Since it is the Christmas holiday, and I am spending the week in southern Spain with my family, I have not been focusing too heavily on economic data and have instead been reading lots of different stuff, including Frederic Wakeman´s excellent The Fall of Imperial China, about the transition from the Qing, especially the late Qing, to the early Republic. Among other things I have been reading there is a very interesting article in the Winter 2010 edition of National Affairs, by Jim Manzi, and AI entrepreneur and senior fellow at the Manhattan Institute, that discusses the US within what he calls “the inherent conflict between the creative destruction involved in free-market capitalism and the innate human propensity to avoid risk and change.”
This has some relevance to China’s long-term economic and social prospects, and is a topic that I have discussed a lot with my students. In fact it is almost a subtext in Frederic Wakeman´s book. To put it simply, one of the great strengths of the US is its ability to change quickly and dramatically, even though this ability necessarily comes with a sometimes brutal insensitivity to the short-term social costs of the change. As Manzi puts it,
An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. This is not so much a matter of anti-market ideology as of the painful realities of economic change. Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.
It is therefore natural for people to organize to prevent the spread of significant innovation. The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms. In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation. It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome.
A big question for me is how China decides in the future to face the continuing trade-off between social stability and rapid change. In the past it is pretty clear that China has experienced wrenching social change. This change began from a widespread recognition during the 1970s that the Chinese model simply was not working, and that without a dramatic transformation, China was likely to collapse. It took the brilliance of Deng Xiaoping to understand how to steer China forward without risking an even worse crisis, and the economic rewards for this transformation have been dramatic, even as the social cost of such rapid change has put increasing pressure on the political and social systems of the country. How is China likely to face the continuing trade-off in the future?
This is not just an abstract and very macro question. It addresses much more specific things such as the liquidation process following a financial crisis. For example, if we were to see a break in the housing bubble, there are broadly speaking two ways to address the problem. The so-called “Anglo-Saxon” model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies. The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.
Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries. One obvious example is the massive railroad bankruptcies that occurred in the US after 1873. The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business. More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.
But there is a cost. Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on. Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger. Other societies are less so.
The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the “Japanese” model. Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers’ expense of course), and excess inventory taken off the market. The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy. In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings. The advantage, of course, is that it much less socially disruptive and painful.
When I discuss this with my students at Peking University their responses, not surprisingly, vary. A number of them insist that Chinese have learned long ago to suffer disruption, and they will be forced to continue absorbing the costs of change since there is a widespread consensus among the leadership that China must continue in its forward rush. Others, the majority, think that although socially the Chinese are used to absorbing the cost of rapid social change, the political system itself is less able to do so. Most interestingly to me is that whenever we have these discussions it becomes pretty clear to me that for most of my students our discussions are not the first time they have thought of this or related issues. This is something that many students, at least within the elite schools, have thought about.
This discussion extends into the whole issue of financial reform, and not just for China. Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short. Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for. The recent financial crisis, which seemed most to affect “Anglo-Saxon” financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.
But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis. Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk. Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital. It doesn’t matter if the system is highly fragmented and deregulated or highly regulated and monolithic. After all a large part of the prestige of the “Anglo-Saxon” model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.
So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems? Neither, it turns out. All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.
So is there no room for financial sector reform? Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim “Never again!” That is silly. It will happen again and again and again. Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during “normal” periods. A financial system designed to minimize the risks of crisis is probably a waste of time. It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run. Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy. So in China’s case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk. It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system. China´s financial sector issues are different. China´s systematic misallocation of capital is its biggest financial problem. China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth. It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth. But no matter how well-designed it is, the regulators should have a plan for the inevitable crisis, because it will come. The interesting question is not how China can avoid problems, but rather how it should deal with them when they come.
There was something else I thought was interesting in Manzi’s article discussed at the beginning of this entry. The graph below reproduces data about the recent history of manufacturing in the US. One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power. The US used to make real “stuff”, according to this argument, but now it no longer does so. What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.
The huge (and hugely disruptive) surge in manufacturing productivity in the last sixty years has dramatically reduced the share of American workers employed in manufacturing, but manufacturing’s share of GDP has barely budged.
The decline in US manufacturing labor has created a sense of crisis in manufacturing, but it mostly means that labor productivity has risen sharply. That is unquestionably a good thing. Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited. China´s growth is not hollowing out US manufacturing. There are certainly problems with imbalances that need to be addressed, but they need to be addressed rationally with a clear understanding of the difficult issues each country faces within the relationship.
By the way, and on a different subject, for those who are interested in demographics, the US Census Bureau released its latest projections. According to the release:
China’s population is projected to peak at slightly less than 1.4 billion in 2026, both earlier and at a lower level than previously projected. Meanwhile, India’s population is projected to surpass China’s population in 2025, according to new data being released by the U.S. Census Bureau. These figures come from the population estimates and projections for 227 countries and areas released today through the Census Bureau’s International Data Base. This release includes revisions for 21 countries, including China.
The latest projections indicate that by 2026, the population of China will begin to decline. Population growth in China, the world’s most populous country, is slowing and currently stands at 0.5 percent annually. China surpassed the 1.2 billion population mark in 1994 and reached 1.3 billion in 2006. According to the latest revisions, India is projected to become the world’s most populous country in 2025. The population growth rate in India currently is about 1.4 percent, nearly three times that of China. The difference in the growth rate between the two countries is explained by fertility. India’s total fertility rate — the number of births a woman is expected to have in her lifetime — is currently estimated at 2.7 and projected to decline slowly, and that is driving population growth in the country.
