February 26, 2007
History holds lessons for China and its partners
By Lawrence Summers A rising Asian power has emerged as an export powerhouse and enjoys rapid, export-led growth fuelled by extraordinarily high savings and investment rates. Its technological capacity is upgraded at prodigious rates and its businesses threaten an ever greater swathe of industry in Europe and the US. Its high level of central bank reserves and burgeoning current account surplus lead to claims that its exchange rate is being unfairly manipulated or, at a minimum, should be guided upwards. Its financial system is bank-centric, heavily regulated in ways that favour domestic institutions and has close ties to government and industry. Rapid productivity growth holds down product prices but asset price inflation is rampant. US congressional leaders demand radical action to contain the economic threat. Delegations of senior US economic officials engage in “dialogue” with their counterparts about the many aspects of the country’s economic policies that promote imbalances, warning of the congressional demons who stand ready to act if “results” are not achieved quickly. All of this describes what is happening in and with China today. It also describes the Japanese economy in the late 1980s and early 1990s before its lost decade of deflation and considerable deterioration in its international relations. While there are obvious differences, notably China’s much lower level of development, the similarities are striking enough to invite an effort to draw some lessons for China and its partners from the earlier Japanese experience. The definitive history of Japan’s dismal decade has yet to be written. But almost all knowledgable observers would agree that significant elements included the bursting of the stock market and land bubbles, the resulting problems in the financial system, the collapse of aggregate demand as banks stopped extending credit and the difficulty of moving from export-led growth to domestic demand-led growth once consumer and business confidence had been lost. In retrospect, Japanese officials made several important policy errors. In order to avoid further yen appreciation after the 1987 Louvre agreement, they followed easy monetary and financial policies that gave rise to huge asset price bubbles and expansions in credit that set the stage for the subsequent downturn. They failed, at a moment when consumers were enjoying record increases in wealth, to encourage a shift to domestic demand-led growth. They also allowed problems in the banking system to fester rather than confront them directly. The result of these mistakes was that Japan did less than it could have done to prevent the serious problems of the 1990s and was not well positioned to address them when they arose. This suggests that if China is to sustain rapid growth and not run into the kinds of problems that Japan encountered, now, when the sun is shining, is the time to fix the policy roof. Allowing the inevitable currency appreciation and spurring domestic demand by encouraging consumption is much easier now, when the economy is at the edge of overheating, than it is likely to be in the future when it cools off. It has been estimated that seeking to maintain the exchange rate at or near its current level could require as much as $400bn in reserve accumulation in 2007, which would almost certainly lead to rapid asset price inflation as renminbi were created to buy dollars. Also, there will not be a better moment to address issues in the banking system. These lessons contrast sharply with those drawn by some observers in and out of China, who attribute Japan’s deflation and consequent poor performance to its willingness to accede to US pressure for exchange rate appreciation. This alternative view offers no explanation for Japan’s asset bubble and collapse and no theory of what measures could have been taken that would have spurred domestic demand-led growth. An additional lesson is the need for modesty regarding economic policy dialogues that seek to create pressure for change. Events and national and political decisions, not international communiqués, shape economic outcomes. The impact of events beyond the control of governments – the collapse of Japan’s asset markets, information technology’s spur to US productivity growth, the Asian financial crisis – dwarfed the issues debated in economic dialogues. Even where government policies might have significant impact, there is no evidence that Japan in the 1980s and 1990s made any changes in domestically sensitive structural policy areas such as housing finance, social security or retail regulation in response to the US Structural Impediments Initiative or its successors. Policy in areas of this kind is shaped by domestic politics; if heavy-handed pressure makes it easier for special interests to invoke nationalism as they resist change, high-profile dialogues can be counter-productive. In a world where goodwill is scarce, heavy-handed dialogues engender resentments that spill over into other spheres. It was a cliché in US-Japan relations during the late 1980s and early 1990s that the US-Japan link was the world’s most important bilateral relationship. Given China’s greater scale, more rapid growth and the greater level of imbalances in today’s global economy, Chinese economic policy and its international economic relations are even more important. By learning from a rather unfortunate history, policymakers on both sides of the Pacific can avoid repeating its mistakes. The writer is Charles W. Eliot university professor at Harvard
Barry Eichengreen: Like Professor Summers, I am not of the view that Japan’s key mistake in the late 1980s was acceding to US pressure for yen appreciation; currency appreciation was inevitable under the circumstances. Rather the key errors were failing to pursue structural and fiscal policies that would have stimulated consumption spending, and engaging in an excessively expansionary monetary policy in a futile effort to avoid further appreciation while producing dangerous asset bubbles.
