The G20 Washington meeting of the leading economic powers avoided all the main issues that are really driving the international financial crisis.
Adding a fiscal stimulus, via tax cuts and increased government spending, to the measures already announced for taxpayer purchasing of bank shares is like administering a pain killer in an attempt to treat a serious disease. It might, at best, make the patient feel a little better. It does nothing to treat the underlying causes of why they are feeling so bad nor will it prevent the symptoms of the disease breaking out again.
The main driving force of the financial crisis remains that the dollar is overvalued and the US economy is over stretched to an extent that destabilises the world financial system. To stabilise the world economy there must, therefore, be a reduction of expenditure by the US.
The only way this can be achieved, without the US population suffering the consequences of this via drastically reduced personal consumption, is if US military expenditure is drastically reduced - which will involve measures such as withdrawal from Iraq. Refusal to acknowledge such economic realities is why the Bush presidency was such a drastic failure - leading first to an unsuccessful war in Iraq and then a financial disaster. However, so far, the US government shows no serious signs of understanding this lesson and therefore the US population will continue to suffer - along with the rest of the world.
Regarding reform of international financial institutions, a 'new Bretton Woods', the only way the IMF could be strengthened is to increase the voting weight of China, India and other new rapidly growing developing countries - as otherwise they will not give meaningful injections of funds. But that means reducing the role of the US - which, so far, it will not agree to. So there is an impasse on that front.
In Britain, meanwhile, the conditions are accumulating for a new financial storm. While other countries will agree to prop up the dollar temporarily for political reasons no major country sees any reason to prop up the pound. The UK therefore faces, in a more immediate form, the same choice as the US. Given the UK's real purchasing power in international terms will fall, as the pound's exchange rate declines, it will either have to cut military expenditure or reduce the living standard of the population below what is required. A fiscal stimulus of tax cuts and increased public spending will, at best, only delay that choice for a short period - and they will only be able to do that provided financial markets do not rebel. Meanwhile the government faces the immediate dilemma that the price at which it agreed to purchase shares in RBS, HBOS and Lloyd's TSB is in every case now above the market price for the same shares - threatening the taxpayer with substantial loss.
It is even clearer in this situation that only the policies of the left - reduction in UK military spending to avoid attacking the living standards of the population, targeted economic aid to those worst affected by the financial crisis to maintain consumer spending, increased state spending on infrastructure to keep up investment and improve the competivity of the economy - have a realistic way out of this financial crisis. The left's case is not only morally superior it is the only economically rational one - as the G20 meeting vividly illustrated.
Cost of bailouts rises as welfare state for corporations gets ever wider
If ever anyone wanted a clear illustration of the class based character of our present economic system, and the moral hypocrisy of capitalism, they need only look at the newly created and rapidly expanding welfare state for corporations and shareholders.
In both the US and Britain we have been told for decades that benefits must be cut back, that the unemployed are work shy, that probably most of those claiming incapacity benefit are fraudsters, in general the welfare state is a bad thing, and we must all be exposed to the full rigour or market forces or the country will be brought to its knees by 'scroungers'.
The moment banks and large corporations were in trouble, however, literally trillions of pounds and dollars were mobilised to help save their money.
In Britain Royal Bank of Scotland, HBOS and Lloyd's TSB were propped up by taxpayers money being used to support their shares. In the US the latest news shows both the still increasing cost of the financial crisis and the widening welfare state for shareholders.
Taking first two US companies in which shareholders were wiped out before their nationalisation, the insurer AIG and the mortgage company Fannie Mae, the cost to the taxpayer of the previous decisions of these companies is rapidly mounting.
Fannie Mae has announced it is losing money so rapidly, $29 billion in the third quarter of 2008, that it may need a cash infusion from the US Treasury Department by the end of the year from a special $100 billion fund the US Treasury set aside in September to aid the company. The already nationalised AIG announced a quarterly loss of $24.5 billion and has won approval from the US Federal Reserve to change to a bank-holding company - thereby opening it up for further government aid by participating in the Paulson bank bail out plan.
Turning to privately owned companies, American Express, the credit card and finance giant, has been granted bank-holding company status - as earlier were Goldman Sachs and Morgan Stanley. The Wall Street Journal reports that under these bank bailout plans the US government had promised: 'not to force banks receiving government assistance to lend out those funds to consumers and small businesses.' That is the main beneficiary will be bank shareholders.
In a surprise tax ruling the US Treasury has simultaneously handed up to a further $140 billion to US banks. The Washington Post commented: 'The financial world was fixated on Capitol Hill as Congress battled over the Bush administration's request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention... corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.
