by Elliott R. Morss
Editor’s note: This is the second of two articles discussing the analysis of a study “The Way Forward”, link below. Part 1 is here.
In my last article, I wondered how the authors of The Way Forward could completely ignore the role of banks as contributors to our global economic malaise. In this piece, I will look their recommendations on what needs to be done globally to rectify the situation. Capital Flows
The authors of the study – Daniel Alpert, Robert Hockett, and Nouriel Roubini (AHR) argue that capital inflows from emerging market countries contributed significantly to the US housing/spending bubble that burst in late 2008. They assert further that a significant portion of those capital inflows came from emerging market governments (primarily China) trying to keep the US dollar strong so as to give their exporters a competitive advantage. They are critical of “China’s continuing policy of pegging the yuan to the dollar.”
There are several problems with these assertions.
1. US Capital Inflows
Table 1 gives data on foreign government and private investments in the US for the 2000–2007 period. While foreign governments purchased $1.4 trillion of US government securities during this period, the foreign private sector purchased far more, $3.8 trillion, with most purchases being equities.
Source: US BEA
These figures suggest to me that the Chinese government was not the main driver of what happened during this period. Instead, US dollar investments were attractive worldwide. In short, this global demand for US financial assets was far more important in keeping the US dollar strong than Chinese Treasury purchases. These “portfolio choices” had more to do with what foreigners saw as good investments than efforts to keep the dollar strong.
2. US Policies
To ease the threat of currency appreciation or inflation, central banks often attempt to “sterilize” capital flows. In a successful sterilization operation, the domestic component of the monetary base (bank reserves plus currency) is reduced to offset the reserve inflow. The Fed had the tools via its discount window and open market operations to mop up excess liquidity resulting from capital inflows. They chose not to use them.
Other AHR Policy Recommendations
The majority of AHR’s other recommendations are directed, at least in part, at China. Inasmuch as I ran a company with Chinese partners for more than a decade working in Asia, I believe I have a pretty good sense of how Chinese authorities would view the AHR suggestions. Consequently, my comments below reflect my sense of how China thinks.
AHR Recommendation 1 – Emerging market countries have the responsibility to stimulate consumption and reduce their savings rate by developing “safety nets”.
“Because China lacks a real safety net and does not have reliable public systems of health care, retirement, and education, Chinese workers are engaged in precautionary savings for these purposes. The best way to reduce this precautionary saving and augment demand would be to encourage China to do a better job of both providing education, health care, and retirement for its citizens.”
Imagined Chinese Response
There are two separate responses.
1. On the absence of a safety net in China and doing a better job of providing education: Table 2 gives the results of the OECD test scores for reading, math, and science in China and the US. At least in Shanghai, students score significantly better in all three tests than their US counterparts.
2. China does not want to have a safety net like that of the US. The US spends far more on health care than any nation in the world and it ranks at the bottom of all OECD countries on quality of care. If having a safety net and no “precautionary savings” in part caused the US real estate/consumption bubble resulting in the global recession, no thanks. In China, we believe some individual “precautionary savings” are good.
AHR Recommendation 2 – Chinese wages are too low. They should be increased.
“One way to correct the imbalance that results would be for China to allow wages to grow faster than productivity to boost labor income and thus increase purchasing power for consumption goods. This would also have the benefit of reducing the race to the bottom in labor costs and would allow wages and incomes to grow in other economies.”
Imagined Chinese Response
Five decades ago when Deng Xiaoping and others started working on economic reforms for China, they realized that China was a resource poor country. Because of this, they decided China must open up to the rest of the world and develop a strong export sector. A high level of exports would be essential to pay for the resources the country would have to import. During the last 15 years, much effort went into developing the infrastructure for a modern nation. Today, the consumer demands of the middle class are growing rapidly. Our projections are that in less than a decade, we will not longer be running a trade surplus. We do not want to become as indebted and as dependent on the rest of the world as the US has become. Consequently, we are not willing to increase wages and consumer demand to help bail out Western nations for their mistakes.
AHR Recommendation 3 – China’s Export subsidies must be eliminated.
“Export subsidies to industry in China and other surplus nations constitute another significant drag on demand, and of course contribute directly to the oversupply problem in the world economy. Essentially for those reasons, they are also illegal under WTO treaty and case law. Export subsidies accordingly must be steadily and expeditiously phased out.”
Imagined Chinese Response
The US and EU import quotas on textile and apparel made in China constituted the largest trade barrier the world has ever known. And while these were formally eliminated in 2005, significant vestiges of them remain in place. For example, the rate at which imports of these products can grow is still limited. This limitation was characterized by a Chinese government spokesman as a “betrayal of the fundamental spirit of trade liberalization espoused by the WTO” and has “seriously damaged the confidence of Chinese businesses and people in the international trade environment since China joined WTO.”
AHR Recommendation 4 – The US should help China Make Investment Decisions
“One option would be for the United States and China to more closely cooperate about the investment of China’s substantial foreign exchange resources…..China would over a period of time gradually reduce its Treasury holdings in favor of investment in the proposed U.S. Reconstruction Bonds, which would have higher yield. A similar commitment could be made with respect to the “Eurobonds” that will eventually be necessitated by increased fiscal union within the EMU.”
Imagined Chinese Response
There are three separate responses:
1. The China government’s primary responsibility is to invest its reserves in accordance with what is best for citizens, and not as a mechanism to bail out Western nations for its bad policies.
2. The U.S. government’s experience with investing reserves is limited. After all, its reserves are only $131 billion while China has almost $3 trillion. To help with its investments, China has hired what it believes to be the best financial strategists in the world.
3. Until and even after the U.S. bank collapse, the U.S. foreign assistance agency (AID) was urging all developing countries to increase their banks’ leverage, citing an outdated study that said greater leverage could increase developing countries’ growth rates.
The Chinese government has done an amazing job over the last three decades to generate growth and reduce the poverty of its people. It has taken a lot of hits from the West for its policies, many of which are uninformed. Over the next decade, the Chinese government has the very difficult challenge of moving from being an export-driven country to one that must satisfy the demands of its growing middle class without running up a large trade deficit. It will not be easy.
“The Way Forward” – Who Paid for the Study? by Elliott Morss
China: Will Increasing Wages Lead to Rebalancing? by Michael Pettis
Chinese Inflation and the Impact on the U.S. Economy by Menzie Chinn
Economic Effects of Large Exchange Rate Appreciations by Menzie Chinn
About the Author
Elliott Morss has a broad background in international finance and economics. He holds a Ph.D.in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance