. Gold would be a possible alternative to the $US, but experience during the 1930s shows that a gold standard can force governments into restrictive fiscal policies which exacerbate a recession;
  • the major East Asian economies with large demand deficits have no non-suicidal short-term alternative to supporting the US's 'cash flow' (CAD) needs with their savings surpluses. If US demand, which has been driving growth in East Asia were not to be financed [1], there would be economic dislocation and political turmoil across Asia - because the economic damage due to a financial crisis would be concentrated in East Asia due to their frequently-poor balance sheets. It would be much less in countries such as the US that have strong balance sheets;
  • the East Asian models seem likely to be unsustainable in the long term;
  • there is thus pressure on East Asian economies to normalize their economic and financial systems (eg increase domestic demand and create profit-oriented financial systems able to attract capital) which would eliminate the US's CAD. For example:
    • Japan is under pressure to correct its current account surplus by boosting domestic demand - because of its deflation risk and the high price of constantly buying $USs to prevent the Yen appreciating and undermining exports [1];
    • China appears to be at considerable risk of a financial crisis;
    • decisions apparently made by early 2004 to divert savings into domestic consumption in China [1] and Japan [1] and thus away from US demand will increase risks of financial dislocations in East Asia;
    • the slow diversification of foreign reserves by Asian reserve banks from $US which seemed to be underway in early 2005 will (a) reduce the US's CAD and (b) expose the Asian central banks to large losses, in the event of a substantial currency re-alignment, and impose a requirement on their governments to either increase taxes or reduce spending [1];
    • setting US interest rates near zero and allowing the $US to fall when East Asian central banks are forced to buy $US will reduce the foreign exchange holdings available to protect their financial institutions with bad balance sheets;
    • East Asian central banks were forced into a contest with financial markets to defend a strong $US [1];
    • authorities may be losing control of the monetary situation in China - and be forced to float the yuan [1];
    • under WTO rules China's financial system must be exposed to international participation by 2007 - though this fact in itself is unlikely to break down elite management of markets.

  • US foreign debts are generally denominated in $USs - over which, as a last resort, the US has the power of the press;

Given the US's fiscal imbalances, the Fed's approach to monetary policy makes no sense unless it is based on a consideration of the East Asian demand deficit / savings surplus. It may even be that the US Fed has recognized the imbalances associated with the East Asian demand deficit since the 1980s - and developed a strategy to manage the situation by ensuring a demand surplus through creation of credit [1] - on the assumption that the resulting fiscal imbalances must eventually resolve themselves. Such an initiative would be compatible with (but pre-date) the US National Security Strategy - which envisages using US power to increase security by stimulating economic prosperity (and democratic reform) elsewhere.

Other analysts have supported the Fed view on the basis that it is rational for economies in East Asia to finance the US current account deficit (despite the poor financial return this provides) because a great economic benefit from accessing US markets [1]. This suggests that there is no urgency about resolving the problem and that it could be addressed by (a) reining in US deficits and (b) emphasis on domestic markets in Asia [1].


  • in the absence of adequate final demand, monetary stimulus may largely have the effect of creating asset bubbles (a phenomenon which some observers have claimed is all that has been achieved [1]);
  • as the demand deficit in East Asia results from the communitarian-mercantilist character of some major economic and financial systems, this will not be resolved until those systems are normalized - a transition which would involve difficult adjustments and might not be achieved without a renewed bout of financial turmoil in Asia;
  • there is a possibility that some might see 'honourable suicide' (by exploding the global financial system) as better than accepting such change (see A Clash over Global Financial Systems?);
  • a huge devaluation of the $US might be required to overcome current imbalances [1] - which would result in massive losses for those holding $US assets;
  • the distortions of the global financial system (eg US current account deficits and debts, massive escalation of money supply) could induce a financial crash in the short term that would make long term resolution irrelevant.

In line with that theory, the US seems to have preferred to resolve the imbalances through slow devaluation (as alternatives such as raising interest rates or fiscal constraints are too difficult). This ultimately suggests a crisis for global currency markets [1]

Global economic integration (on which the ability of all to maximize growth and productivity depends) may be under threat because of the increasing difficulties which appear to exist in creating high value-employment opportunities in developed economies - in the face of outsourcing of high-tech jobs [1]

Japan [1] and China appear to have decided to place greater emphasis on industry to serve domestic demand, and reducing exports to the US and hence the need to finance a US current account deficit [1].

Likely consequences of this would include:

  • shifting Japan and China closer to a position where their insolvent financial institutions could trigger a crisis - by reducing the accumulation of foreign reserves;
  • diversification of US demand for cheap manufactures away from China towards competing sources of supply (eg in south or SE Asia); or
  • to the extent that diversification is not possible:
    • lifting inflation and interest rates in the US, and perhaps slowing global growth;
    • reducing the potential profitability of US companies investing for export back to US - which will reduce US ability to attract capital inflows;

Increasing US savings has also been seen as one option [1] - however this would only be constructive if it was achieved by increasing US incomes and constraining spending.