'The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal... "Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."... The guidance issued from the IRS [Inland Revenue Service] caught even some of the closest followers of tax law off guard because it seemed to come out of the blue when Treasury's work seemed focused almost exclusively on the bailout.
"It was a shock to most of the tax law community. It was one of those things where it pops up on your screen and your jaw drops," said Candace A. Ridgway, a partner at Jones Day, a law firm that represents banks that could benefit from the notice. "I've been in tax law for 20 years, and I've never seen anything like this."'
Simultaneously speaker of the US House of Representatives Nancy Pelosi was calling for a special session of Congress to bail out General Motors and other stricken US car manufacturers.
As the Wall Street Journal noted on 11 November: 'It was a day when even the monolithic U.S. government might be forgiven a sense of being overwhelmed by the current financial and economic situation.' Or as one one figure the newspaper quoted put it about the US government: 'The rescue efforts are "evolving in ways that I don't think anyone anticipated," said Camden Fine, president and CEO of the Independent Community Bankers of America, a trade group. "Things are just hitting them from every single direction, every day, and I don't think they know whether to spit or go blind."'
What conclusions should be drawn from all this? They are both economic and moral.
First, the claim that capitalism is a beautiful market self-regulating system has been shown to be simply untrue. This crisis shows it requires the state to step in to keep it stable.
Second, capitalism's moral hypocrisy and bankruptcy is breathtaking. A poor person on unemployment benefit or a pension can be thrown to the wolves. But if you are a rich US or UK corporation you must be bailed out immediately. It remains to be seen how much and how rapidly public opinion draws the conclusions from all this.
But to adapt Christopher Wren's words in St Paul's cathedral - 'if you want to know the case against capitalism just look around.'
In both the US and Britain we have been told for decades that benefits must be cut back, that the unemployed are work shy, that probably most of those claiming incapacity benefit are fraudsters, in general the welfare state is a bad thing, and we must all be exposed to the full rigour or market forces or the country will be brought to its knees by 'scroungers'.
The moment banks and large corporations were in trouble, however, literally trillions of pounds and dollars were mobilised to help save their money.
In Britain Royal Bank of Scotland, HBOS and Lloyd's TSB were propped up by taxpayers money being used to support their shares. In the US the latest news shows both the still increasing cost of the financial crisis and the widening welfare state for shareholders.
Taking first two US companies in which shareholders were wiped out before their nationalisation, the insurer AIG and the mortgage company Fannie Mae, the cost to the taxpayer of the previous decisions of these companies is rapidly mounting.
Fannie Mae has announced it is losing money so rapidly, $29 billion in the third quarter of 2008, that it may need a cash infusion from the US Treasury Department by the end of the year from a special $100 billion fund the US Treasury set aside in September to aid the company. The already nationalised AIG announced a quarterly loss of $24.5 billion and has won approval from the US Federal Reserve to change to a bank-holding company - thereby opening it up for further government aid by participating in the Paulson bank bail out plan.
Turning to privately owned companies, American Express, the credit card and finance giant, has been granted bank-holding company status - as earlier were Goldman Sachs and Morgan Stanley. The Wall Street Journal reports that under these bank bailout plans the US government had promised: 'not to force banks receiving government assistance to lend out those funds to consumers and small businesses.' That is the main beneficiary will be bank shareholders.
In a surprise tax ruling the US Treasury has simultaneously handed up to a further $140 billion to US banks. The Washington Post commented: 'The financial world was fixated on Capitol Hill as Congress battled over the Bush administration's request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention... corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.
'The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal... "Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks."... The guidance issued from the IRS [Inland Revenue Service] caught even some of the closest followers of tax law off guard because it seemed to come out of the blue when Treasury's work seemed focused almost exclusively on the bailout.
"It was a shock to most of the tax law community. It was one of those things where it pops up on your screen and your jaw drops," said Candace A. Ridgway, a partner at Jones Day, a law firm that represents banks that could benefit from the notice. "I've been in tax law for 20 years, and I've never seen anything like this."'
Simultaneously speaker of the US House of Representatives Nancy Pelosi was calling for a special session of Congress to bail out General Motors and other stricken US car manufacturers.
As the Wall Street Journal noted on 11 November: 'It was a day when even the monolithic U.S. government might be forgiven a sense of being overwhelmed by the current financial and economic situation.' Or as one one figure the newspaper quoted put it about the US government: 'The rescue efforts are "evolving in ways that I don't think anyone anticipated," said Camden Fine, president and CEO of the Independent Community Bankers of America, a trade group. "Things are just hitting them from every single direction, every day, and I don't think they know whether to spit or go blind."'