The slowdown in China’s population growth is the result of declining fertility. China’s total fertility rate is estimated to have been 2.2 in 1990, 1.8 in 1995 and less than 1.6 since 2000. China’s fertility rate is currently half a birth below that of the United States, which is more than two births per woman. Key evidence for the new fertility estimates comes from analysis of data from China’s recent census and surveys. One of the consequences to China’s declining fertility rate is that the number of new entrants to China’s labor force may be near its peak. The population ages 20-24 is projected to peak at 124 million in 2010. This peak is earlier than in India, which is projected to reach 116 million in 2024.
Despite a shrinking younger population, China’s labor force may continue to grow for several years since the population ages 20 to 59 (prime working ages) is not expected to peak until 2016 at 831 million, an increase of 24 million from the current estimated level. “These changes in China’s age structure may affect its economic growth and competitiveness in the world market,” said Daniel Goodkind, demographer in the Census Bureau’s Population Division. Given that China and India together account for 37 percent of the world’s population, their demographic trends have major implications for worldwide population change. The Census Bureau’s International Data Base includes projections by sex and age to 100-plus for 227 countries and other areas with populations of 5,000 or more and provides information on population size and growth, mortality, fertility and net migration.
So much for 2009. In two days I return to Beijing in time for the crazy end-of-year festivities at D22. I wish you all a great 2010.
You nicely categorize the two models for dealing with the crisis following a buildup of excess liquidity and risk. However, considering the US government’s policies of extend and pretend in the banking and housing sectors, with mark to make believe in accounting and simple refusal to foreclose on non-performing loans in both housing and commercial real estate, I suggested the you rename the “Japanese” model to the “American” model.
Financially at least, America is no longer an Anglo Saxon country.
The Japanese model reminds me of Clinton’s motto of ‘telling the truth slowly.’ I agree that with the proper automatic stabilizers the ‘band aid’ method generally works best. In the modern era that may the only way to sustain the Anglo model, people can’t just go back to the farm when the factory closes any more.
One of the key features of the Anglo needs to be letting creditors take an overt haircut, something the US hasn’t felt willing/able to do this time. Also, I don’t know what greater productive use Las Vegas tract housing is going to be put to.
I have two issues with your sanguine view of the decline of manufacturing in the USA.
The first is inaccurate statistics and measurement.
link: http://www.businessinsider.com/the-economy-needs-125000-new-jobs-created-per-month-and-thats-being-optimistic-2009-12
A PROBLEM AT THE VERY HEART OF DATA GATHERING: Recently in Washington a rather large number of economists from academia and from government met to try to hash out a problem with data gathering that has become more and more serious here in the US and has more and more distorted how we value the American economy itself. At heart is how imports into the US are accounted for.
“For example, when a part for perhaps $100 is imported from China and is used in an American automobile … something that happens more and more and more often these days … the stats show that the finished car is American-made because it was assembled here in the US and in the process the US GDP is raised by that same $100 when in fact it should have been deflated by that figure instead. In the process, American workers who might in the past have made the part in question are no longer doing so and are obviously made redundant, hence a job or jobs is lost.
“The unemployment data then ‘finds’ that unemployed worker and accounts for him or her, but the car that is assembled does not, and when it is produced and sold and its value makes its way through the system, it appears that productivity has risen … and rather dramatically so, when in fact it has not. As one of the economists attending that meeting said,
” ‘We don’t have the data collection structure to capture what is happening in a real-time way, or what is being traded and how it is affecting workers. We have no idea how to measure the occupations being ‘offshored’ or what is being ‘inshore.’
“Or as the Assistant Commissioner for International Prices at the US Bureau of Labor Statistics (and how “politburo-like” is a title like that?!!) Mr. William Alterman, said regarding this problem
” ‘What we are measuring as productivity gains may in fact be nothing more than changes in trade instead.’
“This is not an insignificant problem, for as the US has become more and more international in its trading scope the data has become more and more important. Back in the 1975, imports into the US were only 5% of our total economic activity, but in recent years that has swelled to 12%, excluding imports of energy. Thus, many imports into the US are being, and have been, and will continue to be, valued as though they were manufactured here in the US, when indeed they were manufactured abroad and merely assembled here in the US.”
The other issue I have with your sanguine view of the decline of manufacturing in the USA is that our trade deficit is a manufactured goods deficit.
Here is another link (Noam Scheiber) :
http://www.tnr.com/blog/the-stash/do-we-even-have-manufacturing-problem
While we make more than we used to, we account for a steadily decreasing share of the world’s industrial output–and, more importantly, of the output that American consumers and companies buy.
The easiest way to see this is via the trade deficit in manufacturing goods.
It doesn’t look like the Commerce Department breaks out that figure explicitly, but I think I was able to piece it together by combining the trade deficit in capital goods (ex autos), autos, and consumer goods (ex autos and food), which the Commerce site makes available here. I don’t have time to make a chart now, but if you just look at a few snapshots over time, you get the basic trend. In 1980, we had a trade surplus in manufacturing of $17 billion. In 1990, that had become a deficit of $77 billion. The deficit ballooned to $300 billion in 2000, and $433 billion last year. I’d say those are signs of a pretty remarkable decline.
But don’t just take my word for it. Fed chairman Ben Bernanke is actually a manufacturing bull–he tends to similar data on output and productivity. But, when pressed during Senate testimony back in February of this year, even he conceded that the sector has some issues:
But I think it may be that part of the impact on our manufacturing has been the trade deficit, which has to some extent reduced — has been associated with a reduction in manufacturing because trade is very much conducted in manufacture. So the movement in the trade deficit has been associated with greater imports in manufacturing, and that to some extent has been a competitive issue.