Why: to (say) eliminate a $500bn US current account deficit (about 5% of GDP) by reducing spending would require vastly more than a $500bn fall in spending - because most of any spending cut would simultaneously come off national income. Any such cut would have global consequences because of other's dependence on US markets. In particular it would seem likely to trigger the a renewed Asian financial dislocation .

Moreover increasing US incomes would only reduce the current account deficit if there is a way to ensure that those gains are saved (eg by increasing taxes so as to reduce government deficits and debts, or by increasing interest rates so as to discourage corporate / private borrowing).

It can be noted that neither of the latter methods of encouraging saving would appear to be constructive unless they accompanied a rapid increase in productivity and jobs - because in themselves they would also tend to also reduce overall economic activity.

Providing a method for constraining spending can be put in place, the deficit constraint might realistically be reduced by increasing US incomes, noting:

  • the improvements in productivity which were achieved in the 1990s through the development of new corporate strategy, eg radical re-organization of production  (to the network style of the (so called) American new economy) was driven by shareholder demands for increased returns;
  • though not all agree [1] it has been suggested that since the bursting of the bubble in 2000, (a) corporate governance has been tightened; (b) strategy improvements have reportedly seen a significant profitability surge [1]; and (c) an emphasis on longer term strategic options has increased [1]

Quasi 'industry policy' methods could perhaps be used in building economic capabilities to increase US productivity / incomes, so long as protocols and institutions which took account of the adverse impact which democratic political leadership of the process must have (eg by using protocols established by some US Private-Public Partnerships, or as suggested in Developing a Regional Industry Cluster). It would be unlikely, however, that the US would profit from using such methods in the low economic-value-added functions in which much of East Asia currently specializes.

Increasing demand in countries that run large current account surpluses with the US (especially Japan and China) would face political and cultural obstacles. Also, because of the financial (profitability) imbalances which such countries suffer, this also could trigger financial turmoil for China [1] - and also presumably for Japan.

Reform of the global financial system to reduce the risk of financial crises could be desirable - as the excess of demand over production in US which gives rise to its current account deficit has emerged because the need to create credit to prevent financial crisis from affecting the real economy has (starting in 1987) contributed to the asset bubble in US which allowed household savings to be ignored.

Other options which would appear likely to reduce the structural imbalances include:

  • aligning social welfare policies between Western societies and East Asia (eg US savings rates would increase dramatically if social welfare systems were slashed; while East Asian savings rates would fall if serious social welfare systems were established);
  • a redirection of manufacturing investment from countries which support mercantilist economic policies to those operating more balanced policies could make some difference (eg India: has developed a framework for local enterprise as well as foreign investment; encourages both consumer demand and production; values investor profitability; and thus does not have to rely on balance of payments surpluses to protect its financial system from collapse);
  • structural reforms to European economies to overcome their stagnation [1]; or
  • something like the arrangement suggested by Keynes in the 1940s which would encourage countries to run balanced trade accounts [1].

The fact that a deficit of final demand (a feature of the depression of the 1930s) now appears likely to derail global growth suggests that a Keynesian solution may be appropriate (ie boosting final demand by public deficit spending). However this is constrained by:

  • the large public sector debts that exist in some economically significant countries (notably Japan, China) and the significant public deficits already existing in countries such as Germany, France and Italy [1] - and the constraints on these under European Monetary Union rules;
  • the inability of the US to use Keynesian techniques without simply further worsening its current account deficit;
  • constraints on financing such deficits due to limits on tax rates in a globalized economy.

From September 2003 - and continued in the form of comments on relationships with Global Financial Instability in 2007


Observer's Reactions

Reactions to the above evolving analysis from various experienced observers have been as follows:


Unfortunately you are probably correct. China is still dependent on the American consumer spending. How long it takes for the process to run to its inevitable conclusion is anyone's best guess.