What conclusions should be drawn from all this? They are both economic and moral.
First, the claim that capitalism is a beautiful market self-regulating system has been shown to be simply untrue. This crisis shows it requires the state to step in to keep it stable.
Second, capitalism's moral hypocrisy and bankruptcy is breathtaking. A poor person on unemployment benefit or a pension can be thrown to the wolves. But if you are a rich US or UK corporation you must be bailed out immediately. It remains to be seen how much and how rapidly public opinion draws the conclusions from all this.
But to adapt Christopher Wren's words in St Paul's cathedral - 'if you want to know the case against capitalism just look around.'
Arrogance of the private banks
Socialism holds that the rational development of the economy, and therefore the welfare of society, can come into conflict with private ownership in the large scale means of production. In such a conflict socialists hold it is the interests of society that must take precedence over the private owners of the means of production.
Two such conflicts are already being seen in the current financial crisis. The first is that the recession threatens a collapse in investment. However both to keep up demand in the economy, that is to be able to carry out effective counter-cyclical measures, and to ensure long term economic growth, maintenance of investment is crucial. For that reason it may be necessary to carry out nationalisations in key industries such as construction in order to sustain investment. Economies with larger state sectors, such as China, are also able to carry out more effective counter-cyclical measures.
But the second key area is with the banks. In order to counter recession it is imperative that interest rates are radically reduced. The rate at which the state lends to banks, set via the Bank of England's base lending rate, has been radically reduced. However the private banks are continuously either dragging their feet or refusing point blank to pass such interest rate cuts on to their borrowers - as shown clearly this week when major banks attempted not to pass on the one and a half per cent Bank of England rate cut. Simultaneously they are attempting to abolish their lowest rate tracker mortgages. The reason is because they are attempting to make profits that are to be passed on to their private shareholders.
As Phillip Inman puts it rather delicately in the Guardian, shareholders: 'want their banks to increase profit margins. If banks can increase the spread between mortgage lending and paying savings interest, then they can recover more quickly. At the height of the boom, mortgage rates were little more than 0.5% above savings rates. Today, banks want that figure to expand to 2%. If mortgage rates track down with further cuts in the base rate to 1%, which some commentators believe will happen next year, it will be difficult keeping the savings rates above 2%.'
In other words policy is not to be set by the needs of the economy and limiting recession, which requires the sharpest possible reduction in interest rates, but by the desire of bank shareholders to make profits.
Many of these shareholders, incidentally, have just been saved from their holdings being make completely worthless by a huge injection of taxpayers money. Now they not only want their share prices propped up by the taxpayer but that bank lending policy should be dictated not by the needs of the economy but by their desire to make the highest profits.
If anyone ever wanted to know why private property in the means of production can come into conflict with economic development, and the case for bank nationalisation, they need merely study current developments.
Having brought the economy to the brink of disaster through their wrong decisions private bankers now demand that the interests of the entire economy be subordinated to their interests.
Two such conflicts are already being seen in the current financial crisis. The first is that the recession threatens a collapse in investment. However both to keep up demand in the economy, that is to be able to carry out effective counter-cyclical measures, and to ensure long term economic growth, maintenance of investment is crucial. For that reason it may be necessary to carry out nationalisations in key industries such as construction in order to sustain investment. Economies with larger state sectors, such as China, are also able to carry out more effective counter-cyclical measures.
But the second key area is with the banks. In order to counter recession it is imperative that interest rates are radically reduced. The rate at which the state lends to banks, set via the Bank of England's base lending rate, has been radically reduced. However the private banks are continuously either dragging their feet or refusing point blank to pass such interest rate cuts on to their borrowers - as shown clearly this week when major banks attempted not to pass on the one and a half per cent Bank of England rate cut. Simultaneously they are attempting to abolish their lowest rate tracker mortgages. The reason is because they are attempting to make profits that are to be passed on to their private shareholders.
As Phillip Inman puts it rather delicately in the Guardian, shareholders: 'want their banks to increase profit margins. If banks can increase the spread between mortgage lending and paying savings interest, then they can recover more quickly. At the height of the boom, mortgage rates were little more than 0.5% above savings rates. Today, banks want that figure to expand to 2%. If mortgage rates track down with further cuts in the base rate to 1%, which some commentators believe will happen next year, it will be difficult keeping the savings rates above 2%.'
In other words policy is not to be set by the needs of the economy and limiting recession, which requires the sharpest possible reduction in interest rates, but by the desire of bank shareholders to make profits.
