Measuring Economic Weight

The Economist recently ran a story on putting the rise of Asia in perspective it's worth a read and is a useful corrective to many of the arguments that think the future is already here! The Balance of Economic Power: East or Famine The Economist.

There are two main ways to measure the size of economies. We can convert the value of Chinese gross domestic product (GDP), for example, into US dollars and compare it to the GDP of other countries. The advantage of this method is that it provides a neat comparison of a particular country with any other country at any particular time. But the problem with this measure is that it varies with the dollar–renminbi exchange rate and doesn’t accurately reflect the cost of things within the Chinese economy. If the renminbi was revalued this would immediately increase the measured size of the Chinese economy. This is not completely spurious because a higher valued renminbi would enable the Chinese to buy more goods and services on the international market and would increase their ability to invest in other countries. When exchange rates do vary considerably over time, such as the dollar–yen exchange rate since the 1970s, this method may be a problem. For example compare the difference in size of the Australian economy when measured at a time when the Australian dollar was 47.75c against the US dollar in April 2001 to when it reached 98.49c against the US dollar in July 2008. Although for measuring purposes the exchange rate is averaged over a period, variation still poses obvious problems.
Such discrepancies have led to the increased use of an alternative method of measuring the size of economies based on the concept of purchasing power parity (PPP). Statisticians measure purchasing power within individual economies and then makes comparisons on that basis. PPP measures GDP adjusted to reflect different costs of living and production within different economies. Goods and services and production costs are considerably less in China than they are in the United States. We all know that our currency goes further in some countries and less in others. You can live, for example, much more cheaply in Indonesia than you can in Sweden! A popular representation of PPP values is the Economist magazine’s tongue-in-cheek Big Mac Index, which compares the price of Big Mac’s around the world. A Big Mac in Sweden ($4.58) will cost you a lot more than a Big Mac in Indonesia ($1.74) or even the United States itself ($3.45). According to PPP theory, the cost of Big Macs should be the same across countries once local currencies are converted to US dollars. In these February 2009 prices, the Index suggests that the Swedish Kroner is overvalued against the dollar and the Indonesian rupiah is substantially undervalued. Big Macs are not really a good marker of PPP because they are generally considerably more expensive than local-food items in developing countries! There is also now an iPOD Index, which does the same thing, but with a high technology, tradeable item rather than a basic food item. This is significant because products that can be easily traded should, through the process of arbitrage, end up with the same price (allowing for exchange rates).

If we compare what a given amount of dollars will buy in the Chinese economy and compare it to what a given amount of dollars buys in the US economy we can, according to advocates of this approach, get a better idea of the size of an economy. The problem with this method is calculating the different costs of production and living on an ongoing basis. To do a proper analysis of PPP, the World Bank compares a large range of goods and services. It is very difficult to get a comparable basket of goods for diverse countries with substantially different cultures and consumption norms. In December 2007, the International Comparison Program co-ordinated by the World Bank revised down its PPP estimate of China’s economy by 40 per cent making a considerable difference to the measured size of the Chinese economy in 2005!

The best solution to the problem is the messy one of considering both measures together. Table 3.1 below shows that the United States accounted for 21.1 per cent of global GDP on a purchasing-power-parity basis in 2007, down from 23 per cent in 1995 and 24.5 per cent in 1980. China has rapidly caught up, accounting for 10.1 per cent in 2007 (revised down by the Bank by 6 per cent from earlier 2007 estimates!), up from 5.7 per cent in 1995 and 2.2 per cent in 1980. Measuring shares of global GDP by converting a country’s GDP to US dollars at market exchange rates produces very different results. On this basis, as Table 3.2 shows, in 2007 the United States was more than four times larger than China, accounting for nearly 25.3 per cent of global GDP, compared to 6.0 per cent for China. In 1995, according to this measure, the United States was 10 times larger than China. On an exchange basis, Japan’s relative position increased significantly between 1980 and 1995, with the increased value of the yen in the mid-1990s improving Japan’s position. On an exchange basis, Japan’s share of the world economy declined by half between 1995 and 2007. On a PPP basis, Japan’s economy has declined by a much smaller amount. These tables show that US decline has been gradual and that China’s rise has been mainly at the expense of Japan.
In 2006, the developing world accounted for more than 50 per cent of global GDP (measured on a PPP basis), signalling its growing importance. Developing countries grew at a faster rate between 1995 and 2005 than they did during the previous two decades and considerably faster than developed countries. In 2006, developing countries accounted for 43 per cent of world exports, up from 20 per cent in 1970; half of the energy consumption; and 70 per cent of currency reserves. Many see India as a major challenger to China’s mantle as the most important developing country. While China causes considerable anxiety in the developed world about its growing domination of manufacturing, India creates concerns because of its competitiveness in higher paid service and technology jobs. Outsourcing to India will increase in coming years and become even more important as a topic of debate.