Michael – very nicely done indeed. Still trying to wade thru Manzi’s original article and will give it another shot. In some ways too bad you didn’t tackle the broad question of socio-political adjustment rather than narrowing it down to politico-financial; though that’s your primary concern. Perhaps married to the complementary parallel question of sectoral re-balancing, itself a major politco-economic question. Since they are so inter-related, suffer the same interest group sclerosis and represent similar challenges perhaps the one can be taken as representative, besides being discussable.
There seem to me to be financial sector questions, i.e. is China’s finance industry mature enough for the emergence of a more market-like model? But the real problem is the capture of decision-making and related institutions by various power groups; or so it seems to me at my remove. That is does the will, way and political support exist for re-engineering the financial sector in the directions you think appropriate exist?
That strikes me as the heart of the question.And perhaps worthy of further discussion?
The US is the hippocampus of the worlds financial brain. Its nimble-ism is akin to plasticity. Its plasticity makes it prone to instability (seizures or mood swings). At the same time, it can more quickly adapt to disruptions, with neurogenesis based plasticity being related to the speed and ease in which it can adapt. Unlike other areas of the brain. , the hippocampus encodes information immediately. Its inherent adaptability comes at the expense of neuronal longevity, thus it requires a constant supply of new neurons. Supplied by the subgranular zone.
All complex systems with inter-dependencies behave in similar ways. Maybe the US Fed should enlist Fred Gage and the PBOC should do likewise with Moo Ming Poo.
I think that in any country there is a need for a system to smooth the process of adapting a society’s work force to take advantage of technological change. Given that technological changes increase productivity as you point out, the added cost of such a system should be more than offset by the gains from faster adaptation of the workforce.
There are two keys to figuring out a successful system. One is making sure that affected workers get a stake in the new methods; it seems this would require cooperation between government and private enterprise. The Luddites you mention might have been less militant if the owners of the capital invested in automation had worked out a way for the workers to keep jobs; only with different tasks that facilitated automation.
The other key is creating a system where workers can obtain new skills and knowledge with a minimum of bureacratic/guild forms of limiting access to these. If as one type of skill gets saturated with workers, it is easy to switch to a newer skill set that might reduce the institutional barriers to change that you mention.
I love that you love Wakeman’s book (I’m a former student of his). If you’re interested in reading more Chinese history (with an economics/business twist) I recommend:
Parks Coble, The Shanghai Capitalists and the Nationalist Government, 1927-1937
Sherman Cochran, Big Business in China: Sino-Foreign Rivalry in the Cigarette Industry, 1890-1930
Sherman Cochran, Chinese Medicine Men: Consumer Culture in China and Southeast Asia
Karl Gerth, China Made: Consumer Culture and the Creation of the Nation
Wen-hsin Yeh, Shanghai Splendor: Economic Sentiments and the Making of Modern China, 1843-1949
Bryna Goodman, Native Place, City, and Nation: Regional Networks and Identities in Shanghai, 1853-1937
Madeleine Zelin, The Merchants of Zigong: Industrial Entrepreneurship In Early Modern China
You might also read Soul Stealers, Rebellion and Its Enemies…, and The Making of the Modern Chinese State – all by Philip A. Kuhn. He and Frederic Wakeman were the two best of their generation.
Finally, I really love Elite Activism and Political Transformation in China: Zhejiang Province, 1865-1911 by Mary Rankin.
All excellent books. Love your blog.
No one would have a problem with the effects of increased productivity if they benefited everyone equally. But that hasn’t happened in the United States for many years. We have a Google economy now, which employs how many people, as compared to GM in its glory years ? Americans will be tolerant of the ‘Anglo-Saxon’ model until they won’t be. Public opinion is not set in stone and can change.
I agree with your points that:
1. financial crises are the way a distorted system rebalances;
2. crises will happen again and again and again;
3. every major financial crisis in history was preceded by a massive liquidity build-up; and ,
4. how Minsky and Kindleberg describe banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.
It seems to me that minimising the harmful effects of future crises must involve avoiding the distorting conditions of excess liquidity and excessively low costs of capital. And the primary source of these distortions are the very central banks that purport to give stability to our economies. Many now agree that the recent financial crisis arose out of an investment bubble (mostly in western residential real estate) that was aided by a too low interest rate policy. But this interest rate policy itself arose out of attempts to mitigate the bursting of the TMT bubble of 2001, that itself arose from the excess liquidity conditions of the Y2K scare and the LTCM crisis of the late 1990′s, and so on and so on.
Perhaps our crises would be smaller and more manageable if we allowed interest rates to be set by the market as the natural balance between the supply of savings and the demand for credit rather than by central banks trying to engineer economic outcomes.
So with the extremely low prevailing short term interest rates and the distortions in long rates caused by quantitative easing, I think today we are simply building to our next crisis rather than actually unwinding the imbalances of this past one.
Interesting as usual.
1. Unfortunately the US itself seems to not want to follow the “anglo saxon” model this time. The extend and pretend process is instead in full swing. The size and scope of the bubble seems to be too big for the social/political system to handle the “anglo-saxon” way.
2. I think we have to separate “banking” and “financing innovation.” It is the mixing of the two that has contributed to the current crisis (Glass-Steagall to some extent).
In Canada there are 6 major banks, heavily regulated. The banks by and large do “banking”. They issue mortgages and actually continue to hold many of them. The government restricts mortgage innovation. As a result Canada’s banking system has survived quite well (although they continuously fought government regulation) and Canada has suffered far less than most anglo-saxon economies and its banking system remains stable.
The other issue of course is “financing innovation”. While small businesses regularly complain about access to financing from banks the fact remains that financing innovation is not a “banking” function. It is far too risky to be done by true banks. It is better left to capital markets, VC, etc, and these are best kept separate from banks. That way when a “crisis” erupts it is the risk taking part of the system that needs to “destruct and rebuild”", leaving the banking system used by the majority of the economy on sounder footing.