Many of these shareholders, incidentally, have just been saved from their holdings being make completely worthless by a huge injection of taxpayers money. Now they not only want their share prices propped up by the taxpayer but that bank lending policy should be dictated not by the needs of the economy but by their desire to make the highest profits.
If anyone ever wanted to know why private property in the means of production can come into conflict with economic development, and the case for bank nationalisation, they need merely study current developments.
Having brought the economy to the brink of disaster through their wrong decisions private bankers now demand that the interests of the entire economy be subordinated to their interests.
Keynesian and Marxist analysis of the financial crisis - part 2
Socialist Economic Bulletin has previously noted the great increase in interest in both Keynesian and Marxist economic analysis under the impact of the international financial crisis. On the blog 21st Century Socialism Noah Tucker has a far more extensive piece surveying the latter issue.
This notes, among other things, that: ''The President of France has been improving his understanding of the current crisis by reading Marx's Capital, and Germany's Finance Minister has grudgingly conceded the correctness of "certain elements of Marxist theory". '
This notes, among other things, that: ''The President of France has been improving his understanding of the current crisis by reading Marx's Capital, and Germany's Finance Minister has grudgingly conceded the correctness of "certain elements of Marxist theory". '
China and the international financial crisis
China's reaction to the international financial crisis will play a crucial role not only for its own but for the world economy. However, seen from China's perspective, the international financial crisis has features which differ significantly from those in Europe or the US. This post looks at some of these.
The first point is that in confronting the international financial crisis direct financial turmoil is not a key feature of the situation in China - unlike the spectacular manifestations of this seen in Europe or the US. China's banks had almost no exposure to now heavily discounted, or worthless, sub-prime mortgage or similar financial products. While in Hong Kong there is some concern over the direct financial fallout, no mainland Chinese bank has suffered significant losses in this field. The immediate issue for China is the effect on its productive economy and on the renminbi’s exchange rate. But underlying these is a still more fundamental issue – maintenance of China’s savings and investment rates.
Indeed. seen from China, the international financial crisis might be posed from a different angle. It may be viewed as the 'third great Asian financial crisis' – the first being that of Japan and the yen in 1973-90, and the second that of the South East Asian debt and currency crisis of 1997. To emerge successfully will require from China an enormous response and a new stage of its economic development.
Socialist Economic Bulletin has noted that the fundamental determinant of the much higher rates of growth of a number of Asian economies, compared to the US or Europe, is their far higher investment rates. Therefore for the US and Europe to regain competitiveness with Asia one of two things has to happen. The US and Europe have to raise their investment rates up to Asian levels, or the Asian economies have to lower their investment rates down to US and European ones.
These two courses have very different implications for world economic growth. If the US and Europe raise their investment levels towards Asian ones then Asia will essentially maintain its present economic growth rate and that of the US and Europe will increase – i.e. world economic growth will accelerate. If, however, Asian investment levels are reduced towards US and European levels then the growth rate of the Asian economies will also fall, while economic growth in the US and Europe will not increase – i.e. world economic growth will decline. It is, therefore, far preferable that the US and Europe increase their investment rates rather than that those in Asia fall.
Nevertheless, in successive economic crises of the last thirty years, the outcome was the opposite of the preferable one – the US and Europe did not increase their investment rates, indeed those in Europe fell, but the investment rates of a number of Asian economies declined.
To illustrate this process in more detail, Figure 1 shows the level of fixed investment as a percentage of GDP for the US, Germany and France. As may be seen, the US fixed investment level has been essentially constant for the last half century at around 20 per cent of GDP – itself a continuation of a very long term trend in US investment rates. The German and French levels were somewhat higher than that for the US for the period up to the early 1970s, at around 25 per cent of GDP, and then fell to levels comparable to the US. Such investment levels generate rates of growth of 1.5-3.5 per cent a year.
If these US and European trends are compared to the situation in Asia there is a clear contrast. Asian economies have achieved far higher levels of investment, reaching over 40 per cent of GDP, and far higher rates of growth – in some case approaching or achieving double digit rates. However, the effect of both the post-1973 crisis in Japan, and the 1997 crisis in South East Asia, was to reduce these investment rates and with them also rates of growth of growth of GDP.
Considering this trend in a number of Asian countries in greater detail, Figure 2 shows the proportion of GDP accounted for by gross fixed capital formation in Japan. Japan’s fixed investment level peaked at 36.4 per cent of GDP in 1973. At this time, averaging the preceding five years, the annual average rate of growth of Japan’s GDP growth was 9.3 per cent.