But as The Economist reports:

Since 1995 Asia’s real GDP (even including less sprightly Japan) has grown more than twice as fast as that of America or western Europe. Morgan Stanley forecasts that it will grow by an average of 7% this year and next, compared with 3% for America and 1.2% for western Europe.

Yet a closer look at the figures suggests that the shift in economic power from West to East can be exaggerated. Thanks partly to falling currencies, Asia’s total share of world GDP (in nominal terms at market exchange rates) has actually slipped, from 29% in 1995 to 27% last year (see chart 1). In 2009 Asia’s total GDP exceeded America’s but was still slightly smaller than western Europe’s (although it could overtake the latter this year). To put it another way, the output of the rich West is still almost twice as big as that of the East.

As the graphic makes clear, Asia's (especially) China's growth is considerably more significant when it comes to measurements based on PPP. China's currency is kept artificially low and if allowed to rise China would increase its economic weight, but at the same time it would slightly undermine China's export growth potential as Chinese exports became relatively dearer on global markets.

So what about Asian exports? The Economist reports

the region’s 31% share of world exports last year was not much higher than in 1995 (28%) and remains smaller than western Europe’s. Indeed, the shift towards Asia appears to have slowed, not quickened. Its share of world output and exports surged during the 1980s and early 1990s. Although China’s share has grown since then, this has been largely offset by the decline in Japan, whose share of output and exports has halved.

A renewed emphasis on exports by the US could be an outcome of the economic crisis and the Obama administration aspires to doubling US exports in 5 years. (See "Can Obama Really Double Exports in Five Years?".) This doubling figure of course also requires some unpacking. It would be more meaningful if it meant a doubling of exports in comparison to the rise of GDP rather than a simple doubling of the USD figure.

What about the financial sphere?

Asian stockmarkets account for 34% of global market capitalisation, ahead of both America (33%) and Europe (27%). Asian central banks also hold two-thirds of all foreign-exchange reserves. That sounds impressive, but their influence over global financial markets is more modest, because official reserves account for only around 5% of the world’s total stash of financial assets. The bulk of private-sector wealth still lies in the West. The fact that Asian currencies make up only 3% of total foreign-exchange reserves indicates how far Asia still lags in financial matters.

While there is no doubt that on a PPP basis Asia has been expanding enormously, it's important to remember that Asia's international transactions are mainly conducted in USD. Asia (once again especially China) consumes considerably less than Western countries.

What really matters to Western firms is consumer spending in plain dollar terms. Although over three-fifths of the world’s population live in Asia, they only account for just over one-fifth of global private consumption, much less than America’s 30% share. But official figures almost certainly understate consumer spending in emerging Asia, because of the poor statistical coverage of spending on services. Figures from the Economist Intelligence Unit, a sister company of The Economist, suggest that Asia accounts for around one-third of world retail sales. Asia is now the biggest market for many products, accounting for 35% of all car sales last year and 43% of mobile phones. Asia guzzles 35% of the world’s energy, up from 26% in 1995. It has accounted for two-thirds of the increase in world energy demand since 2000.

Many Western firms are more interested in Asia’s capital spending than its consumption, and here Asia is undoubtedly the giant. In 2009, 40% of global investment (at market exchange rates) took place in Asia, as much as in America and Europe combined. In finance, Asian firms launched eight of the ten biggest initial public offerings (IPOs) in 2009 and more than twice as much capital was raised through IPOs in China and Hong Kong last year as in America.

Finally, The Economist, contains a graphic illustrating just how far Asia fell from its historical position of dominance up until 1800.

