Whether 70-style high inflation is inevitable:

US-China relationship in the time of crisis:

This is from FT. Gary Becker and Kevin Murphy ask you to have faith in capitalism. I hope you still do.

Do not let the ‘cure’ destroy capitalism

Capitalism has been wounded by the global recession, which unfortunately will get worse before it gets better. As governments continue to determine how many restrictions to place on markets, especially financial markets, the destruction of wealth from the recession should be placed in the context of the enormous creation of wealth and improved well-being during the past three decades. Financial and other reforms must not risk destroying the source of these gains in prosperity.

Consider the following extraordinary statistics about the performance of the world economy since 1980. World real gross domestic product grew by about 145 per cent from 1980 to 2007, or by an average of roughly 3.4 per cent a year. The so-called capitalist greed that motivated business people and ambitious workers helped hundreds of millions to climb out of grinding poverty. The role of capitalism in creating wealth is seen in the sharp rise in Chinese and Indian incomes after they introduced market-based reforms (China in the late 1970s and India in 1991). Global health, as measured by life expectancy at different ages, has also risen rapidly, especially in lower-income countries.

Of course, the performance of capitalism must include this recession and other recessions along with the glory decades. Even if the recession is entirely blamed on capitalism, and it deserves a good share of the blame, the recession-induced losses pale in comparison with the great accomplishments of prior decades. Suppose, for example, that the recession turns into a depression, where world GDP falls in 2008-10 by 10 per cent, a pessimistic assumption. Then the net growth in world GDP from 1980 to 2010 would amount to 120 per cent, or about 2.7 per cent a year over this 30-year period. This allowed real per capita incomes to rise by almost 40 per cent even though world population grew by roughly 1.6 per cent a year over the same period.

Therefore, in devising reforms that aim to reduce the likelihood of future severe contractions, the accomplishments of capitalism should be appreciated. Governments should not so hamper markets that they are prevented from bringing rapid growth to the poor economies of Africa, Asia and elsewhere that have had limited participation in the global economy. New economic policies that try to speed up recovery should follow the first principle of medicine: do no harm. This runs counter to a common but mistaken view, even among many free-market proponents, that it is better to do something to try to help the economy than to do nothing. Most interventions, including random policies, by their very nature would hurt rather than help, in large part by adding to the uncertainty and risk that are already so prominent during this contraction.

Government reactions have demonstrated the danger that interventions designed to help can exacerbate the problem. Even though we had well-qualified policymakers, we have gone from error to error since August 2007.

The policies of the Bush and Obama administrations violate the “do no harm” principle. Interventions by the US Treasury in financial markets have added to the uncertainty and slowed market responses that would help stabilise and recapitalise the system. The government has overridden contracts and rewarded many of those whose poor decisions helped create the mess. It proposes to override even more contracts. As a result of the Treasury’s actions, we face further distorted decision-making as government ownership of big financial institutions threatens to substitute political agendas for business judgments in running these companies. While such dramatic measures may be expedient, they are likely to have serious adverse consequences.

These problems are symptomatic of three basic flaws in the current approach to the crisis. They are an overly broad diagnosis of the problem, a misconception that market failures are readily overcome by government solutions and a failure to focus on the long-run costs of current actions.

The rush to “solve” the problems of the crisis has opened the door to government actions on many fronts. Many of these have little or nothing to do with the crisis or its causes. For example, the Obama administration has proposed sweeping changes to labour market policies to foster unionisation and a more centralised setting of wages, even though the relative freedom of US labour markets in no way contributed to the crisis and would help to keep it short. Similarly, the backlash against capitalism and “greed” has been used to justify more antitrust scrutiny, greater regulation of a range of markets, and an expansion of price controls for healthcare and pharmaceuticals. The crisis has led to a bail-out of the US car industry and a government role in how it will be run. Even one of the most discredited ideas, protectionism, has gained support under the guise of stimulating the economy. Such policies would be a mistake. They make no more sense today than they did a few years ago and could take a long time to reverse.

The failure of financial innovations such as securities backed by subprime mortgages, problems caused by risk models that ignored the potential for steep falls in house prices and the overload of systemic risk represent clear market failures, although innovations in finance also contributed to the global boom over the past three decades.

The people who made mistakes lost, and many lost big. Institutions that made bad loans and investments had large declines in their wealth, while investors that funded these institutions without proper scrutiny have seen their wealth cut in half or much more. Households that overextended themselves have also been badly hurt.