The economic events which commenced in 1973, and which were accompanied by the first ‘oil shock', greatly affected Japan. The proportion of GDP devoted to gross domestic fixed capital formation declined to 27.5 per cent by 1986, and Japan’s average annual rate of growth of GDP, over the preceding five years, fell by two thirds to 3.1 per cent. By 1986 the Japanese economy, which had been expanding almost three times as fast as the US in the early 1970s, was growing more slowly than the US – in comparison in 1986 the average annual growth rate of US GDP over the preceding five years was 3.5 per cent.
Japan’s investment rate then temporarily rose under the impact of the hyper lax monetary regime during the ‘bubble’ economy in the late 1980s – a consequence of Japanese financial policies introduced to aid US economic stability following the 1987 Wall Street stock market crash. Following the bursting of Japan's financial bubble in 1990, the investment rate fell again and by 2002 gross domestic fixed capital formation had declined to 25.8 per cent of GDP while Japan’s five yearly annual growth rate of GDP had declined to 0.2 per cent.
Summarising these processes, under the successive impacts of the oil price increase and the monetary effects in Japan of the measures it chose to take to respond to the 1987 Wall Street crash, the proportion of the Japanese economy devoted to fixed investment fell by 10.6 per cent of GDP, and Japan’s annual growth rate decelerated from 9.3 per cent to 0.2 per cent - a 98 per cent decline.
If Japan post-1973 was the first great Asian economic/financial crisis, the second was the debt and currency crisis of the South East Asian economies in 1997. The similarity of the outcome to the earlier crisis in Japan’s is striking.
Figure 3 therefore shows South Korea’s rate of gross domestic fixed capital formation. This rose progressively to 39.0 per cent of GDP in 1991. By that year the average annual rate of growth of South Korea’s GDP over the preceding five years was 9.4 per cent.
By 1996, the last year before the currency crisis, South Korea was still investing 37.5 per cent of GDP and its five yearly annual average rate of growth of GDP was 7.3 per cent.
Following the 1997 debt and currency crisis, however, the proportion of South Korea’s GDP devoted to fixed investment fell sharply, to only 28.8 per cent of GDP in 2007, and its five yearly annual average growth rate of GDP declined by almost half to 4.4 per cent.
Figure 4 shows the similar process in Thailand. By 1996 the proportion of Thailand’s GDP devoted to fixed investment was 41.1 per cent of GDP – although this level was clearly unsustainable as it far exceeded the domestic savings available to finance it, resulting in a balance of payments deficit of 8.2 per cent of GDP. Thailand’s five yearly average annual rate of GDP growth was 8.1 per cent.
Following the currency crisis, by 2007 the proportion of Thailand’s GDP devoted to gross domestic fixed capital formation had declined to 26.8 per cent and the five yearly average annual rate of GDP growth had fallen to 5.6 per cent.
Figure 5 shows the similar process in Malaysia. By 1996, the last year before the debt/currency crisis, Malaysia’s gross domestic fixed capital formation was 42.5 per cent of GDP - although again this was being unsustainably financed by a balance of payments deficit. Malaysia’s five yearly annual average rate of growth of GDP was 9.6 per cent.
By 2007, ten years after the currency crisis, the proportion of Malaysia’s economy devoted to fixed investment had fallen to 21.7 per cent and the five yearly average annual rate of growth had dropped to 6.0 per cent.
Therefore, although the mechanisms of the crises were different, the outcomes in Japan in 1973-90, and South East Asia in 1997, were essentially the same - the proportion of the economy devoted to investment fell drastically and therefore so did the growth rate.
The impact of these two previous Asian economic crises, therefore, clearly illustrates the challenge facing China. China’s level of investment is significantly higher than Japan’s in 1973 – China's fixed investment rate is over 40 per cent of GDP compared to Japan's 30-35 per cent at that time. China's annual average annual rate of growth for the last five years is over ten per cent compared to Japan's nine per cent in 1973. In a number of South East Asian states, on the eve of the 1997 crisis, their very high investment rates were unsustainable, as they far exceeded domestic savings levels and were financed through extremely high balance of payments deficits. In contrast China’s savings level, running at over 50 per cent of GDP at nominal exchange rates, is even higher than its level of investment – see Figure 6. China, therefore, does not fact the international financial constraints facing South East Asia in 1997. There is, therefore, nothing inherently financially unsustainable in China’s very high investment rates. It has more than adequate domestic savings to finance its current investment levels and, therefore, approximately its present growth rate.
But it is the international context that has changed significantly and poses the economic challenge. With many economies moving into recession, and virtually all slowing, China's export growth will become significantly harder - even more so as simultaneously the renminbi is becoming a ‘hard’ currency.