The “scandal” of the current crisis is the extent to which those that benefited from and fueled the bubble escaped with their fortunes in tact and the scale to which “citizens” have been burdened with the fallout costs. There must be a penalty for failure … which seems not to exist in the current US unregulated regime.
3. China – India. And that is why India will continue to struggle. Imagine where India would be today if it had followed the Chinese 1 child policy. India is clearly already in overshoot mode.
4. If the goal is: “It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.” we will always have trouble. It is the “rapid” part that is the problem! If you try to run any system at an “artificially fast rate” you will run into trouble.
It’s always seemed to me that the trick to creating a flexible economy was to provide a social safety net, including continual educational opportunities, so as to bring down anxieties about the future, but not so great a comfort that it leads to complacency.
Here in the U.S., the most obvious needless anxiety is health care, and education a close second. The costs of both have become so untethered to the rest of the economy that a middle aged couple with teenagers is compelled to obsessed with maintaining the status quo.
I think if you convinced people their lives and the future of their children weren’t always hanging on by a thread, they would be willing to put up with more short-to-medium term disruptions.
Manzi implies that we have a clear choice between untethered free (free from state intervention) markets, or democracy which comes at an economic cost. So … we can have either economic freedom or political freedom, but not both.
Such dichotomies reflect an ideology that goes unnoticed in the thinkers like Manzi, who fool themselves into thinking they possess no ideology.
The driving force behind China’s booming economy is the transformation of a rural population into an urban society. Compared to subsistance farming, almost any urban occupation represents a dramatic improvement in productivity. With hundreds of millions migrating into urban cities over the coming years, the Chinese economy will maintain its economic momentum for the forseeable future. The Chinese economy will leapfrog the GDP of the recession plagued United States to become the largest economy in the world by 2020. The Washington Consensus Elites would rather squander US capital on stupid wars in the Middle East including bombing Iraq, Afghanistan, and soon Iran.
There is a big structural difference between the China vis-a-vis the rest of the world that is under-discussed, namely that China is a net value destroyer. Sure you can produce more stuff, and generate more income, but income and value are not the same things. The US generates innovation, as Japan did and does, and as others do too on a large scale. China copies it and produces in large volumes, a disruptive force far more “disruptive” than Japan’s productivity innovations were in the 1970s. Go to any electronics market in Guangzhou or Shenzhen and you can find hundreds of “i-Phone killers”, more shanzhai products that have a minor tweak, but provide the same functionality (far less reliably) at a fraction of the cost of a 6000 RMB original. The same thing applies to cars, airplanes under design, the list goes on. Absolute productive capacity is thus China’s necessary evil to keep this model going, and the poor allocation of capital is necessary to keep the system going. This is partly the case because the system chokes off real innovation. Think of foreign equity valuations over the long-term, especially those related to the production of real stuff and not services, and unless these firms are doing what they do substantially in China (not likely because of protectionism and the desire to replace foreign brands with domestic ones), they are overvalued not just on a cash flow basis but also because you can almost hear the air rushing out of the value of their IP and intangible assets. As for the Manzi article, where does the rule of law figure in? This generally accompanies democracy, and increases economic value. Economic freedom without the rule of law means that we need to revise Inferno for to include another circle of hell for China’s industrial future.
It’s very interesting that the conflict between free-market capitalism and pure democracy is identified. This makes me think whether a combination of authoritarian government formed by the true elites (wise and moral) and the free-market competition based model (in most industries excluding those delivering universal services such as health care, nation-wide postal and railroad system)is the best way to go from a social-political perspective.
Manzi: ” It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome”
Does not hold water. A dynamic freemarket economy has become an illusion. Today we see a great example as Fannie/Freddie equities gain 15% after the announcement that taxpayers will backstop all losses for the next 3 years. The amount of taxpayer aid provided exceeds the market caps of both. This is neither dynamic or free.
Being too successful may be really not good because it will attract all sorts of wrong types of attention. “China policy” experts from the West promote “snake oil” solutions to the Chinese for their own self-serving agendas. The US political elites, jealous of China’s booming economic growth, will utilize every political and economic tactic to attempt to derail China’s economic growth. Unlike Japan, China isn’t dependent on the US military, so the Chinese can independently maintain a sovereign monetary policy. The Washington Consensus Elites should be rebuffed in their attempt to obtain the revaluation of Chinese yuan. Like the formerly booming Japanese economy previously before the Plaza accord, the ulterior motive exposed is really to collapse the Chinese economy from an overvalued currency.
Michael
Another great post. However I take exception to your conclusions concerning US manufacturing:
“One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power. The US used to make real “stuff”, according to this argument, but now it no longer does so. What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.”
“Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited. China´s growth is not hollowing out US manufacturing.”
Clearly, the US industrial base has been substantially eroded by low cost imports from China and other export oriented countries. Whole industries have been wiped out and others have been reduced to a small fraction of what they were in the past. This trend is continuing. In many cases the US manufacturing facilities affected are not inefficient or outmoded operations being replaced by more efficient producers. Rather, many are world class, state of the art, highly efficient facilities that simply cannot complete with state subsidized industries. Somehow, the statistics you show in the graph do not capture the reality of what is happening on the ground in the real world. Comments from Lark suggest some potential problems with how data is collected and categorized, and I suspect there others.
I agree with Steve Jones about the extend and pretend process that the government has employed. And I believe that based on the explosion of government borrowing many fiat currencies are going to come into question in the next couple of years, and that’s why I think one of the only safe assets to own is gold. I also recently came across another m&a story in the gold mining sector at http://www.goldalert.com/gold-price-blog.php
Penmont trumped Goldcorp’s offer for Canplats Resources for the 2nd time in less than a week. With all of the money printing the govt is doing, I think gold will continue to do well, which is gonna lead to more deals like this where the big gold mining companies and gold producers seek out the smaller gold exploration companies.