Given the losses, actors in these markets have a strong incentive to correct their mistakes the next time. In this respect, many government actions have been counterproductive, shielding actors from the consequences of their actions and preventing private sector adjustments. The uncertainty from muddled Treasury policy on bank capital and ownership structure, the willingness of the government to change mortgage and debt contracts unilaterally and the uncertain nature of future regulation and subsidies help prevent greater private recapitalisation. Rather than solving problems, such policies tend to prolong them.

The US stimulus bill falls into the same category. This package is partly based on the belief that government spending is required to stimulate the economy because private spending would be insufficient. The focus on government solutions is particularly disappointing given its poor record in dealing with crises in the US and many other countries, such as the aftermath of hurricane Katrina and failure effectively to prosecute the war in Iraq.

The claim that the crisis was due to insufficient regulation is also unconvincing. For example, commercial banks have been more regulated than most other financial institutions, yet they performed no better, and in many ways worse. Regulators got caught up in the same bubble mentality as investors and failed to use the regulatory authority available to them.

Output, employment and earnings have all been hit by the crisis and will get worse before they get better. Nevertheless, even big downturns represent pauses in long-run progress if we keep the engines of long-term growth in place. This growth depends on investment in human and physical capital and the production of new knowledge. That requires a stable economic environment. Uncertainty about the scope of regulation is likely to have the unintended consequence of making those investments more risky.

The Great Depression induced a massive worldwide retreat from capitalism, and an embrace of socialism and communism that continued into the 1960s. It also fostered a belief that the future lay in government management of the economy, not in freer markets. The result was generally slow growth during those decades in most of the undeveloped world, including China, the Soviet bloc nations, India and Africa.

Partly owing to the collapse of the housing and stock markets, hostility to business people and capitalism has grown sharply again. Yet a world that is mainly capitalistic is the “only game in town” that can deliver further large increases in wealth and health to poor as well as rich nations. We hope our leaders do not deviate far from a market-oriented global economic system. To do so would risk damaging a system that has served us well for 30 years.

The writers are professors of economics and the University of Chicago and senior fellows at the Hoover Institution. Gary Becker was awarded the 1992 Nobel prize in economics and Kevin Murphy was awarded the Clark Medal in 1997. To join the debate go to www.ft.com/capitalismblog

WSJ asks the question: China’s trade surplus is shrinking, foreign investors withdrawing and the broad economy slowing sharply. So what’s a fair value for the yuan now?

Beijing has an answer: Since July, the yuan’s daily exchange rate against the dollar — effectively set by the government — hasn’t changed much. It currently costs 6.83 yuan to buy a dollar, as it did last summer.

The exchange rate’s variation has been so low that it fits the definition of a pegged currency, posits Marc Chandler, strategist at Brown Brothers Harriman.

Washington has long claimed that the yuan is too weak.

But a key leg of the argument that the yuan is undervalued — China’s massive trade surplus — has become wobbly.

The surplus narrowed in February to $4.8 billion from about $40 billion in each of the previous three months, and in all likelihood will fall for the first time in five years in 2009.

There is a line of thought that even detects pressure on the yuan to decline because trade and investment flows have reversed so sharply.

Citi Investment Research economist Ken Peng foresees a stable yuan for the rest of this year, and is watching for any signs that Beijing may guide the currency lower. Language highlighting “flexibility in currency management” would be one.

It would take a very steep depreciation to make China competitive against its export rivals. Since July, the yuan is up 33% against the Korean won and up 12% against the Singapore dollar, for example. This has made Chinese exports relatively less competitive while spurring more imports and thereby providing somewhat of a boost to other economies.

The U.S. Treasury will announce this spring whether it will slap a “currency manipulator” tag on China, something that it hasn’t done since 1994.

In fact, by any objective standard China is a currency manipulator, even if, naturally, it dislikes the term.

But with China holding its currency stable against the dollar even as its trade position has weakened, Washington’s long-standing argument that Beijing is keeping the yuan unjustifiably low is losing weight.

When the US demand waned, China exports more stuff to India.  India however is using anti-dumping measures to fend off China's imports. 

Trade tensions often rise during economic recession.  Similar spats recently also happened between the US and Mexico.  This WSJ piece has a nice comparison between China and India and their relative position in the world trade. 

NEW DELHI — Spats over toys, tires and iron ore are stoking tension between China and India, as the two Asian giants try to pry open each other's markets and soften the impact of the global economic slowdown.