This graph, however, provides a lesson that The Economist, perhaps did not intend. Despite its continuing dominance of the world economy until the early nineteenth century, from the mid sixteenth century Europe - led by Spain and Portugal, followed by Holland and England - is clearly in the ascendancy. Gross economic weight is clearly not everything.

The Future of American Power?

The future of US power has been a major topic of discussion recently. The global economic crisis, which for once affected the US as much as any other country in the world and the rise of China and the s

It often seems that 'declinists' mistake one possible future for present reality. Other writers correctly acknowledge that US power remains preponderant, but suggest that the US could soon be rapidly overtaken by China or somewhat peculiarly by something called 'Asia', which assumes some sort of Huntingtonian 'civilizational' assault on the Western and US power.

Others seem to be saying that the US shift to deficits will undermine future US power as taxes need to be raised to drawn down the deficit.

This latter view is evident in a piece by Thomas Barlow in which he argues that the innovative capacities of the US are in danger. The 'self-made man' is under threat! He ignores the fact that US innovation has often been the result of a fairly typical mix of state and private initiative. Think the Internet! Indeed as Fred Block controversially argues the US has long had a "hidden developmental state".

Barlow points out that the US is on top when it comes to the knowledge intensive economy. Californian businesses, he points out spend more money on R&D than Germany. "If US states were countries ... 12 of them would be ranked among the top 25 nations globally by total business R&D expenditures."

My gut feeling is that the US is a long way from being seriously challenged by the great Asian powers and its dominant position will once again become clear in the light of (the albeit) slow recovery.

Contrary to Barlow, I think that if the US ever got its state intervention right by developing a comprehensive public health system and extending educational opportunities across the poorer sections of US society, its strength would be fundamentally renewed. In other words, if the US developed a fairer, more egalitarian society it would become an even more productive economy.

The greatest danger for the US and the world is a shift towards a reactionary aggressive isolationism caused by deepening economic problems and misguided interpretations of their causes.

The debt thing once again

Crikey's Glenn Dyer and Bernard Keane have an interesting response to Barnaby Joyce's latest muddle headed thinking on debt. "Barnaby reveals Coalition debt debacle — will heads roll?"

Once again Barney Joyce, the Opposition’s finance spokesman, has shown himself to be completely unaware of Australia’s debt position, its composition and why it exists.

His rant/ramble in this morning’s Australian - so sublimely silly that even Dennis Shanahan couldn’t muster any enthusiasm for it - confuses privately-held foreign debt (it is large) with public foreign debt (not much at all).

“The net foreign debt is about $638 billion. It is one of the highest net debt to gross domestic product ratios in the developed world,” Barney wrote.

The alternative Finance Minister fails to appreciate the background to our foreign debt and how it has grown, especially over the past decade or so, with a tripling under the Howard Government, of which his leader Tony Abbott and putative Treasurer, Joe Hockey, were ministers. Indeed, Hockey’s first Ministerial position was Financial Services.

They should all head to the quarterly balance of payments figures from the Australian Bureau of Statistics which give detailed information on our foreign debt, gross and net. It’s called our net international investment position. The latest edition is due for release next week.

The ABS figures show that net foreign debt was $192.3 billion when the Howard Government won office in the March quarter of 1996; by the September quarter of 2007, just before the Government lost office, it had ballooned to $577.17 billion.

Three times its 1996 level.

That was accompanied by an entirely coincidental dropping of the issue from Coalition rhetoric.
Under the Abbott doctrine of ministerial responsibility (Peter Garrett application), Mr Abbott and Mr Hockey should therefore take responsibility for this explosion in our foreign debt.
Most of this foreign debt - in fact the overwhelming proportion of it - is private foreign debt raised by companies large and small, from our big banks, to BHP, to CSL, to Caltex, down to smaller companies with trade finance arrangements in place offshore.

Australia cannot “default” on this debt. Only the holders of that debt can default. Senator Joyce seems to have no understanding whatsoever of that crucial point, nor do other critics.

Some holders of that foreign debt have already defaulted or rescheduled, without damaging Australia’s credit standing. Going back 25 years, the likes of Bond Corporation and Bell Resources had foreign debts that were renegotiated, written down after those companies collapsed. Likewise with groups such as Allco Financial Group, Babcock and Brown and its various groups have failed and the holders of that foreign debt have had to endure losses.
And the Centro duo, the Retail trust and the Properties arm, have renegotiated billions of dollars of foreign debt that have involved the holders either taking losses or converting their debt into equity.