But there is another example from Asian history with even more apposite lessons – that of Korea. Like China now, Korea in the 1960s and 1970s pursued export-led growth with a bank-based financial system, heavy reliance on foreign capital, and strong state direction. In the first half of the 1990s it came under international pressure to liberalize the capital account and move to a more flexible exchange rate; unfortunately, the pressure to move on the first front was more intense than the pressure to move on the second. (Now there’s is a lesson worth remembering…) Financial opening without financial restructuring, and excessive reliance on the assembly of consumer electronics for export and on building up heavy industry at the expense of developing the domestic consumer market, set the stage for a major financial crisis.
But the most important parallel between China and Korea is that both experienced high growth under authoritarian regimes. This brings us to the key difference: Korea completed the transition to democracy before the old growth model came tumbling down. When the crisis struck, discrediting existing office holders, they were replaced with politicians not connected to the old regime. At public insistence, large conglomerates that had been major beneficiaries of the old system were allowed to fail. The financial system was radically restructured and opened to foreign competition. The exchange rate has been allowed greater flexibility, and it has appreciated against the dollar, avoiding another period of excessive dependence on export demand.
Everything is not sweetness and light in Korea. Finance has been more extensively restructured than industry. The shift toward a better balance of consumption and investment initially produced a crisis in the credit-card industry. Korea’s critics will emphasize yet other problems. But the economy’s quick recovery and subsequent growth point to the fact that policy has delivered a fundamental change in the country’s economic structure – because the electorate insisted. Do we think that China can complete its transition to democracy in the relevant time frame? And without such a transition, will it possess the political will for a radical restructuring?
Posted by: Barry Eichengreen | February 27th, 2007 at 8:35 am | Report this commentMonty Graham: In offering China lessons from history, Lawrence Summers revisits policy errors made in Japan during the 1980s, ones that arguably led to the Japanese economy, then almost surely the most dynamic in the world, going into a prolonged slump beginning in the early 1990s from which recovery has only very recently been realised. (Indeed, there are analysts who believe that Japan’s problems might still not be wholly resolved, in spite of the return of respectable growth rates there.)
It is difficult to argue with Summers because, for the most part, he is correct, both in his identification of those policy errors that were made and in arguing that there is a risk that China now could make similar errors, albeit in quite a different context.
However, he misses at least one error that Japan made that likely will loom large in any “definitive history of Japan’s dismal decade”(a history that Summers correctly notes has not yet been written) and one that also bears importantly on the situation in China today.
This is that, simply, by the 1980s, the structure of many of Japan’s domestic markets had become rigidly oligopolistic. This was especially so where large “keiretsu”-affiliated firms were able to build strong entry barriers or, alternatively, induce Japanese regulatory agencies to build entry barriers on their behalf. Thus, in the markets dominated by these firms, there was very little effective competition. The problem arguably was compounded by the fact that complex interlocking ownership schemes were created so that there was no effective market for corporate control.
Ironically, for a time, this system became touted as a source of advantage of Japanese firms, and western management “gurus” earned, if “earned” is the right term, large fees by explaining how Japanese firms concentrated in rigid oligopolies and protected from any risk of change of control were able to develop long term advantages that their western rivals, saddled with too much competition and threat of hostile take-over, had to forego. The disadvantage of the western system, above all else, resulted from requirements that western firms had to meet the quarterly earnings demands of notoriously short-sighted financiers on Wall Street and the City of London, whereas similar demands were not placed on Japanese firms. Indeed, theoretical articles by certain Japanese economists put forth models of “ruinous competition” that backed up the contentions of these gurus.
But the reality was, in most such industries (there proved to be exceptions, e.g., automobiles), rigid oligopoly was marked by increasing lack of price competition. Instead, prices were kept high via various collusive means. Facing none of the incentives for internal development that are created by external competition, Japanese firms themselves experienced ossification, due in part to highly bureaucratic and hierarchical management structures. Simultaneously, many such firms employed more than the optimal number of workers, and at high wages (hence, high prices did not necessarily translate into higher earnings). Arguably, protected from effective competition, these firms also faced diminished incentives to undertake those sorts of investments that might lead to efficiency increases.
As this malaise increased during the late 1970s and early 1980s, Japan could have taken steps to increase competition (or, to use the term that best fits the problem, to increase “contestability”) within such markets. In particular, restrictions on imports or, more importantly, foreign direct investment in Japan might have been eased, and the authorities encouraged foreign-based firms to come into Japanese domestic markets in order to create more competition in these markets. But Japan did not do so; rather, officials at MITI, the Ministry of Finance, and sector-specific regulatory agencies made it even more difficult than before for a foreign firm to enter Japanese markets via imports or foreign direct investment. One consequence is that, to this day, of the OECD nations, Japan has the lowest amount of FDI per unit of national output. Indeed, as noted earlier, regulatory agencies made it difficult for any new entrant, whether foreign or Japanese owned, to enter many regulated markets.