China's exporters covet a growing India to help offset slowing demand from the U.S. Yet India is accusing Chinese companies of swamping its market with what it can't sell elsewhere, and has lodged antidumping cases against China at the World Trade Organization. The trade disputes are testing efforts to improve what's long been a prickly relationship between the two neighbors.

"We've always said the world is large enough for India and China, but we have a problem with a surge in exports that hurts Indian industry," said Indian commerce secretary, Gopal K. Pillai, in an interview. "It's a cause for worry."

On Thursday, officials from Indian and Chinese commerce ministries met in New Delhi to find common ground. The two governments agreed to set up a working group that would meet every few months on trade issues before they reach the WTO. Zhong Shan, China's vice trade minister, said Beijing wasn't considering retaliating against India, but didn't rule out taking future action at the WTO.

"I believe both countries have the ability to talk through problems," he told reporters. "Both economies can work out of the shadows of the current crisis together."

The two nations often have touted their potential to join forces. Their growing economic heft and developing-country status could make them allies in setting prices for natural resources, partners at trade forums and big buyers of each other's goods, officials from both countries say.

China is India's largest trade partner. Bilateral trade rose 34% to $51.78 billion in 2008 from the year earlier, according to Chinese government statistics.

While trade has flourished, frictions haven't eased much — and might be getting worse. Recent disputes highlight how tough times have hardened the economic rivalry.

This year, India blocked Chinese toy imports for safety reasons before relaxing the ban for some products. On Wednesday, China raised India's toy ban during a WTO discussion on technical barriers to trade. India has about a dozen antidumping cases against China outstanding at the WTO, including investigations into export surges of truck tires and industrial chemicals.

The disputes partly reflect the jostling of goliaths in a slowing global economy. India seems more reluctant than China to open domestic industries that haven't faced much foreign competition, according to Pranab K. Bardhan, an economist at the University of California, Berkeley who studies the Chinese and Indian economies. "India is among the least globalized countries in the world," he says.

By contrast, China's exports account for more than one-third of its economic output, and the decline has been sharper. In February, China's exports fell 26% from a year ago. The IMF projects China's economy will grow 6.7% this year, off from the 9% growth the year before.

As Chinese exports slow and factory jobs disappear, Beijing has come under pressure to combat signs of foreign protectionism. India may not generate the same demand as the U.S., but its barriers to a big and growing market are cause for concern, says Wen Fude of the Institute of South Asian Studies at Sichuan University.

"Most of these trade frictions created by India towards China are unreasonable," he says.

Indian officials counter that while China talks about free trade, what it practices is something different. Mr. Pillai, the commerce secretary, says Beijing subsidizes exporters, obstructs Indian farm imports and supports Chinese companies who prey upon vulnerable Indian industries.

"The fundamental problem is that China isn't a market economy," he says. A plaque at the commerce ministry entrance draws a clear distinction with its neighbor. "India: Fastest Growing Free Market Democracy," it says.

Even in complementary trade areas, there have been problems recently. Indian trading companies have complained that Chinese steelmakers have backed away from orders of Indian iron ore after reducing production, causing major losses.

Some see the potential for China and India to work through their differences by doing more business together. Having been through an infrastructure boom of its own, China could help India's build-out of roads, bridges and airports, according to Anil Gupta, a professor at University of Maryland and co-author of "Getting China and India Right."

Chinese executives who are doing business in India complain that distrust remains part of the commercial relationship. The two countries fought a 1962 border war, which India lost, and some of the territory between them remains unsettled. Chinese investments also have been subjected to rigorous security reviews; work visas have been a problem for some executives.

Mr. Pillai says out of 38 proposals, only two Chinese projects have been rejected on security grounds; thousands of Chinese work in India without visa problems, he adds.

India and China still are far from forging a broad economic alliance that some officials envision. Despite both countries clashing with the U.S. on farm imports at the Doha Round of trade talks, they continue to compete fiercely — for export markets, energy assets and investment projects. "Cooperation hasn't really worked," Mr. Pillai says.

This will help domestic consumption, will also help GM. Let’s see how many trucks/pickups Chinese farmers can buy…

Swedish model and its lessons offered to the current global financial crisis. A must read.

by Lars Jonung

The Swedish banking crisis was part of a major financial crisis that hit the Swedish economy in 1991-93. Its origin should be traced to financial liberalisation in the mid-1980s that triggered a rapid lending boom. The pegged exchange rate for the krona prevented monetary policy from mitigating the boom by means of interest rate increases. The boom turned into bust and crisis around 1990, threatening a meltdown of the banking sector. The response of policymakers developed into the Swedish model for bank resolution. It comprises the following seven key features.