In fact, Joyce’s ignorance seems to extend to the recent history of the Australian financial system, especially the collapse of groups like AFG and B&B and the debt rescheduling by the Centros (and GPT, which was in a big European joint venture with B&B).

Ratings agencies are well aware and are unconcerned because they can differentiate between private and public debt. Australia’s Triple AAA rating has been maintained. The rating was actually lifted to its current high level during the Howard Government’s huge expansion in debt.

Why didn’t Dennis Shanahan, point any of this out in his commentary on Barney’s ramble?
In his column, Barney quoted David Gruen of Treasury as saying our debt was very high. Barney obviously missed this comment from the same David Gruen in a speech in Sydney last Friday where he made a very telling point about the ‘quality’ of our foreign debt:

As I have noted, Australia’s current account deficit reflects high and rising investment – and, in particular, investment to expand the capacity of the traded goods sector. This distinguishes Australia from most other countries with large current account deficits. In the United States and the United Kingdom, for example, rising current account deficits since the mid-1990s have reflected falls in the national saving rate, with the rate of investment being broadly unchanged.

In other words, money we owe the rest of the world has been invested in productive assets and in creating wealth in the future, unlike the US and UK where it was used to finance housing and current consumption (some in Australia has been used for that purpose, but not the majority).

Barney doesn’t understand that point: we are borrowing from offshore to invest in assets (Gorgon LNG, iron ore mines, gold mines, infrastructure, Queensland coal seam gas) that will generate income in future years to both meet the interest cost and repay the debt.

We can pay our way. There is rising concern that the likes of Greece might have trouble doing so on a continuing basis. That’s why there’s a tinge of default about these countries, and not about Australia.

Barney apparently doesn’t get that, either out of political calculation, or plain ignorance.

 
While I agree with much of this article, the authors seem to accept a growing myth perpetrated by policy-makers that all of this foreign debt build up is productive …

A good deal of foreign debt has been borrowed by the banks and lent to Australian households to bid up the price of houses.

This can be considered as productive (see Christopher Joye’s view of these things) but it could also be seen as unproductive. A household debt to disposable income ratio of 160 makes households very vulnerable to a period of low growth and rising unemployment. Although we have just had a big test of our vulnerability, there is still the potential for rising private debt to be a problem. Especially if it continues on its upward trajectory.

Just what level of froeign and household debt would be unsustainable?

It’s also the case that rising public debt throughout the world may increase competition for funds and the need to cutback on spending to pay off public debt could also cause problems. As Wayne Swan might say” We can see the light but we’re not out of the woods yet”.

But the authors are correct in highlighting the policy line in Australia that the real problem now is dealing with the politics of prosperity rather than the politics of vulnerability. This seems to be a return to the complacency of 2007-08.

I love the irony of mainstream liberal economists having so much faith in the communist leadership of China to ‘manage’ such a complex political economy.

US Energy Breakdown

The following is from US Energy Information Administration.
http://www.eia.doe.gov/emeu/international/contents.html

I think most people assume that renewables are further advanced in the US. It's a pity that the US couldn't go on with renewables after Jimmy Carter put solar panels on the roof of the Whitehouse in the 1970s. (Ronnie Reagan took them down).

Interestingly solar is 1% of 7% = 0.07 %
Obama is now backing nuclear. See "Obama Pushes Nukes to Beat Pollution Crisis"

See http://www.eia.doe.gov/oiaf/ieo/world.html for more statistics on world demand.

Putting the Political Back into Political Economy

The following are some key quotes from an article that is probably quite relevant to this blog's title.

Vivien A. Schmidt (2009) “Putting the Political Back into Political Economy by Bringing the State Back in Yet Again”, World Politics, 61(3), pp. 516–46.