Luca Bratzi, does the US have rule of law when political connected Wall Street firms receive multi-billion dollar taxpayer bailouts. If you are Goldman Sachs, you have got essentially the red bat-phone to Washington D.C for a taxpayer bailout of any amount. AIG received a $180 billion dollar taxpayer bailout that was laundered to Goldman Sachs executives. Rule of law would allow those who essentially bet wrongly to fail, instead of bailing out people with friends in high places.
Mike G (and others who have made similar points) I don’t want to suggest that the US, Japan, or indeed any other country lies at either end of the two extremes, or could possibly do so even in theory. No country can prevent any short-term adjustments, nor can any country absorb all adjustments immediately without trying to mediate them. The point is that there may be a real trade-off between the two that involves not just economic costs but also political and social costs, and any economic analysis should take these into consideration when trying to forecast how policymakers will respond.
OGT, again I would stress the overall process. Whether or not there are individual assets that might not be recycled into economic use, the point is that one kind of adjustment process increases the overall efficiency of recycling assets usefully and the other doesn’t. At any rate I would imagine that even deeply discounted Las Vegas tract housing has some use.
Lark, I believe the data Manzi uses refers to value added, not to total sales.
Ma Bole, thanks for the suggestions. I have already read the Coble and Yeh books and will start ordering the others (thank god for Amazon.com)
Purple, I am not sure that is the right way of looking at it. Overall unemployment in the US over the past twenty or thirty years has not been noticeably worse than during the prime manufacturing years. Similar arguments were made about the collapse of agricultural employment but it did not result in rising overall unemployment in the US. In China we heard similar arguments over the past decade about weakness in the low-end export industry leading to rising unemployment in places like Guangdong, but that never happened. This is because the rise in productivity is usually caused by rising wages, which reflect demand for labor elsewhere. Increased investment in improving labor productivity is usually the result, not the cause, of workers moving elsewhere.
David B, unfortunately I agree with you that current global monetary policies may be increasing the risk of another overinvestment cycle and another asset bubble.
Bob, I am not sure I agree. It seems to me that you are saying that Americans consume too much because of a lack of a social safety net. In China we say that Chinese save too much because of a lack of a social safety net. It is hard to reconcile these – and I suspect that neither is true.
David Chiang and Anonymous, thanks for your various assertions, but if you want actually to participate in the debate please do so under one name. As for your last comment, a rule of law does not imply that all issues are satisfied “justly”, however we might define just. It implies that the rules of the game are sufficiently well-established that economic agents can meaningfully plan around them. Of course we want both, a system that is just and a system that is rule-based, but these have different consequences and it is not unreasonable to separate them in an economic discussion.
G. Stephen, I don’t doubt that several sectors of US manufacturing have been hurt, and perhaps unfairly so by subsidies, but it seems to me that we need to get a sense of proportion. China will need to change its policies because the US, Europe and other Asian countries are unlikely to continue absorbing the costs to their own manufacturing sectors, but China cannot do so quickly. I am afraid that apocalyptic statements about the collapse in US manufacturing will make it hard for these countries to work out a relatively smooth transition.
Mr Pettis
I agree on the problem solving ability swipe – after all, it’s more important to learn how to handle a disaster than to spend time worrying about how to sidestep, after all at some point you’re going to run out of pavement!
Frankly, I’m not sure how the asset bubbles are going to deflate or how the crises are going to be resolved. The real tipping point one suspects is when they loosen regulations regarding outflow of capital – that is probably when deflation of asset bubbles really take place and the subsequent stampede begins. Where capital leaves asset classes but cannot leave the country efficiently is probably a reason why the asset bubbles keep popping up again and again without any sense of resolution.
For everyone’s sake, fervently hoping no one takes the japanese path, the scars of the 90s have never quite left some of their institutions. So it really starts to look like the devil and the deep blue sea . Which is the lesser evil?
On that cheery note, have a great festive season everyone!
Michael Pettis, Within the economic sphere, the rule of law is sufficiently established in the Chinese economy. Otherwise, why would China be the top recipient of FDI particularily in the manufacturing sector. Korea’s LG Group announced yesterday a $4 billion investment into Guangzhou of a 8th generation LCD production facility. Intel is investing $5 billion at a state-of-the-art semiconductor fab in Tianjin. Samsung also announced the building a $4 billion LCD fab in Suzhou. Taiwan’s Inventec will invest $800 million to build a new production facility in Chongqing, China. Frankly, there isn’t any factual evidence that Chinese rule of law is damaging to China’s economy.
Honda, BMW, Volkswagan, Nissan, and General Motors have all announced plans for new Chinese factories. More jobs for China, the most business-friendly country in the world. A country where cheap electricity from hydropower, nuclear power and coal is perfectly accepted in the next decades. A country without environmentalism, without the climate change hysteria, where the economy is still the priority to politicians. How bad does it have to get until the US political elites realize they are commiting economic suicide for the nation?
G. Stegen- I’ve been thinking about the notion of the US economy suffering from a financialized version of Dutch Disease. (Inflated currency and influx of money both draining the tradable goods sector and inflating ‘home goods’ like services and real estate, usually associated with natural resource booms). China plays into this effect in this model, certainly, but major problem is actually the US reserve currency status and the disproportionate size of the financial services sector.
Prof Pettis- The point I was trying to make about the tract housing is that it seems the disposition of the assets is relatively inconsequential. The 1873 railroad was no more technically functional after bankruptcy than before. The important thing, economically, would seem to be disposition of the debt and out dated contracts, which I don’t think necessarily disagrees with anything you wrote.