As illustrated in Figure 7, the renminbi's exchange rate moved up against the dollar prior to the outbreak of the international financial crisis and it has remained constant against the dollar since its onset. As, however, the dollar has moved up against almost all currencies, except the yen, this means that the renminbi has undergone an upward revaluation against almost all other currencies.
The first point is that in confronting the international financial crisis direct financial turmoil is not a key feature of the situation in China - unlike the spectacular manifestations of this seen in Europe or the US. China's banks had almost no exposure to now heavily discounted, or worthless, sub-prime mortgage or similar financial products. While in Hong Kong there is some concern over the direct financial fallout, no mainland Chinese bank has suffered significant losses in this field. The immediate issue for China is the effect on its productive economy and on the renminbi’s exchange rate. But underlying these is a still more fundamental issue – maintenance of China’s savings and investment rates.
Indeed. seen from China, the international financial crisis might be posed from a different angle. It may be viewed as the 'third great Asian financial crisis' – the first being that of Japan and the yen in 1973-90, and the second that of the South East Asian debt and currency crisis of 1997. To emerge successfully will require from China an enormous response and a new stage of its economic development.
Socialist Economic Bulletin has noted that the fundamental determinant of the much higher rates of growth of a number of Asian economies, compared to the US or Europe, is their far higher investment rates. Therefore for the US and Europe to regain competitiveness with Asia one of two things has to happen. The US and Europe have to raise their investment rates up to Asian levels, or the Asian economies have to lower their investment rates down to US and European ones.
These two courses have very different implications for world economic growth. If the US and Europe raise their investment levels towards Asian ones then Asia will essentially maintain its present economic growth rate and that of the US and Europe will increase – i.e. world economic growth will accelerate. If, however, Asian investment levels are reduced towards US and European levels then the growth rate of the Asian economies will also fall, while economic growth in the US and Europe will not increase – i.e. world economic growth will decline. It is, therefore, far preferable that the US and Europe increase their investment rates rather than that those in Asia fall.
Nevertheless, in successive economic crises of the last thirty years, the outcome was the opposite of the preferable one – the US and Europe did not increase their investment rates, indeed those in Europe fell, but the investment rates of a number of Asian economies declined.
To illustrate this process in more detail, Figure 1 shows the level of fixed investment as a percentage of GDP for the US, Germany and France. As may be seen, the US fixed investment level has been essentially constant for the last half century at around 20 per cent of GDP – itself a continuation of a very long term trend in US investment rates. The German and French levels were somewhat higher than that for the US for the period up to the early 1970s, at around 25 per cent of GDP, and then fell to levels comparable to the US. Such investment levels generate rates of growth of 1.5-3.5 per cent a year.
Figure 1
If these US and European trends are compared to the situation in Asia there is a clear contrast. Asian economies have achieved far higher levels of investment, reaching over 40 per cent of GDP, and far higher rates of growth – in some case approaching or achieving double digit rates. However, the effect of both the post-1973 crisis in Japan, and the 1997 crisis in South East Asia, was to reduce these investment rates and with them also rates of growth of growth of GDP.
Considering this trend in a number of Asian countries in greater detail, Figure 2 shows the proportion of GDP accounted for by gross fixed capital formation in Japan. Japan’s fixed investment level peaked at 36.4 per cent of GDP in 1973. At this time, averaging the preceding five years, the annual average rate of growth of Japan’s GDP growth was 9.3 per cent.
Figure 2
The economic events which commenced in 1973, and which were accompanied by the first ‘oil shock', greatly affected Japan. The proportion of GDP devoted to gross domestic fixed capital formation declined to 27.5 per cent by 1986, and Japan’s average annual rate of growth of GDP, over the preceding five years, fell by two thirds to 3.1 per cent. By 1986 the Japanese economy, which had been expanding almost three times as fast as the US in the early 1970s, was growing more slowly than the US – in comparison in 1986 the average annual growth rate of US GDP over the preceding five years was 3.5 per cent.
Japan’s investment rate then temporarily rose under the impact of the hyper lax monetary regime during the ‘bubble’ economy in the late 1980s – a consequence of Japanese financial policies introduced to aid US economic stability following the 1987 Wall Street stock market crash. Following the bursting of Japan's financial bubble in 1990, the investment rate fell again and by 2002 gross domestic fixed capital formation had declined to 25.8 per cent of GDP while Japan’s five yearly annual growth rate of GDP had declined to 0.2 per cent.