The Swedish model for bank resolution

Political unity

A central feature was the political unity across party lines which underlay the bank resolution policy from the very start. The Centre-Right government and the political opposition – the Social Democrats – joined forces and avoided making the banking crisis into a partisan political issue. This unity, initially forged by the determination of the major political parties to defend the pegged exchange rate of the krona, lasted throughout the crisis. Political unity guaranteed the passage through the Swedish parliament, the Riksdag, of measures to support the financial system. It also created policy trust amongst voters.

Blanket guarantee of bank deposits and liabilities

The Swedish government, in cooperation with the opposition, announced in a press release on 24 September 1992 – a critical month when currency pegs in several European countries were successfully attacked – that depositors and other counterparties of Swedish commercial banks were to be fully protected from any future losses on their claims. The guarantee was successful in the sense that foreign confidence in the solvency of the Swedish commercial banks remained intact.

In addition, this measure proved highly beneficial, as it expanded the options for the Riksbank to support commercial banks regardless of their financial position. The government guarantee of bank liabilities gave the Riksbank the option to lend to any commercial bank operating in Sweden, even to those that were on the brink of insolvency.

Swift policy action

Once it was fully understood that a serious financial crisis was in the making, the government, the Riksdag, and the Riksbank responded by taking decisive steps to support the financial system, in particular to help banks in distress. In this way, the confidence of depositors and counterparties in the financial system was strengthened at an early stage of the financial crisis by swift and determined action. Throughout the resolution of the crisis, confidence could then be maintained at a relatively low political cost.

An adequate legal framework based on open-ended funding

In December 1992, the Riksdag, passed legislation by an overwhelming majority to establish a Bank Support Authority, Bankstödsnämnd, as envisaged in the press release of 24 September 1992. The parliament approved open-ended funding for the Bankstödsnämnd, rather than settling for a predetermined fixed budget. This was a deliberate choice in order to avoid the risk that the Bankstödsnämnd would be forced to go back to the Riksdag to ask for additional funding at a later stage. The open-ended funding underpinned the credibility of the bank resolution policy.

The Bankstödsnämnd was set up as an independent agency at arm’s length distance from the government, the Riksbank, and the Finansinspektion (the financial supervisory authority) to underline its independence. This construction fostered credibility and trust in its operations. The opposition was given full insight into its activities. The agency was staffed by professionals, and it began operation in the spring of 1993, shortly after being established.

Full information disclosure

Banks that turned to the Bankstödsnämnd with requests for support were obliged to give disclosure of all their financial positions, opening their books completely to scrutiny. This requirement facilitated the resolution policy and made it acceptable in the eyes of the public.

Differentiated resolution policy to maintain the banking system and prevent moral hazard

Banks that turned to the Bankstödsnämnd were dealt with in a way that minimised moral hazard. The policy priority was to save the banks, not the owners of banks or the bank managers. Banks in trouble were first asked to obtain capital from their shareholders. If they were not able to do so, present owners would have to surrender control and ownership before public support was given. Faced with this threat, private banks in Sweden made great efforts to raise capital from their owners. One bank, the SEB, decided to withdraw its request for government support. Banks that were in temporary difficulties could ask for government guarantees.

Out of six major banks, two were not expected to be profitable in the long run. They were taken over by the government with the aim of being re-privatised. Their assets were split into a good bank and a bad bank, the “toxic” assets of the latter being dealt with by asset-management companies set up by the Bankstödsnämnd, which focused solely on the task of disposing of them. When transferring assets from the banks to the asset-management companies, the government applied cautious market values, thus putting a floor under the valuation of such assets, mostly real estate. This restored demand and liquidity, and thus put a break on falling asset prices. The “good” assets of the two failed banks were transferred to a new bank that eventually emerged as Nordea, now one of the major Nordic banks.

The role of macroeconomic policies in ending the crisis

The bank resolution was facilitated by monetary and fiscal policy. The fall of the pegged exchange rate of the krona on November 19, 1992, following heavy speculative attacks, was an important move towards recovery. Once the krona was floating, it depreciated sharply, encouraging a rapid growth in exports. The ensuing fall in interest rates eased the pressure on the banking system. In July 1996, the crisis legislation and the blanket guarantee were abolished. The government allowed huge budget deficits to build up during the crisis, mainly as a result of the workings of automatic stabilisers, peaking at around 12% of GDP in 1993.