Michael, no, I just meant that any tendency among Americans to resist economic change is largely attributable to the fact that our safety net has a lot of holes that other developed countries don’t have. I have two niece’s who had babies over the last year and they’ve already set up college funds. Meanwhile, for my friends in Munich with a 13-year-old, funding college is no worry at all.
I guess this is a check on consumption that is countered by much lower taxes.
David Chiang – to echo Prof. Pettis’ comment, while it may be the case that Goldman has been the recipient of political favors, this individual case has little or nothing to do with the rule of law at a systemic level. Think basic property rights, the enforceability of contracts, etc. These kinds of things need effective mechanisms to protect them in order to increase economic value creation; they can’t just be words on paper, as is the case in China. If China is able to bring about legal reforms that would protect basic economic rights (especially property), the impact on wealth and growth prospects would be huge. The problem is that China is still investing in hard assets, and not on social infrastructure or capital in a meaningful way. I will only go so far as to say that China needs to realized the effective rule of law as a necessary complement to other aspects of economic development without raising any ideological suggestions. Imagine what this would do to add value to the skills and knowledge of the millions and millions of talented people and businesses that are on the short end of the arbitrary application of legal procedures of all kinds in China. And by the way, the largest shareholders of Goldman and other favored financial institutions in the US are pension funds. Look at bank share prices and think about who else has benefitted from government generosity in addition to overpaid financial executives.
Luca Bratzi, The US version of transparency and rule of law is that the American people are permitted scream and bitch all they would like to vent anger. But the US political elites do whatever they want for themselves and cronies. Politically connected Wall Street banks and Hedge Funds receive trillions in federal taxpayer bailouts for failed investments, the American public gets a bone thrown at them in the form of a $1500 cash for clunker. And whatever happened to Obama’s promise to remove US troops from Iraq within 90 days of being elected President. Not only are US troops staying indefinitely occupying Iraqi oil fields, but another 30 thousand troops are being deployed to Afghanistan with stealth reconnaissance aircraft deployed along the Chinese western border. It’s part of US military containment strategy targeting both Iran and China. While China is typically characterized as a threat to humanity by the US government controlled corporate media, at least the Chinese haven’t bombed to death, 1 million Iraqi citizens in the past 8 years.
David Chiang:
Please, the point on rule of law is “how much better it could be”. All those businesses you mention have made calculated guesses about the returns they will get in spite of the risks (including inconsistent enforcement/intepretation of contracts). They have determined that the cheap wages, the disregard of local authorities for environmental protection, the subsidized energy costs and the tax giveaways that the local cities provide outweigh the risks of rule of law issues.
These are just more of the hidden taxes that China passes on to its citizenry…if there were more transparent government and legal process, wages would not need to be so low and a lot less people would be sick from environmental pollution.
Also, it is not just about contract enforcement. The unclear regulations that subject a business to the individual authority interpretation (whim) at a local level creates huge uncertainty when making investment decisions.
On the whole, you might be right…China is the most business (investment) friendly place in the world. But that title comes at a deep price to its citizens.
Professor Pettis: Thanks for an excellent posting.
I remain puzzled by the numerous comparisons of China with Japan, the United States and Europe — as the systemic logic driving their politico-economic systems are so different. Hence, what makes sense say in China might be totally absurd in the USA or Europe — and vice versa.
This conundrum is brilliantly explained in the seminal work by D.C. North, J.J. Wallis and B.R. Weingast (Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History) MIT Press. This approach is currently all the rage in development think tanks; earlier papers can be found on the NBER and World Bank websites.
North, Wallis and Weingast (NWW) focus is on the State’s monopoly over violence as the key logical idea behind human organisation and history. At the big risk of over simplifying a great book, they explain that the natural order of human organisation is “Limited Access Order” societies. LAOs form “peaceful” coalitions between warring factions by restricting entry to crucial institutions (business, government, religion, education, etc.) to the elite and dividing up the resultant economic rents. The elite clearly gain from LAOs, but so do the non-elite through peace and stability.
But LAOs are inherently dynamic and unstable; each faction must maintain its potential for violence to remain credible (e.g. coalitions among rival gangs in a mafia).
NWW define 3 types of LAOs: fragile; basic and mature. Fragile LAOs: are unstable failed states where the “state” is functionally non-existant in terms of providing basic public goods (security, justice, etc.) Pakistan, Afghanistan, etc.
Basic LAOs: have a functioning state but everything including the nascent private sector and NGOs depend on the state.
Mature LAOs: have developed private sectors and NGOs, but entry into key institutions is still limited to the elite.
The state does not have a monopoly over violence in any LAOs — and is constantly creating alliances among different power groups.
By contrast, Open Access Orders (OAOs) are a historical rarity starting in England and the USA in the 19th Century. By definition, there is “open access” to critical institutions. NWW suggest that OAOs exist when a third of the population can actively compete for entry into key institutions. OAOs have state monopoly over violence and they are all democracies.
In summary, OAOs create larger economic rents by fostering “competition” among the elite, while LAOs create stability and peace and hence economic rents by RESTRICTING competition among the elite. They are DIFFERENT ANIMALS.
What relevance for China? Ever since the fall of the Manchu dynasty, China has been a fragile LAOs i.e. a failed state dominated by civil war, revolution and chaos, including Mao’s bloody rule. In short, the sickman of Asia.
Since 1977-78 China Deng succeeded in establishing a “basic LAO” and the longest period of “peace and internal stability” in over a century. It is only now starting to put in place the pillars for a “mature LAO” including inter alia, a better, functioning (far from perfect)legal system, universal primary and secondary education, as well as “private property rights” for urban property. To be sure a lot remains to be done, especially in terms of political reform and human rights. But difference between the situation in 1978 and now is like night and day !