  • am quite sympathetic to [considering] cultural conditions (indeed, others are reckless to ignore them). But there are certain immutable human characteristics that set some basic foundations so, we should not try to read too much into these differences.  
  • global growth has been critically dependent on demand from US. But it is a big bubble.
  • be careful not to characterize the US or any other economy as being consumer driven. This is Keynesian hogwash. Production must always precede consumption (as a matter of logic no less than economic laws).
  • in this sense, the ongoing high consumption of US households is only that they are consuming beyond their means. And this is the consequence of reckless over expansion of the money supply. Were it not, then others would have to reduce their consumption unless global production rose due to higher global productivity (it ain't happened) or higher global savings (no evidence of this).
  • as far as European economies go, they are best characterized as worker-oriented rather than producer- or consumer-oriented. This means that profits suffer (and elderly die by hundreds in France while health care workers take time off rather than do their jobs)
  • Export orientation is little more than neo-mercantilism and creates the imbalances and distortions that caused the Japanese economy to collapse then followed by the hiccups in East Asia in 1997-98. It is a ruinously deceptive model and doomed. Alas, china will find the same fate...soon...?
  • while social relationships are important amongst Asian elites, the same is true in much of Europe (e.g., Italy) and in some parts of the US economy. It is not so much "nationalist goals"  that cause poor financial outcomes in Europe or elsewhere. It is that what is implemented are special interest goals that are portrayed as serving national interests (like the CAP) while actually accruing benefits to small groups and large costs on consumers and taxpayers.
  • the accumulation of large foreign reserves may incidentally protect institutions with bad balance balance sheets, but it is also a misguided element of the neo-mercantilism that many of the countries pursue. France once had a gold fetish much like many Asian countries have a foreign reserve fetish.
  • all financial systems should regulated to ensure that there is adequate finance for production, but neo-mercantilism introduces distortions that build up.
  • the correction of the US current account deficits will be something that is driven by economic reality. First, the effects of an inflated currency will begin to be felt. The subsequent rise in prices will push up long-term interest rates so that borrowing for production will drop as will employment. Then the final effect (not cause) will be declining consumption.
  • it is likely that China will trigger more turmoil in Asia (by the way, avoid the word "crisis" given its Marxist lineage...note that the word seldom appeared in mainstream economic literatures until the 1990s when it became a jargonized expression that has no real meaning nor any solid theory behind it)
  • although China's economic growth depends on foreign investment, it still contributes a relatively small component of total GDP...the boost has come from loose credit and public-sector debt and the looting of the banks to support government policy....
  • while much foreign investment seems to have been unprofitable for investors, and stalling US consumption demand may contribute to the demise of China's high growth, it is likely to be "internal and fatal contradictions" introduced by central planning and ruinous control over the financial sector that have not been resolved that will do the trick!
  • analysis based upon macroeconomics [should be rejected], whether offered by Keynesians or monetarists. They are simply different sides of the same coin. It is the inability to see the similarity in these 2 schools of thought (or their actual merging) that causes most analysis to go wide of the mark.
  • what we are seeing was best described by Mises and some other Austrian economists as a "boom and bust" cycle caused by loose credit policy that led to microeconomic distortions through misguided signals sent through relative prices that led to "mal-investments" that eventually come home to roost in the form of excess capacity and economic decline.

21/10/03 - A

Am more optimistic in hoping that the likely outcome (a muddling through between the important players - USA, Japan and Europe) is unlikely to involve any crisis more major than the ones we have already seen. Eventually, the Europeans and the Japanese [are likely] to be shamed into increasing demand by running looser monetary policy. No need (hopefully) for yet more fiscal stimulus.

Hope that you exaggerate China's fragility, provided their policy makers do nothing dumb.

21/10/03 - B

It is just a face saving move for [US] to complain about the Chinese currency. China's Yuan pegging to dollar is a great deal to the US service economy. It keeps inflation low, helps finance the massive US deficit spending and housing boom bubble, and contributes to American corporations' bottom lines. No economic expert touts the de-pegging as a good thing. Treasury Secretary John Snow showed up on CNBC, Bloomberg TV, etc. and couldn't give a straight answer as he faced questions from either GOP-leaning or Democrat-leaning economists. My guess is that Bush isn't serious. He brought that up to pre-empt a potential election issue so he wouldn't lose too many votes in the manufacturing / labor union camp.

21/10/03 - C

The following issues were raised:

  • Has global growth been critically dependent on demand from US consumers? Don’t think so. It is true that US consumers have spent a lot and saved very little. But the idea that spending creates growth is incorrect. Except for the shortest of runs, in which wages and prices are sticky, supply creates its own demand (Says Law), not the other way about. Because the US consumer has spent so much, investment in new capital that brings productivity growth has slowed.
  • The US economy is coordinated by financial markets and so, increasingly, are those of East Asia. It is true that the East Asian financial markets are less flexible and impersonal that the US (and EU) markets, but they are markets. And foreigners participate in them big time. So there is [no] problem about bad balance sheets that is significantly contributing to the current imbalance in the global economy.
  • The US cannot resolve its current account deficit without increasing its saving. The increased saving could come from decreased consumption or increased production (and income).
  • China and the other East Asian economies are capable of growing at rates of 8 percent or so independently of what the US does.
  • Asia crisis #2 can only happen if there is an unexpected deflation. And that can be avoided by East Asian monetary policy.  
  • Don't know how the world will resolve the current imbalance. It likely that it will sustain for many years and then gradually rather than suddenly be dealt with.
  • in the meantime, there are other huge demographic movements at work that will create tensions—the aging population of the US and EU and the very young population of most of the RoW. Life cycle (Modigliani) considerations suggest that the deficit of the US will persist and an EU deficit might join it.
  • the worst fear is that Mercantilism will take hold in the face of the US (and perhaps EU) deficits. The best outcome is to ignore these deficits and let the world economy function as an integrated capital market.