But why, the reader might ask, is this of any relevance to China? China after all has been quite open to FDI, albeit that this openness has come with plenty of strings attached, e.g., requirements for local partners in almost any undertaking. But, even with strings attached, “foreign-invested enterprises” (FIEs) in China have, since the early 1990s, contributed substantially to the growth of the Chinese economy and, in particular, to the growth of the export sectors (about half of all of China’s export growth since 1993 or thereabouts has been generated by FIEs).
A principle concern now is that, while most firms in the heavily outward-oriented foreign-invested sectors in China are efficient and dynamic, much of the domestic economy is still dominated by state-owned enterprises (some of which however are now partly privatized) that still too often are inefficient and operate in markets where internal competition is less than robust. Indeed, in many instances, internal Chinese markets are divided into regional monopolies, such that there is effectively no competition at all. Moreover, in current times of rising Chinese nationalism, there are moves afoot to keep things this way.
In this last matter, much of the current focus and concern is on the draft Chinese anti-monopolies law that is to be considered by the Democratic Peoples Congress (DPC) later this year. The law is not in final form, but there is concern that the law could be used by Chinese nationalists not as a means to foster greater competition in those markets in China where relatively inefficient incumbent firms nonetheless face little competition, but rather as a means to “protect” such firms from the putatively “anticompetitive practices” of foreign firms. In practice, such protection might, as was the case two and three decades ago in Japan, mean the putting in place of measures making it difficult to impossible for foreign firms to acquire Chinese firms.
Some Chinese nationalists, however, would go further than this and attempt to use the new law as a means of going after intellectual property of successful western firms, perhaps via forced licensing of technologies as a condition for the foreign firm to do business in China. This last would be going in the wrong direction; a major reason why it is desirable that markets should be competitive is that competition promotes efficiency and consumer welfare. This, in modern doctrine, competition authorities do not seek to protect competitors (individual firms, that is) if they are inefficient and hence unlikely to survive competition from more robust firms, and certainly do not seek to protect inefficient competitors by destroying the attributes that make other firms more efficient. But, apparently, this latter is exactly what at least some Chinese nationalists would seek to do. The DPC thus needs to bear in mind that foreign firm participation has been one of the keys to the enormous strides that the Chinese economy has accomplished and, in particular, to make sure that the new anti-monopolies law does not become the new anti-foreign competition law. To go the latter route, in fact, would truly be an example of China repeating the errors of Japan.
Posted by: Monty Graham | February 28th, 2007 at 11:25 am | Report this commentRonald McKinnon: Congratulations to Lawrence Summers for bringing up the important parallel between US Japan bashing in the 1980s into the mid 1990s and China bashing now. “Bashing” here means threatening trade sanctions unless the industrializing country with a saving surplus, ie, a current account surplus—particularly a bilateral one with the United States—appreciates it currency. And the yen did rise all the way from 360 to the dollar in 1971 (just before the Nixon shock) to touch 80 to the dollar in April 1995, when the dynamic duo in the U.S. Treasury of Robert Rubin and Lawrence Summers finally called off the American mercantilists and announced a new “strong dollar” policy. Thereafter, Japan (but not China) bashing ceased—at least up to a month or so ago.
But the damage had been done. The Japanese economy was thrown into a deflationary slump and a near zero interest rate liquidity trap from the fear of future yen appreciation that prevented the Bank of Japan from re-inflating the economy. This led to Japan’s infamous “lost decade” of the 1990s, with a deflationary hangover into the new millennium that greatly hampers economic decision making in Japan’s still fragile macro economy in 2007.
Summers suggests that “The definitive history of Japan’s dismal decade has yet to be written”. However, Kenichi Ohno and I thought we had made a good start in our book Dollar and Yen: Resolving Economic Conflict between the United States and Japan (MIT Press, 1997). The first chapter is titled “The Syndrome of the Ever-Higher Yen” and analyzes American mercantile pressure from using the threat of trade sanctions to get the yen up and up, and then subsequent chapters show the deleterious economic consequences for Japan of getting the yen so overvalued.