So what is the point of this posting? Most or even all of the numerous criticisms that you and others make about China’s shortcomings in terms of industrial, trade, financial policy and especially RULE OF LAW etc. make perfect sense — if China was an OAO society. But, these criticisms are rather irrelevant in a LAO context. The challenge is to modulate and repackage these criticisms to achieve the same results within the logic driving China’s LAO coalitions. NWW’s book provides some killer ideas on how this can be done and is a great read. It also provides insights into the surprising resiliancy and adaptability of China’s LAOs despite enormous external and internal stress.
Sorry for the length of the post, best regards and happy new years ! James
Hello Michael,
I’m a Bimba grad, but never attended your class. Your blog is censored in China for unknown reasons, otherwise the green dam function is supposedly to screen off pornographic materials, unless the government views your blog dirty the minds of its citizens.
I take great interest in your academic curiosity as to what China would do when the asset bubble goes burst. It is highly unlikely it will be the “Anglo-Saxon” way, since it is closely linked to a social system in which “democracy” seems to be patented as their IPR. It would certainly not be the Japanese way, as it is more concerned of social and financial stabilities of the nation and people as a whole. In China, political self interests and economic policies are inseparable. Granted, it is the same everywhere in the world, but it is unique in China, a country with one fifth of humanity, sufficiently a critical mass to inflict substantial disruptive and destructive force, such as a tsunami, to the rest of the world, should catastrophic economic derailment occur. 70% of the nation’s wealth is controlled in the hands of 0.4% population, of which the majority, if not all, are CCP members. Another interesting survey indicated that 92% of these 0.4% novel riches are linked to high ranking comrades and their siblings. There are 70 million CCP members in a country of 1.3 billion souls, amounting 5% of total population. About 8% of these 70 million (5% of 1.3 B) are county level and up, SOE party bosses, to politburo comrades. It is precisely 0.4% of CCP elites and cronies holding up the entire fort of China’s economic well-beings. It is premature to speculate what China would do in case when the asset bubble bursts, but the logical decision making process of the 0.4% inner-circle policy makers and influence peddlers can be summed up as follows:
1. First of all, strengthen CCP rule legitimacy by all means, including brute force, in the name of social stability, patriotism, national security and interest.
2. The government controlled banks, instead of calling up loans and requesting more collaterals, would print more money to hold up artificial asset values, and package non-performing loans and assets as “innovative” financial instruments to be marketed internally and overseas, and/or being digested in off-shore IPOs. As a result, asset value would become stagnant with gradual decrease in price over time, at the same time, causing hyper-inflation of for all the rest commodities, merchandises, and labor cost.
3. Manufacturing sectors are way over capacity cranking out products with dirt cheap price for export dumping. SOE factories are on the live line from state owned banks incurring with huge losses, all in the name of creating jobs for workers otherwise would roam on streets aimlessly protesting for injustice.
4. The disruptive and destructive force to the rest of the world will be importing mixed bag of hyper-inflation for some, and deflation for dumping products (most of the products, if not all, on super market and Wal-Mart shelves).
5. If comes to necessary, the government would float the RMB to adjust inflation and deflation impact. This is a trump card to hold until the last minute.
6. If social chaos continues as unemployment mounts. The very final trump card would be the announcement of disbanding the CCP, change the name to PAP, ultimately, still the same bunch of 0.4% controlling 70% of nation’s wealth. There is such a Soviet Union precedent to announce the disbandment of communist party, practically overnight, all political and economic bad debts had been written off.
7. China has not only baffled Chinese with unexpected surprises, but also keeps foreign sinologists employed, as its social and economic havoc has been equivalent to violent volcanic eruption in recent history. Remember those familiar years – 1958, 1966, 1978, 1989. Now, watch out for 2012. The scale of each of such eruptions increases in size, shifting from internal to external. There is no way to run when this tsunami hits the shores.
The American manufacturing sector had changed drastically and irreversibly pathetic since 1949 with 34% of employment force, to now less than 10% of the work force. Simple question will be asked where had this 24% of the work force gone? Although the productivity seems to be stagnant for 6 decades, an indication shows products are made with value added because of R&D product improvement, which may require negligible work force to burry their heads in Labs. US workers no longer make the real “stuff” as they used to be. The curve on the graph indicates value of the product (high tech) as opposite to quantity (real stuff).
The rule of laws in China means Machiavellian trickeries. Commercial law books are copied from other countries’. The passing of a “law” does not require public consultation, debates, public hearings, even voted on by the inner-circle politburo comrades, such as the “monopoly law”. Some university professors, usually billed as “authorities” by the government simply pirated the “law” from outsiders and announce it is the law effective immediately. Legal professionals do not know the details until MNCs coming to China to commission lawyers to do legal due diligence. Law enforcement does not seem to care or bother what is in the law. The beauty of this system is that one can negotiate his way in/out of legal interpretations, or simply pay as at the toll gate. As David Chiang hailed that China is land of laws, that is why MNCs are coming in droves investing billions. But the fact is these MNCs are doomed in their own countries, they have nowhere to go. As the former Minister of Foreign Trade Wu Yi once joked “they fly in like moths diving into the fire”. This is not the light of the tunnel, but a deadly fire.
Undeniably, and no offense to anyone, it is a challenge to make money from these three ethnic groups in descending order, Jews, Indians, Chinese. After all, the Chinese are not so bad to rank the third place. In 2012, when the China tsunami hits the world, it would be catastrophic of unimaginable destruction. The after shock, another huge wave called the Indian tsunami would clean up all debris onshore to the open sea.