HOW do we explain why some advanced capitalist countries have gone farther than others in their neoliberal reforms? Or why countries with similar capitalist systems have taken different paths to reform while countries with different systems have taken similar paths? Mainstream theoretical approaches in political economy have difficulty responding to these questions for two reasons. First, whether they theorize capitalist convergence to a single neoliberal model, divergence to two varieties of market economies, or differentiation into three coalitions of financial capitalism, such approaches tend to underestimate if not ignore the importance of one crucial player: the state. Second, their analytic frameworks reinforce this neglect of the state at the same time that they emphasize continuity over change—whether the historical institutionalist approach (HI), which reduces the state to the rules and regularities that shape political economic institutions’ path-dependent development, or the rational choice institutionalist aproach (RI), which limits the state to the incentive structures that constrain political economic actors’ rational choices. (516)

...

The state’s significance for comparative political economy can be differentiated in four basic ways.

(1) As a political economic setting ...

(2) In terms of policy, the state stands not only for the substantive content of policies, which may alter HI macrohistorical institutions and RI incentive structures but also for their effects on different varieties of capitalism. These effects do not simply move such varieties along a continuum from faire (state action) to laissez-faire (market action); rather, they also push them toward faire faire (state-setting guidelines for market action) or faire avec (state action with market actors).

(3) As a polity, the state constitutes the political institutions that frame the interactions between political and economic actors.

(4) With regard to politics, the state consists of actions resulting not just from the strategic interactions among RI actors in HI macrohistorical contexts but also from the kinds of interactions analyzed by the newest of the new institutionalisms—discursive institutionalism (DI)1—which are driven by the substantive content of ideas and the interactive processes of discourse.

By focusing on the discursive political coordination, communication, and deliberation at the basis of public action, DI offers a way into the explanation of the dynamics of institutional change. It serves to offset the highly static approaches of HI and RI by explaining the reframing of strategic action and the reshaping of institutional practices through ideas and discourse. (517)

...

Although the division of states into liberal, enabling, and influencing tells us a lot about how the state tends to deal with the market, it tells us little about the state’s actual policies, that is, about their content, their implementation, or their effect. And all of this complicates the story told so far for all three varieties of capitalism. The first complication comes from the fact that state policies in recent years seem very similar in content, as the convergence theorists would argue, since all countries have liberalized their financial markets, deregulated their businesses, and increased the flexibility of their labor markets. In fact, however, although such policies may be similar, they are not the same. Divergence scholars have pointed out, for example, the many differences in the kind and degree of liberalization of the financial markets or in the deregulation of the banking sector, differences that are also generally in keeping with their variety of capitalism. State policies also show great differences in the timing and extent of reforms in labor-market flexibility within and across varieties. (522-3)

...

Another way of thinking about the unexpected policy mix of states in different VOCs is to see that although all states have become more neoliberal, moving along a continuum from faire (do) toward laissez-faire let do)—that is, from interventionist state toward hands-off state by doing less on its own and leaving more room for market actors to act on their own—this has not meant a slide all the way to laissez-faire and leaving everything up to market actors. Rather, states have largely turned to faire faire (have do) by having market actors perform functions that the state generally did in the past, with clear rules as to what that should entail [e.g. US]

...

However, many states also engage in faire avec (do with) by doing a lot in collaboration with socioeconomic actors—the pattern of cooperation most typical of CMEs—corporatism.

Figure 1 State Actions of the Three Varieties of Capitalism on a Fourfold scale from Faire to Faire avec to Faire faire to Laissez-faire

...

In short, the HI approach, which emphasizes the political institutional context, goes a long way toward helping to explain differential neoliberal reform success in countries in the same varieties of capitalism. But it does not take us far enough. We still do not know why specific policies succeeded, in particular ones that went against the traditional political economic patterns of state action, reversing long-standing policies and overcoming political institutional obstacles to change. This is because we need one more variable: politics.

...

The state, in short, not only frames the action of the other players, when it stands for political economic and political institutional context, but it can also reframe the action when it stands for politics, through the policies promoted by political actors with ideas about the public’s interests that are different from the ideas of economic actors about their own narrow self-interests.

Thus, taking ideas seriously, as well as legitimating discourse in which such ideas are embedded and through which such ideas are conveyed, can also lend insight into politics. But how does one approach questions of ideas and discourse? Some answers are provided by discursive institutionalism (DI), which takes account of the substantive content of ideas and the interactive processes by which ideas are conveyed and exchanged through discourse.