However, I have a few quibbles with Summers analysis of Japan bashing. He suggests that “the alternative (exchange rate) view offers no explanation for Japan’s asset bubbles and collapse and no theory of what measures could have been taken that would have spurred domestic demand-led growth”. In fact, in Chapter 5 we showed that the bubbles in Japan’s stock and real estate markets from 1985 through 1989 were endogenous to the behavior of the exchange rate. First, after the yen rose steeply in 1985-86 associated with the Plaza Accord (September, 1985), Japan suffered a growth recession—what the Japanese called “endaka fukyo” (high-yen induced recession) through 1987. This itself put downward pressure on Japanese interest rates, but this downward pressure was greatly accentuated by the belief that American pressure on the exchange rate would continue and the yen would go ever higher—the open-interest parity effect. These low interest rates encouraged a bidding up of asset values. Not wanting to tolerate a resurgence of budget deficits, the Ministry of Finance then became an active cheer leader for rising asset values to encourage domestic spending to get the economy growing again. On top of this was the sense of “triumphalism”: with asset values and the yen rising, it seemed as if high-tech Japan was on the verge of a “new era”, where it could buy up much of the lower-tech rest of the world rather cheaply.
The asset bubbles deflated rather sharply in 1990-91, so that domestic spending was negatively impacted. However, the slump in the economy was further accentuated by a further sharp appreciation of the yen through April of 1995 from American pressure associated a trade dispute on automotive components. With the crash in the real estate market, a banking crisis naturally developed from the defaults on real estate and other loans throughout the economy. No surprise there. But Summers suggests that the banking authorities “also allowed problems in the banking system to fester rather than confront them directly”—a view widely held in Japan as well.
However, the failure of Japanese banks to grow out of their bad loan positions for the decade ensuing after the crash was not primarily due to laxity on the part of the regulatory authorities or the banks themselves. Rather the fear that the yen could go higher drove Japanese interest rates toward zero—the dreaded liquidity trap. With interest rates compressed toward zero in the 1990s and even today, the profit margins of the banks, i.e., the spread between deposit and loan rates, were greatly reduced so that the banks could not generate sufficient profits to write off their bad loans and recapitalize themselves. True, the government tried to inject new capital into the banks on several occasions, but new lending continued to look unprofitable, and bank credit continued to fall throughout the lost decade. To risk further overburdening already overtaxed readers, Japan’s banking impasse in the face of the liquidity trap is treated in Chapter 4 (with Rishi Goyal) in my more recent book Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue (MIT Press, 2005).
But none of these reservations lessen my delight in having Lawrence Summers draw parallels from the consequences of Japan bashing in the 1980s and 1990s with the possible negative consequences for China of being bashed in the new millennium. However, I do disagree with Summers’ observation that further appreciations in the renminbi are “inevitable”. Those that don’t learn from history are condemned to repeat it.
Posted by: Ronald McKinnon | March 1st, 2007 at 12:41 am | Report this commentBrad Setser: I agree with Dr. Eichengreen on two counts: exchange rate flexibility should have priority over capital account liberalization and the debate over exchange rate adjustment in East Asia should include Korea’s experience, not just Japan’s experience in the late 1980s. Right now, full Chinese capital account liberalization would likely lead to an upsurge in inflows - Chinese intervention makes many Chinese assets almost as cheap as Chinese goods, at least for those with euros or pounds – and add to the already difficult job facing the People’s Bank. As Dr. Eichengreen notes, unlike many Asian economies, Korea has managed to maintain positive growth even as it has allowed its currency to appreciate in both real and nominal terms – though no doubt Korea would currently be a lot happier if the yen and yuan had joined the won in appreciating against the dollar.
But I really wanted to raise a somewhat different issue, one that Dr. Summers, I think, hints at. Japan’s experience in the late 1980s is often taken as evidence of the dangers of exchange rate appreciation. Yet a strong case can be made that the bubble economy had its roots not in yen appreciation but in the monetary policies Japan adopted to offset yen appreciation.
Looking around the world today, I would posit that the greatest risk of new bubble economies is likely found not in countries that are allowing their currencies to appreciate – countries like Korea - but rather in countries
Posted by: Brad Setser | March 1st, 2007 at 12:52 am | Report this commentthat are resisting pressure for appreciation. Many countries that are resisting pressure from both the current and capital account to appreciate are building up reserves and experiencing rapid money growth. In some countries, notably many oil exporters, inflation has picked up substantially and real interests have turned quite negative, fueling real estate bonanzas – bonanzas that may lead to the construction of unoccupied office towers that sit on someone’s balance sheet for a long-time. China has avoided a similar acceleration in inflation and the resulting real appreciation for reasons that Martin Wolf laid out in a series of columns last November – but certainly shows signs of strong asset price inflation.