Summarising these processes, under the successive impacts of the oil price increase and the monetary effects in Japan of the measures it chose to take to respond to the 1987 Wall Street crash, the proportion of the Japanese economy devoted to fixed investment fell by 10.6 per cent of GDP, and Japan’s annual growth rate decelerated from 9.3 per cent to 0.2 per cent - a 98 per cent decline.
If Japan post-1973 was the first great Asian economic/financial crisis, the second was the debt and currency crisis of the South East Asian economies in 1997. The similarity of the outcome to the earlier crisis in Japan’s is striking.
Figure 3 therefore shows South Korea’s rate of gross domestic fixed capital formation. This rose progressively to 39.0 per cent of GDP in 1991. By that year the average annual rate of growth of South Korea’s GDP over the preceding five years was 9.4 per cent.
By 1996, the last year before the currency crisis, South Korea was still investing 37.5 per cent of GDP and its five yearly annual average rate of growth of GDP was 7.3 per cent.
Following the 1997 debt and currency crisis, however, the proportion of South Korea’s GDP devoted to fixed investment fell sharply, to only 28.8 per cent of GDP in 2007, and its five yearly annual average growth rate of GDP declined by almost half to 4.4 per cent.
Figure 3
Figure 4 shows the similar process in Thailand. By 1996 the proportion of Thailand’s GDP devoted to fixed investment was 41.1 per cent of GDP – although this level was clearly unsustainable as it far exceeded the domestic savings available to finance it, resulting in a balance of payments deficit of 8.2 per cent of GDP. Thailand’s five yearly average annual rate of GDP growth was 8.1 per cent.
Following the currency crisis, by 2007 the proportion of Thailand’s GDP devoted to gross domestic fixed capital formation had declined to 26.8 per cent and the five yearly average annual rate of GDP growth had fallen to 5.6 per cent.
Figure 4
Figure 5 shows the similar process in Malaysia. By 1996, the last year before the debt/currency crisis, Malaysia’s gross domestic fixed capital formation was 42.5 per cent of GDP - although again this was being unsustainably financed by a balance of payments deficit. Malaysia’s five yearly annual average rate of growth of GDP was 9.6 per cent.
By 2007, ten years after the currency crisis, the proportion of Malaysia’s economy devoted to fixed investment had fallen to 21.7 per cent and the five yearly average annual rate of growth had dropped to 6.0 per cent.
Figure 5
Therefore, although the mechanisms of the crises were different, the outcomes in Japan in 1973-90, and South East Asia in 1997, were essentially the same - the proportion of the economy devoted to investment fell drastically and therefore so did the growth rate.
The impact of these two previous Asian economic crises, therefore, clearly illustrates the challenge facing China. China’s level of investment is significantly higher than Japan’s in 1973 – China's fixed investment rate is over 40 per cent of GDP compared to Japan's 30-35 per cent at that time. China's annual average annual rate of growth for the last five years is over ten per cent compared to Japan's nine per cent in 1973. In a number of South East Asian states, on the eve of the 1997 crisis, their very high investment rates were unsustainable, as they far exceeded domestic savings levels and were financed through extremely high balance of payments deficits. In contrast China’s savings level, running at over 50 per cent of GDP at nominal exchange rates, is even higher than its level of investment – see Figure 6. China, therefore, does not fact the international financial constraints facing South East Asia in 1997. There is, therefore, nothing inherently financially unsustainable in China’s very high investment rates. It has more than adequate domestic savings to finance its current investment levels and, therefore, approximately its present growth rate.
Figure 6
But it is the international context that has changed significantly and poses the economic challenge. With many economies moving into recession, and virtually all slowing, China's export growth will become significantly harder - even more so as simultaneously the renminbi is becoming a ‘hard’ currency.
As illustrated in Figure 7, the renminbi's exchange rate moved up against the dollar prior to the outbreak of the international financial crisis and it has remained constant against the dollar since its onset. As, however, the dollar has moved up against almost all currencies, except the yen, this means that the renminbi has undergone an upward revaluation against almost all other currencies.
China’s exporters, therefore, face a double squeeze. First, the markets in the economies into which they are exporting are either contracting or growing far more slowly. Second, the renminbi’s exchange rate is rising. This combination squeezes China’s exporters while simultaneously cheapening imports. China's balance of payments surplus may, therefore, decrease from its current level – the last available data being for 2007 showing a surplus of $372 billion.
However, statistically, the balance of payments is necessarily equal to the difference between domestic savings and investment - China’s balance of payments surplus reflecting that its savings level is even higher than its investment level. If China’s balance of payments surplus declines this can therefore only be achieved by its investment level moving up towards its savings level or its savings level declining towards its investment level, or a combination of the two.