21/10/03 D

You make good long term points.  Stephen Roach makes similar points. But right now markets are embracing [a different] view.  The US problem really hits the road in two or three years when (if) the
world can't finance its deficits.


You asked about:

  • the costs which China carries by having to deposit hard currencies with central bank in order to manage its exchange rate;
  •  the effect on exchange rates of domestic expansion of the money supply by authorities (eg the FED),

For every dollar from exports and foreign investment that enters China (about $378 billion last year alone), the PBOC must supply an equivalent amount of yuan. Since more money enters China than leaves it, the supply of yuan keeps rising. China's money supply surged 21.6% as of the end of August over the same time last year.

To get to the bottom of the impact of expansionary monetary policy on exchange rates, the following explanation is a bit unorthodox, but it is merely correcting years of misconceptions. First, inflation is too often defined or understood as rising prices. This is simply wrong. Rising prices are the RESULT of inflation, which should properly be understood as an excessive expansion of the money supply. In this sense, inflation of the money supply can have at least 3 possible results, viz., rising consumer/producer prices, asset bubbles, depreciation of the domestic currency.

Inflation of the money supply can cause a currency to depreciate if it leads to excess supply on foreign currency markets. This is what has happened to the US dollar.

So, it is even possible that the yuan might follow the US dollar down if it were de-pegged! Especially if the Chinese were allowed to choose where to place their capital assets. The outflow of domestic funds might then swamp the inflow from foreigners.

The Chinese people are not better off with quasi-mercantilist policy which involves building up foreign reserves rather than allowing an expansion of private, commercial banks along with letting foreign banks set up shop. It is not clear that there is any difficulty in attracting foreign capital under the current regime, and there would certainly be more if the financial system were to be liberalized.

The likelihood of China experiencing a financial crisis is determined by the internal and fatal contradictions of its quasi-mercantilist policy that has contributed to NPLs and captive labour and excess capacity and so forth.

Your point about cultural factors shaping the way enterprises do business [may not be] a good explanation. Sure, there is some of this, but much of it reflects the dead hand of the defunct communist ideology. In all events, the nature of the incentive structures and the absence of the rule of law are important. If these were allowed to change by throwing quasi-mercantilist policies overboard, you would see considerably different behavior. The sooner they start doing this, the better they will be And it turns out that "culture" is neither immutable nor is it deterministic.

Attachment: The Problem is Financial, Not Currency, Manipulation

The Problem is Financial, Not Currency, Manipulation - email sent 10/3/15

Professor Jeffrey Frankel
Harvard University

Re: Chinese currency manipulation not a problem, China Spectator, 10 March, 2015

I should like to endorse your conclusion that China’s currency manipulation is not in itself a particularly serious problem.

However the financial manipulation that characterises the major ‘bureaucratic non-capitalist’ systems in East Asia (ie Japan originally and China since the late 1970s) is a significant problem. Savings gluts / demand deficits have been needed to avoid financial crisis in countries where state-linked financial systems mobilized capital for production through state-linked entities with little regard for return on capital.

Some early suggestions about why such financial manipulation is more significant than mere currency manipulation was outlined in China may not have the solution, but it seems to have a problem (2010). The domestic financial repression that was needed to avoid financial crises in the ‘bureaucratic non-capitalist’ systems not only led to a requirement for currency manipulation but also seriously distorted the international financial system because of the changes that were needed elsewhere if global growth was not to stall. This was not the only cause of the global financial crisis – but it was arguably a significant factor.

More recent reasons for suggesting that chronic financial manipulation is a major issue is outlined in Why Interest Rates Can't Stimulate the Economy (2015). The latter referred to the current dependence of global growth on ever rising public and private debts that seem sustainable in a low interest rate environment but are likely to be unsustainable once interest rates rise.

The ‘bureaucratic non-capitalist’ systems are facing potential crises (eg see Japan's Predicament and China: Heading for a Crash or a Meltdown?). China seems to be staging a ‘fight-back’ through attempts to create an international ‘sphere’ in which the autocratic methods of exerting political and economic power that operate internally could be expanded (eg see Creating a New International 'Confucian' Financial and Political Order, 2009+).

In the context of that apparent effort to create an authoritarian / bureaucratic alternative to the liberal democratic post-WWII international order that the US has championed, it is interesting that (as your article noted) China has now started selling its stockpile of US Treasury bonds – a move that will presumably amplify the trend towards financially and economically disruptive higher interest rates that the US Federal Reserve has been edging towards.

John Craig