Past Crashes, Current Lessons, and China’s Externalities

John Plender in the Financial Times wrote a very solid piece, “Credit squeeze could be harbinger of a Chinese crash,” which looks at the major financial train wrecks of the past century and finds a common element: immature but rapidly growing economies acting as major global creditors. The efforts to manage the resultant imbalances lead to asset price bubbles that eventually go boom.

It’s a clever reframing of widely accepted facts, and paints China as the most significant of the immature economy causing instability. Plender believes that the sooner a crash comes in China, the less likely that global damage will result.

There has been a good deal of discussion among economists as to whether the current global imbalances (code for the US hoovering up savings from all over the world, primarily China, Japan, Taiwan, and the Gulf States, to fund consumption) result from the US’s low saving rate, or China’s savings glut. The Plender reading would tend to put blame on the Chinese.

I’ve never found this “is it the US overconsuming or China oversaving” debate terribly helpful. First, it tends to come from a need to assign blame in order to get someone to take action (as opposed to taking the position that whatever remedy is suggested is simply a good idea). Second, the two actors look woefully co-dependent. Third, even if Chinese oversaving truly is the culprit, it’s a hard argument to sell. It’s hard to sympathize with overweight, overhoused, SUV-driving, carbon profligate Americans when contrasted with hardworking, thrifty Chinese.

The one way you might give the “savings glut” notion some emotional resonance would be to demonstrate the degree to which China’s surplus is due to underspending and underinvestment on pollution controls, quality standards, and safety. In other words, the Chinese gains have been won unfairly because their manufactures produce more externalities than manufacturers are permitted to incur. That logic is at the core of the debate about imposing tougher import standards on Chinese goods, but I haven’t seen anyone make the more general argument, particularly regarding China’s horrific environmental record.

From the Financial Times:

Financial crises come in all shapes and sizes. Yet looking back over the past 100 years from the vantage point of today’s credit squeeze, the big financial dislocations appear to follow the same pattern.

The backcloth has invariably been a shift in global power whereby the growth of an immature creditor country wedded to protectionist trade policy has contributed to imbalances of savings and investment. Attempts to manage the currency volatility arising from imbalances have derailed monetary policy and created bubbles in asset markets, leading to crashes and financial distress.

Exhibit A is 1929. British financial power had been waning since the First World War. Yet the Americans were reluctant to take on Britain’s hegemonic role in global finance. The free-trading British ran a substantial trade deficit at the time which permitted the high-saving, protectionist-inclined US to run a big trade surplus.

The impetus for the stock market euphoria of the 1920s came partly from a loose monetary policy pursued by an inexperienced Federal Reserve in a misguided attempt to help the British preserve the value of the pound after the return to the gold standard. As so often, when efforts are made to manipulate an external price, the exchange rate, instability was simply transferred to internal prices – in this case prices of equities. By the summer of 1929 when the party was truly riotous the Fed pricked the bubble. Then came the Depression.

Consider, now, the 1980s, by which time the US was the dominant financial power. An overvalued dollar in the early years of the Reagan administration exacerbated a trade imbalance with an instinctively protectionist Japan, now the world’s biggest creditor country. The Group of Seven’s Plaza Accord in the mid-1980s addressed dollar overvaluation. There followed the Louvre Accord in February 1987, which was intended to stabilise a dollar that threatened to go into free fall.

Against a background of trade friction and currency volatility stemming from the differential stages of development of the world’s two largest economies, investors were twitchy about imbalances. When Treasury Secretary James Baker threatened to talk the dollar down in October 1987 in response to a German threat to raise interest rates, panic ensued and the backwash of an astonishing one-day crash was felt around the world.

Yet this was not a severe financial dislocation. It is best seen as a premonitory blip which prompted an excessive policy response that happened to cause the global economy to overheat. In fact the main financial event was taking place in Japan where official intervention to stabilise the dollar was having the same impact as the Fed’s intervention to prop up sterling in 1927. As with the 1929 Crash, it was the central bank’s decision in 1989 to raise rates that pricked the bubble and set the scene for more than a decade-worth of economic stagnation.

Finally, we have the credit squeeze. This is a complex phenomenon, but there is little doubt the accumulation of reserves in Asia, and more particularly China, has played an important part in the debacle. Once again imbalances are part of the story, with a protectionist, high-saving China pursuing an exchange rate policy that threatens to generate a current account surplus of close to $400bn this year.

One consequence is a huge accumulation of Asian official reserves in dollar assets. Note, too, that much of the toxic financial innovation in US credit markets was helping facilitate the frenetic recycling task necessitated by global imbalances. Meantime, maintaining an artificially low value for the renminbi creates excess liquidity in China. This affects equity markets and the resulting boom is exacerbated because the real return on domestic bank deposits is negative.

In the absence of policy change the credit squeeze could be regarded as a harbinger of a Chinese crash to come. And since China is still at an early stage of development, it may be a case of many bubbles and many crashes. The only question is whether the impact is felt globally, as in 1929, or mainly domestically, as with Japan in the 1990s. The longer policy remains inflexible, the greater the likelihood of a global backwash.

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  1. Anonymous

    Consider some of the reasons for China’s enormous saving rate:
    * firms save too much because so many are state-owned firms that are tax-privileged and don’t have to pay dividends.
    * households save too much because they have no social security system to speak of. They have to save for their health care, their old age, their children’s education. There is no unemployment benefit.