Which of these two occurs will have a huge influence on both the Chinese and the world economies. As already noted, in the case of both Japan and the South East Asian economies, faced with crisis, investment levels fell. Their economies consequently drastically decelerated – negatively influencing the rate of growth of the world economy. A major deceleration of China’s economy, particularly under conditions of recession in other major economies, would have very negative consequences for international growth.
The health of the world economy, therefore, requires that if China’s balance of payments surplus is to shrink this should be by moving its domestic investment rate up towards its savings rate, not by its savings level falling towards its investment rate.
Domestic economic requirements China push in the same direction. The exchange rate of the renminbi has not merely moved upwards but will remain higher due to the underlying strength of China’s economy. A clear lesson of the current crisis is that any primary use of China’s financial resources not for domestic investment but fundamentally to attempt to maintain a low exchange rate of the renminbi will not work as a strategy – even in cases where the renminbi is stabilised against the dollar it moves up against other currencies.
China will, therefore, have to learn to compete at a higher exchange rate. This requires that its whole economic mechanism become more efficient, which can only be achieved through investment. China will cease to compete as a pure low wage economy – Vietnam and other economies now occupy the place China did twenty years ago. High levels of investment are therefore vital if China's economy is to compete in this new context.
Put in other terms, China's traditional strategy has been to keep its currency's exchange rate down to the level of productivity of its economy. In the future China will have to raise the level of productivity of its economy up to its appreciating exchange rate - requiring gigantic further investment in its productive base.
Consequently the cyclical requirements of economic management, that is ‘Keynesian’ anti-recessionary measures, coincide with the structural requirements of a high investment level. So far the Chinese government is heading in the right direction in announcing successive waves of infrastructure and other investment – railways, roads, housing. The fact that China has a large state owned economic sector allows it to take far more direct ‘Keynesian’ measure to sustain investment than are available in the US or Europe.
Nevertheless the scales of the programme’s which are required are gigantic. If, to take a hypothetical example, China’s balance of payments surplus were to fall by half under the impact of pressure on exporters and cheaper imports due to the higher exchange rate, while its savings level remained the same, this would required $175-$200 billion extra a year investment in China’s domestic economy. While there is no financial constraint on this, due to the high savings rate, the task of physically gearing up the economy for such a scale of extra-investment programmes is gigantic.
Naturally this particular example is arbitrary, and China’s balance of payments surplus may not fall to this degree, but it shows the scale of economic forces and shifts which are involved.
At the same time China faces new economic challenges it has not experienced previously. The fact that China is acquiring a 'harder' currency will undoubtedly lead to central banks of other countries wishing to hold the renminbi as part of their foreign exchange reserves – an issue China has not faced on a significant scale before.
Simultaneously China will come under pressure to use its financial resources for measures other than investment in its domestic economy. The US has announced that it is arranging dollar swaps for four economies that it considers systemically crucial – Brazil, Mexico, Singapore, and South Korea. But there will be a whole series of much weaker economies in deep trouble and it will undoubtedly be proposed that China should finance these, probably via intermediaries such as the IMF, rather than investing its resources in its domestic economy. When China attends the international economic summit in Washington on 15 November the US will also almost certainly propose that China accelerate a programme of buying US Treasury bonds.
So far China is rightly adopting the approach that 'the most important task for us now is to manage our own affairs well', as vice-premier Wang Qishan put it. But pressure put on China to change that stance, and divert resources away from its key goals, will increase. In other words many other people also have their eye on the funds which China could invest in its domestic economy.
With all these pressures, together with domestic programmes of improving social welfare and attempts to improve conditions in rural areas taking place simultaneously, not to mention other issues to manage, Chinese economic policy makers are going to be kept extremely busy in the coming months.
However, as noted, while there are many specific issues to tackle they are all within the framework of one decisive strategic choice. If China responds in the same way that Japan did in 1973-90, and South East Asia did in 1997, that is by reducing its savings and its investment levels, this will be bad not only for the Chinese economy but for the world economy. If, however, China is able to maintain its savings and investment levels through the present ‘third’ Asian currency crisis, which is a crucial aspect of how the international financial crisis appears from its perspective, not only will that be good for the world economy but it will be one of the greatest pieces of macro-economic management, not to speak of practical management of huge investment programmes, ever seen.
China since 1979 has achieved one of the greatest economic miracles in history. Confronted with the third great Asian financial crisis China again faces a gigantic challenge to its macro-economic management. How successfully it confronts that will have profound consequences not only for its own but for the entire world economy.
Note:
This article is adapted from one that appeared on the blog Key Trends in Globalisation.
Update 10 November:
China has announced a further large scale stimulus package.
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