I have just read a speech by Zhou Xiaochuan, Governor of the People’s Bank of China, that was posted on the PBoC website yesterday entitled “Instability and Evolution of the Financial System”. In the speech he argues about the inevitability of financial turbulence and its usefulness in forcing necessary reforms. I was struck by a comment in his very first paragraph:
For the past five years, China’s economy has basically maintained a steady and rapid growth without any real bumps. In fact, I am a bit worried that some young people may think that this kind of smooth, stable status is normal. In fact, the more likely norm is that a financial system faces instability or turbulence of varying degree every few years; (to be) free from all such instability would be, in fact, abnormal.
Has Zhou become a Minskyite? For those who don’t know, Hyman Minsky is one of the most important “unknown” economists I can think of – although in the last year or so I have been seeing a lot more references to him. I used his work extensively to develop a model for financial crises which I wrote about in my book, The Volatility Machine. I don’t want to oversimplify him, but one of Minsky’s best-known insights is that financial crises are a necessary and inevitable companion of functioning financial systems and are embedded in the very structure of financial markets – this insight is most often sound-bitten in the phrase: financial stability is destabilizing. According to Minsky, changes in market volatility automatically cause systematic (and opposite) changes in the behavior of market participants so that risk, and the risk of crisis, cannot be eliminated from financial markets, even in theory.
If you are a Minskyite, then, it seems to me that rather than try to come up with policies that eliminate the risk of crisis, you are more likely to be interested in figuring out how financial crises are transmitted into the real economy. From a policy point of view you would be concerned with designing a financial system that permits rapid recovery among financial institutions and that is most likely to minimize the adverse impact of a financial shock on the ability of economic actors to finance economic activity. Very flexible financial systems with lots of moving parts generally do better, as recent US experience seems to indicate – in the past three decades we have had a series of financial crises that seemed to have left pretty minor impacts on the underlying US economy.
In his speech Zhou makes a reference to a classic text much loved by assorted Minskyites (and others), Extraordinary Popular Delusions and the Madness of Crowds, and as an aside, I would note that in my experience an awful lot of people who study financial history tend towards Minskyite views, but I don’t think Zhou is one of the crowd. In his speech he makes the following statement:
In reviewing international financial instability or turbulences since the 1970s, we may have two observations. First, while many kinds of instability or turbulences afflict financial systems, only (a) minority is created by the financial system itself. The majority reflects problems in the real economy — the so-called “mirror image” in financial sector. The real economy and the financial system mirror each other…
Second, problems in developed countries, particularly in those emerged in mature market economies, are often relatively new as these economies are often places where financial innovation activities are concentrated. These problems are so new that market participants and regulators alike have a hard time predicting their course. Naturally, it’s a big challenge to find solutions. In comparison, problems faced by the emerging markets or developing countries are more often a repeat of those already experienced by the developed economies. Thus, the way for dealing with instability often can more probably be drawn from the international historical experience.
Although I think some of the things Zhou says in his speech suggest that his model of crises has lots of overlap with Minsky, I think overall his view is closer to the consensus economics views that suggest that financial crises occur because of macroeconomic mismanagement, and as such they “mirror” problems in the underlying economy.
I think Minsky would argue that, except to the extent that large fiscal deficits create rising levels of debt, financial crises have little to do with the way the economy is managed or performs. They are caused primarily, or even exclusively, by instability in the structure of the balance sheet. It is very possible for a very badly managed economy to avoid financial crisis and for a well-managed, well-performing country to have crises (maybe South Korea’s collapse in 1997 is the best recent example of a healthy country succumbing to a horribly mismatched balance sheet, although the US too has managed sharp financial crisis in the past few decades with robust productivity growth). When a country – or any other economic entity with a balance sheet – mismanages the relationship between its liabilities and its assets, it runs the risk of an adverse shock causing the balance sheet to collapse. That is what a financial crisis is.
Too bad Zhou isn’t fully one of the Minsky crowd. If he were he would be more concerned about minimizing the consequence of crisis on the Chinese economy rather than protecting the economy from crisis, which I think is an impossible task. This would drive a number of policy recommendations – including on flexibility in the financial system, strategies for developing an investor base, the CIC investment strategy, and the treatment of NPLs in the banking system.
In his speech he does make some interesting points, especially on the history of recent Chinese financial crises, in a section called “Parsing China’s experience”. Let me quote (extensively):
In 1985, China experienced a high inflation rate of 8.8 percent. In the anti-inflation process, the decision-makers learned how to build a two-tier banking system. The blind optimism about the balance of payments existed at that time was also corrected in this process…
The next round of inflation, starting in 1993, caused the third plenary session of the 14th CPC Central Committee to lay out a formal macroeconomic policy framework as well as various guiding perceptions and principles, including what kind of macroeconomic policy framework should be established…
Through the 1990s, the Chinese banking sector faced a predicament characterized by the underdevelopment of a sound “credit culture.” During this period, shortcomings of the credit culture were exemplified by two main types of bank lending. The first was policy lending, including those determined by the government plan or under variety of administrative interventions. The second was so-called “relationship-based lending”…
At the end of 1997, the Asian financial crisis spread to its full scale. Although China averted a head-on hit by the crisis, its aftermath had produced long-term effects on the Chinese economy, including, most obviously, the problem of non-performing loans (NPLs)…
In February 2002, at the second National Financial Work Conference, plans were made to strengthen financial supervision (later on in 2003 the China Banking Regulatory Commission (CBRC) was established). It was also decided to kick off a new round of reforms on the commercial banking sector, clean up bank balance sheets, and proceed with financial restructuring…
Just before the Enron and WorldCom cases were exposed in the United States, the Chinese media had unveiled a fund scandal in its securities trading. In this case, some institutions were found of manipulating stock prices. The year 2001 also saw the Yin Guang Xia case, which was similar to the Enron scandal in that the listed company disclosed false information and engaged in unlawful trading in its stock. In 2003, a larger scandal of listed company broke out with the collapse of the De Long Conglomerate. Following these incidents, China’s financial regulations and corporate governance standards were improved and toughened to counteract the misconducts by using complex corporate structures, which occurred in the De Long Case.
By the way, and I guess as a complete aside, as long as I am on the subject of favorite little-known economists, let me add the name of Alexander Hamilton to the list. Of course the first US Secretary of the Treasury is famous as an historical figure (and has made a big comeback in the past decade, before which he had been almost ignored for about seventy years), but he is also the theorist who more-or-less invented US economic policy in the 19th century and perhaps even the phrase “infant industry”. His 1791 Report on the Manufacturers, a brilliant overturning of Smith and Ricardo which should be the blueprint for China’s economic development, set out probably one of the best (and highly practical) expositions ever of economic development policy.
I am reminded of this because I was reading earlier today Justin Lin’s 2007 Marshall Lecture in which he made extensive favorable references to Freidrich List (and his “infant industry” argument), but the German List, who was originally an ardent free trader, developed most of the framework of his economic theories during his exile in the US in the 1820s, when he lived with and met a number of prominent Hamiltonians and was able to examine up close what was then called the “American system”. I think we need to revive Hamilton as one of the great economists, and the only excuse I have for inserting this little lecture into my blog is that, as a developing country, China could do an awful lot worse than to have its leaders study the works of Alexander Hamilton (political and financial, as well as economic).