With regard to the substantive content of ideas, DI calls attention to the ways in which political actors’ ideas serve to (re)conceptualize interests and values as well as (re)shape institutions. Such ideas can be specific policy ideas, such as the varying state responses to neo-Keynesianism among LMEs, CMEs, and SMEs in the postwar years. They may be more general programmatic ideas, such as states’ radical paradigm shift from neo-Keynesianism to neoliberalism in the British LME or the French SME.57 But they may instead be underlying public philosophies.

These could be foundational political ideas about the role of the state in the French SME as opposed to the U.S. LME, which ensured that the development of the railway system in the former was state led and in the latter was led by private actors;58 foundational economic ideas at moments of “great transformation” that resulted in states embedding liberalism in the 1930s and then disembedding it beginning in the 1970s in the Swedish CME and the U.S. LME; or collective memories that are generated at critical moments, as in the state-framed agreements in the 1930s establishing the collaborative institutions of wage bargaining in Sweden, which have persisted with only incremental changes until today.

With regard to the discursive processes by which ideas are conveyed, DI encompasses a coordinative discourse consisting of the individuals and groups at the center of policy construction who are involved in the creation, elaboration, and justification of policy and programmatic ideas; and a communicative discourse that consists of the individuals and groups at the center of political communication involved in the public presentation, deliberation, and legitimization of policy, programmatic, and philosophical ideas.

By contrast, the communicative discourse consists of political actors engaged in a mass process of public persuasion, in which political leaders, government spokespeople, party activists, spin doctors, and others communicate the ideas developed in the coordinative discourse to the public for discussion, deliberation, and modification of the ideas in question. These political actors are engaging broadly—with members of opposition parties, the media, pundits, community leaders, social activists, public intellectuals, experts, think tanks, organized interests, and social movements, as well as, naturally, with the electorate. (531-2)

...

[O]ne of the reasons for turning to discursive institutionalism is to use ideas and discourse to help explain the dynamics of change (as well as continuity) in political economy. What distinguishes DI from HI to begin with is that instead of treating critical junctures as unexplainable times when the HI rules and regularities shift, DI makes these moments its objects of explanation by closely examining sentient agents’ changing ideas about their actions in response to material events. Moreover, instead of mainly describing the incremental processes of change in the rules, as in HI, DI explains those processes of change through the ideas and discourse of the agents who reproduce those rules—and change them—in everyday practice. (532)

...

Conveying good policy ideas through a persuasive discourse helps political actors win elections and gives policy actors a mandate to implement their ideas. (533)

...

Our main question is: when do ideas and discourse matter for institutional change. That is, when do they exert a causal influence for change as opposed to continuity (since ideas in a deeper sense always matter)? ...

[DIs investigate institutional change over time]

—through process tracing of ideas held by different actors that lead to different policy choices in social democracy;

—through matched pairs of country cases where everything is controlled for except the discourse to show its impact on welfare adjustment;

—through speeches and debates of political elites that then lead to political action on railroad policy;

—through opinion polls and surveys to measure the impact of the communicative discourse;

—through interviews and network analysis to gauge the significance of the coordinative discourse, and more. (534)

Finally, they often also show that ideas and discourse matter by demonstrating that no other structural factors can account for the clear changes (or continuities) in interests, paths, or norms signaled by political actors’ expressed ideas and intended actions. (535)

...
RI approaches to political economy can easily make convergence to a neoliberal model look inevitable by focusing on the pressures of economic forces and the logics of political incentives that (necessarily) lead all rational economic actors to respond (rationally) in one way alone—for better or for worse. For those in favor of a neoliberal model but also for those opposed, this provides a set of ideas for a normative discursive strategy focused on getting people to accept or revolt against the model.

HI approaches to political economy do not make things look inevitable— they make them appear inexorable, with divergence into liberal market economies or coordinated market economies the result of countries subject to very different historical rules and regularities for a very long time. Inserting an RI logic of interaction into this hi framework only adds the inevitable to the inexorable. ...

So what does bringing the state back in do? First, in pointing to the continued existence of a third, state-influenced variety (or “nonvariety”) of capitalism using the same ri/hi mix of methodologies, it shows that there is nothing inevitable about the neoliberal model; nor is anything inexorable about the split into two varieties. And second, by pointing to at least three varieties, it saves France, Italy, and Spain—not to mention the Asian Tigers and the bulk of developing capitalist democracies— from the dustbin of history.