    Do you think the powers that be in Republican American want people to realise the consequences for financial stability of instituting the New Dickensianism, that puts all the risk on the household like that?

  2. Yves Smith

    I’ve been saying for some time that our pressing China to let the yuan float falls in the category of “be careful for what you wish for.” While these global imbalances are unsustainable, it’s not clear to me that it is to our advantage to accelerate the inevitable.

    And yes, your point about personal savings is absolutely correct. Japan also has weak safety nets and therefore high savings rates.

  3. bionick

    “Plender believes that the sooner a crash comes in China, the less likely that global damage will result.”

    This falls in the category of wishing evil onto your more successful neighbor. And it’s also pure hypocrisy. All of a sudden American neo-liberals turned socialist and began poring tears over poor exploited working classes in China. It’s all crocodile tears.

    Japan and China are very homogeneous old-style societies that have “invisible” social safety nets. Plus, Japan does have unemployment, national pension and health insurances (
    Japan also has, or at least until recently had, an exceptionally good public school system. US on the other hand has one of the highest, if not the highest, wage disparities in the world. Take away the remaining vestiges of government provided support in the US and you will see homeless children on the street in no time. We will not turn into Japan, but more likely into Brazil with its huge drugs and guns infested slumps.

  4. Yves Smith


    In fairness to Plender, he sees a crash in China as inevitable, so it isn’t a matter of wishing a crash on China.

    As for safety nets, agreed that Japan and China have much stronger informal ones than we do. But even that tends to reinforce a higher savings rate.

    And I have said elsewhere that the US tendency to characterize the post bubble years in Japan as a disaster is misguided. They socialized their bubbles, in part because they were so vast that the dislocations of letting them collapse would be huge, but in part because of their social pact to share pain. And while the whole deflationary period has been characterized as some sort of disaster for Japan, they have a massive trade surplus and haven’t taken a hit in their standard of living. The immediate post bubble years did represent a cost in terms of lost growth, but I think the story post 1997 is more debatable, particularly since it is to Japan’s advantage to be seen as a basket case.

  5. "Cassandra"

    I agree almost entirely with your last comment, and have written you a note off-line with some extended thoughts. But with pseudo-conspiricist explanations (like how the PPT could alledgedly be be attributed to being so successful at always saving The Market when the rest of government is in practice rather bumbling and ineffectual) come inconsistencies and so one would ask: how could Dr Jekyll engineer such a consistent public relations coup in order justify predatory monetary policy for mercantile advantage, when Mr Hyde is persistently all over the map slaughtering whales, trying to sink anti-whaling vessels, and axe-murdering “Flipper” by the tens-of-thousands” ?? Could the same canny people really be responsible??!?

  6. Anonymous

    You see no near-term disaster from Japan’s lost decade, but consider the long term. Young people who graduated into the teeth of the economic slump could not get onto a regular career path, and so became “freeters”, working a series of part-time jobs. There are millions of them, more or less trapped into this lifestyle and growing older. They have little prospect of permanent employment or marriage or opportunity to build up retirement savings.

    There is indeed a disaster here, a looming demographic disaster, in a country with one of the lowest birth rates and the most rapidly aging population, and a ferociously competitive emerging economic superpower next door.

    Short sharp recessions don’t permanently prevent university graduates from finding employment in their field; long ones do. A university degree that has gone completely stale with time is essentially worthless to a prospective employer. Japan will pay the price for its cohort of freeters for decades to come.

  7. Yves Smith

    Japan’s real estate and stock market bubbles were massive, far greater than the real estate bubble we are experiencing now. Banks were lending 100% against the value of real estate that never traded. I don’t believe we are going to get out of this one with a mere 1991-1992 short sharp recession, and the Japanese similarly would not have gotten out that easily either.

    As for “freesters,” young people here are not that much better off. Entry level jobs in IT and the law are being offshored. A director at McKinsey told me perhaps 7 years ago that Yankelovich projected that new college graduates would have eleven jobs before they retired. They meant different employers, not a combination of promotions and moving to new companies. I’ve seen more recent stats, but can’t recall the source, which offer even more grim figures. And most Americans aren’t saving enough for retirement.

    And I don’t think you can tie the low birth rate to the deflation. From what I have read and heard, Japanese women don’t want to get married because they don’t like the deal offered by society, particularly as regards childrearing. They now have the option of staying at home with their parents and workin, and they seem to enjoy that and play it out as long as possible. By all accounts, it’s a lifestyle choice issue, not a US Depression “we don’t have the money to have kids” scenario.

  8. bionick

    �In fairness to Plender, he sees a crash in China as inevitable, so it isn’t a matter of wishing a crash on China.�

    I don�t get it. One never says I wish this, one always says it is inevitable. When it IS inevitable, what�s the point of fighting it?

    And remember Al Gore�s frog in the slowly heating pot. See, people are warm-blooded (unlike frogs), they would quickly notice when the temperature was raising. What people can not notice is a slow deterioration of economic conditions. Plus, they tend to keep a fa�ade and remain in denial. Things could probably get much worse and still pundits, opinion makers and the multitude might still contend that nothing changed and everything is peachy like before.

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