James,
North et al do have an interesting framework to deal with the fundamental problems of political economy by developing a simple taxonomy that foregoes ideologically laden and nonsensical (at least for the opurpose of accumulating systematic knowledge) terms like democracy. Michael’s dilemma looks a bit more like Pzreworskis observation that markets are oriented (ideally) towards pareto optima and “democratic” political systems towards median voter preferences. Combine a robust Schumperian economy with an activily participating (but risk averse and possibly poorly educated median voter) and you have conflict. Eliminate Schumperian elements and the actively participating risk averse voter (even if well educated but averse to free markets, like in say north western europe) will move towards social democracy. Etc
I think the key is in participation and voter orientation. Voter in martial terms (an unhappy PRC citizen may become quite politically relevant if his preferences are misdirected or ignored).
Many scholars are looking for grand political/institutional economy connections (like the Legal Origins school) and these folks, but it is apparently very hard to come up with something that is useful in policy terms. History and comparative politics are best sudied within one’s own head, perhaps.
“This is because the rise in productivity is usually caused by rising wages, which reflect demand for labor elsewhere.”
Productivity in agriculture was enabled by oil which delivers diesel oil and many machines powered by it. There is a direct link between these machines and the number of horses and humans replaced by them. No such technology exists to explain the fake manufacturing productivity improvements.
As pointed earlier, when a $100 gizmo used to be made in US is changed to incorporate $50 from China then stats show higher productivity even though remaining US workers don’t really produce more. To really understand what is going on, change your chart to include the quantity of parts being imported into US for assembly into Made in US products.
The reality is that most of the so called productivity improvement in US is based on simply replacing US made parts for cheaper parts from Asia.
This job losses are real problem and increasing portion of manufacturing revenue is being sent to Asian part suppliers. We are now reaching the point when those Asian part suppliers starting to build their own products and brands, at which point the manufacturing part of GDP curve will also tumble.
Remember how Honda and Toyota started and where they are now!
You write always too simplistically about “Chinese see themselves…” maybe because you work in China and feel proud of doing so, that you keep indulging a national/racial view of topics that otherwise could be dealt with far more objectively. you never fail to self promote either. it is trite. Please stop this so that we can read abou the issues rather than read about how intelligent Deng was, or how great China is, or how bad Anglo Saxon Finance is etc. it is annouying . thank you.
Dave Chiang, China is not the top recipient of FDI except nominally. Other countries receive a larger amount as a share of GDP. More importantly, FDI is typically the least efficient form of foreign investment, and is only significant as a share of total foreign investment in countries that limit portfolio inflows. Most foreign investment in other large economies is in the form of portfolio flows.
OGT, I agree. The disposition of debt and the related assets is probably the key issue.
James, thanks for bringing up Doug North. I am a huge fan. Of course I agree that China functions within a different institutional framework than some of the countries within which it is compared, but balance sheets are balance sheets, and they tend to function the same way – the institutional framework may determine such things as the true (versus formal) liquidity of liabilities, but in the end you need to understand balance sheets in pretty much the same way. I also discuss trade issues a lot, and since China operates within an international framework in trade (by definition), China-specific factors don’t apply.
Gull-up, you bring up too many issues to discuss, but ay any rate I cannot tell you how China will react to its overcapacity problem. That depends on too many factors, including political factors, and depends to some important extent on the international trade environment.
Fake, you say “The reality is that most of the so called productivity improvement in US is based on simply replacing US made parts for cheaper parts from Asia.” That idea may be popular in the press but it doesn’t make much sense to me. Most of the recent productivity improvement comes I believe from the expansion of computer technology. By the way, if you can increase productivity even by “simply replacing US made parts for cheaper parts from Asia,” that is a net gain for the US economy and for US employment. If not, the US would have been a much richer country if it continued to engage in the agricultural/manufacturing mix it enjoyed 200 years ago,.
Hui Nao, no offense but I find your comment moronic. Where exactly did I refer to “how the Chinese see themselves”? What exactly was my racial view of the topic? I assume that since I am writing about China, I can actually make references to “Chinese” from time to time, no? Is it equally offensive when I refer to the “French”? And why is it inappropriate for me to discuss “how intelligent Deng was, or how great China is, or how bad Anglo Saxon Finance is” (not that I remember doing any of those)? This is, after all, a blog about Chinese financial markets.
Some of the data Manzi uses is quite misleading. For example, he says “Europe” opted for social democracy, but the stats he presents on “Europe” include eastern Europe, the Ukraine, and Russia, whose economic performance can’t plausibly be attributed to their adopting German-style social democracy. (He insists his definition of “Europe” is OK since it’s the dictionary definition, but ignores his implicit modification of that definition with his reference to countries that adopted social democracy.) Fuller criticism and a link to Manzi’s response here: http://www.tnr.com/blog/jonathan-chait/conservative-accidentally-makes-the-case-social-democracy
Thanks for another thought-provoking post!
Are you sure “lark” doesn’t have a point? The first article he links to quotes someone from the Bureau of Labor Statistics, which appears to be the source of the Real Manufacturing and Employment graph from Manzi.
I know that’s not central to the point of the article, but still…
It is interesting how the percentage against GDP. The same could hold if GDP was falling as well but in the case of the US we know that not to be true.
Prof. Pettis, really appreciate your posts.
David B., I think we should call the TMT bubble GS1 for Greenspan Bubble No. 1. He was ardently fanning the Y2K scare and pumping liquidity into the market. And the subsequent real estate bubble should be identified as GS2 because Greenspan blew up the bubble by dropping the interest rate to zero in response to the Y2K bubble bursting. And then he raised the rate rapidly! after suckering many non-vigilant homeowners into mortgages they could barely afford if the interest rate stayed at zero.