A successful bank resolution

The Swedish bank resolution was successful. Sweden’s banking system remained intact. It continued to function with no bank runs and hardly any signs of a credit crunch. It remained largely privately owned and became profitable shortly after the crisis.

In the long run, the net fiscal cost – the ‘cost to the taxpayer’ – turned out to be very low, close to zero. Figure 1, displaying the net fiscal costs for 39 systemic banking crises in 1970-2007, demonstrates Sweden’s favourable ranking with a net fiscal cost of almost zero. The gross fiscal cost for the bank support policy amounted to around 4% of GDP initially.

Figure 1. Net fiscal costs from systemic banking crises, 1970-2007, per cent of GDP.

Can the Swedish model be exported?

Answering this question requires comparing the Swedish crisis of the early 1990s with the present global crisis. On a very general level, the similarities are striking. The two crises are both financial crises driven by identical forces – a boom fuelled by lax monetary policy and negligent financial oversight, later turning into a bust.

On the other hand, there are considerable differences. The Swedish crisis of the early 1990s was primarily a local phenomenon, or – more accurately – a Nordic one, as Finland and Norway also went into crisis at roughly the same time as Sweden. Being a small open economy, Sweden was able to abandon its pegged rate and obtain a significant and lasting depreciation of its currency that contributed to strong recovery. This option is hardly open to an individual country today because the present crisis is global.

The small size of the Swedish financial system in the 1990s facilitated the bank resolution policy. Policy-makers dealt with a limited number of banks – only six major banks – in an overall environment of trust in the banking system. This is in sharp contrast to the current situation in the US, for example, with thousands of banks of different types and many non-bank financial actors, and where public trust in the financial system and its actors (“Wall Street”) is extremely low.

The Swedish bank resolution policy was faced with a financial system that was much less sophisticated and much less globalised than the financial systems of today. There were no structured products, no sophisticated derivatives, hardly any hedge funds, less securitisation, and so on. Indeed, the ongoing crisis has been difficult for the authorities to manage, in part, because some traditional central banking tools – especially in the UK and the US – are not well suited, either legally or architecturally, to provide liquidity for the institutions most in need, including investment banks and insurance companies.

In addition, Sweden has a tradition of substantial public confidence in its domestic institutions, political system, and elected representatives. Such social capital made it easy for the government and opposition to reach swift and stable agreements on policy actions.

In spite of the differences between Sweden in the early 1990s and the world today, the Swedish experience holds lessons. A policy to support the financial system benefits from political unity and from being carried out swiftly and openly. The aim should be to save banks in distress, not their owners or managers. This minimizes moral hazard. The resolution policy should be implemented within a consistent and all-encompassing strategy, having a legal framework in which the administration of the support is left to experts acting at arm’s length from the government, the central bank, and the financial supervisory authority. The support benefits from being financially open-ended to ensure the solvency of the financial system. The support should also be designed in a way that the public perceives as fair and just.

The Swedish case illustrates that the task of government during a financial crisis, or – in popular terms – the task of the taxpayer, is to serve as the capitalist or investor of last resort by recapitalising the financial system, thus dampening the effects of the financial breakdown on the real economy.

The Swedish formula cannot be fully imported by other countries due to institutional differences. Still, its guiding principles are applicable outside Sweden today, most prominently in four areas. First, the Swedish experience demonstrates that the threat of public receivership or nationalisation should be a real one as it forces the private sector to find private solutions. Second, the Swedish record suggests that banks in distress, nationalised as well as in private hands, should be split into a good and a bad bank, in order to get the financial system swiftly working again – more precisely, bad assets should be taken off the balance sheets of banks to prevent them from becoming “zombie” banks. Third, the bank resolution policy credibility is significantly enhanced by an open-ended financial commitment by the government. Fourth and finally, policy action should be swift and decisive to arrest the negative feedback loops arising during a financial crisis.

To sum up, the Swedish model of bank resolution should be used as a general template for countries facing financial crisis, but these countries will need to adapt the details of the implementation to their own circumstances.

Jonung, L., (2009) “The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful.” European Economy, Economic papers 360, European Commission, February 2009, Brussels.