...

DI puts real politics, the politics of leadership and opposition, back into the mix and shows how policies within particular polities and political economies are the result of politics that reduce RI inevitability and HI inexorability. (540)

...

In so doing, DI thereby demonstrates that the shape of all market economies depends upon public choices resulting not only from the power clash among interests but also from the battle of ideas throughdiscourse and deliberation. It also shows, however, that institutional context matters and that such battles of ideas follow different patterns of discursive interaction in different countries, given the greater need for a coordinative discourse in Germany (where the state needs to bring interest groups into agreement), a communicative discourse in the U.K. (where the state needs to persuade the public), and both coordinative and communicative discourses in France (where both interest groups and the public need to be brought on board in order to avoid the veto of the streets). Putting across this particular set of ideas—that we need to put the political back into political economy by bringing the state back in yet again—constitutes the normative discursive strategy of this article. (541)

Michael Pettis on China's Reserves and Bubbles

Never short a country with $2 trillion in reserves?

http://mpettis.com/2010/02/never-short-a-country-with-2-trillion-in-reserves/
February 2nd, 2010 by Michael Pettis
Filed under Balance of payments, Reserves.

I am traveling in DC, NY and Boston over the next few days, and between meetings and jet-lag it is hard for me to do much on my blog, but I did want to extend a short piece I wrote that was published yesterday in the South China Morning Post. This is because it is about central bank reserves, a topic that to my dismay probably generates more confused and mistaken thinking than any other topic in economics.



As many of my readers know (although I have not made any reference to it on my blog) hedge fund manager Jim Chanos recently made some headline-inducing claims about China. Chanos, a successful hedge fund manager who has made his reputation – and fortune – by identifying and shorting seriously overvalued assets, most famously Enron, seems to have read the PivotCapital piece that got a lot of attention last year, and partly as a consequence he claimed that China is undergoing a speculative bubble that makes it the equivalent of “Dubai times 1,000 – or worse”.



His claim was met with incredulity by New York Times columnist Thomas Friedman. Freidman is best known for his writings on globalization, and although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty, I also have no doubt that he does not understand China much and understands almost nothing about central bank reserves and the functioning of the global balance of payment. I have read many of his articles, and so far I am pretty sure that these aren’t his strong points.



In response to Chanos’ claim Friedman made a number of very questionable statements about China. These are matters of dispute and although I think they are completely wrong, they are at least defensible. For example he says its true that there may have been risks of bubbles. ”In the last few days, though, China’s central bank has started edging up interest rates and raising the proportion of deposits that banks must set aside as reserves — precisely to head off inflation and take some air out of any asset bubbles.”



Really? I think you have to be a tad credulous to believe that the RMB 7.5 trillion lending target for 2010 and the slightly higher interest rates represents taking air out of the asset bubble. I would argue that they simply mean that the astonishing rate at which they were pumping air into the bubble has moderated slightly, to merely excessive.



He also says:



Now take all this infrastructure and mix it together with 27 million students in technical colleges and universities — the most in the world. With just the normal distribution of brains, that’s going to bring a lot of brainpower to the market, or, as Bill Gates once said to me: “In China, when you’re one-in-a-million, there are 1,300 other people just like you.”



Aside from perhaps his overestimating the quality of the education system, this is very bad statistics, and perhaps shows how easily we can get intellectually overwhelmed by large numbers. If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer (and what about India?). After all if you cut China into four countries, each country will have only one-fourth the number of geniuses. Does that really mean that the four countries together are stupider? If we combine the US, Canada and Mexico into one country, its a pretty safe bet that the total number of geniuses will be more than any of the three countries currently possess, but will average intelligence rise? Can we really make the three countries richer that way (of course there may be good economic arguments for suggesting that unifying North American into a single country will make it richer, but the larger number of geniuses is not one of these arguments).



Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.



Too bad, because he was. Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves. He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”



Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing. It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape. Anyone who wanted to short it must be pretty stupid, right?



But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion. China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.



But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.



The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.



The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.



Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.



Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.



The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.



Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.



These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).



In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.



It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.



We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two. Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.



But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.