Michael Dooley: Larry Summers warns that if China is not careful it could end up looking like Japan in 1988. Not good if you consider the condition of Japan’s banking and asset marketssince 1988 - not bad when you recall that Japan’s GDP in 1988 was about ten times its post war level. Our view is that the export led growth/exchange rate policy that Summers criticizes and associates with problems in the financial sector also provides the best chance to imitate the remarkable growth performance of Japan and other Asian countries.
Can China and other low income countries skip the export led growth phase and depend on domestic financial development? In a first best world it ought to be possible. The dream is to reform the domestic financial system and allow domestic savings and domestic financial intermediation to drive balance growth. The realityis that domestic financial markets are the last thing real countries get right. As Willie Sutton is supposed to have said he robbed banks because “that’s where the money is.” Willie stole about $2 million in his career and there are many more sophisticated rent seekers in emerging markets. The political economy against reform of financial markets (rounding up all the Willies) and ending resulting waste of domestic savings may be the principle constraint on economic development.
It is clear that financial reform and international financial integration (in that order as Barry reminds us) are important aspects of economic development. It is not clear, however, that either can or should precede industrial development. From 1955 to 1988 per capita income in Japan rose from one fifth the US to rough equality. Not a bad performance.
Posted by: Michael Dooley | March 2nd, 2007 at 12:01 pm | Report this commentWillem Buiter: Henri Ford Sr. must have been a professional economist before he turned to car manufacturing. Instead of saying what is so often attributed to him: “History is bunk”, he actually said: “History is more or less bunk”, a phrase including three weasel words that neuter what could have been an interesting statement. Let me therefore firmly state that comparing Japan in the late 1980s and early 1990s with China today is more or less bunk.
China is a poor, developing country. Japan in the late 1990s was a rich industrial country. The fact that China’s financial system is bank-centric makes eminent sense given its stage of development. Capital market development is much more institutionally demanding (for both the private and public sectors) than banking sector development. China should not engage in premature domestic financial market development. Continued reform, including commercialisation and ultimately privatisation of the state banks, and the removal of obstacles to the entry of foreign banks into the Chinese market are two key reforms. Financial market development is indeed important. And it is happening, as is evident, for example, from the stirring of a domestic corporate bond market. However, as the recent hickups of the rudimentary but wild and woolly Shanghai stock market remind us, domestic financial markets will for some time to come play a secondary role compared to the banking system.
China’s growth rate, although sustainable for much longer when one just considers the availability of labour and capital resources and the scope for continued international technology transfers, needs to slow down significantly because it is environmentally unsustainable. This was not an issue for Japan in the 1980s and 1990s. What if China were to ignore completely its growing contribution to global warming (not a great strategy for making friends and influencing people around the world)? Even a narrowly nationalistic cost-benefit analysis cannot ignore the depletion, in China, of fresh water resources, the poisoning of the air, water and land, the widespread soil erosion, deforestation and desertification and the general destruction of the natural environment.
A telling example is provided by the Beijing Olympics. For the duration of the games, much normal industrial activity in the region will have to be suspended. Even so, I pity the poor marathon runners who will have to manage 42 kilometers while breathing foul air. The environmental supply constraints will either be recognised and thus prompt an early voluntary and planned deceleration of growth and change in its nature, or they will be played down and result in a a not too much delayed involuntary cull of actual and potential growth.
Whether or not China’s lower environmentally sustainable growth rate will be (and ought to be) associated with a smaller or larger current account deficit is by no means obvious.
From an environmental perspective, it is in particular China’s investment rate that is too high and too destructive. I consider this excessive investment to be a rather more serious problem than the possibly even more excessive saving rate and the associated current account surplus that troubles the protectionist clans in the US. Other things equal, a lower investment rate means a larger current account surplus.
Should China save less? Chinese demographics and the absence of a serious PAYG social security scheme (or a completely fiscalised state pension) mean that high private saving rates seem perfectly individually rational. This retirement saving is re-enforced by increased saving to finance educational expenditures and increased precautionary saving for health contingencies, as the publicly funded health services are perceived as inadequate and private health insurance is effectively non-existent. I agree that the government should introduce more generous state pensions, and ought to spend more on health and education. That would reduce the national saving rate. Whether it would reduce it by more than the necessary reduction in the Chinese national investment rate remains an empirical issue that I don’t have the data to answer.
Larry asserts: “Allowing the inevitable currency appreciation and spurring domestic demand by encouraging consumption is much easier now, when the economy is at the edge of overheating than it is likely to be in the future when it cools off”. Quite the contrary. The last thing you want to do when the economy is overheating is to encourage consumption (presumably through tax cuts or increased transfer payments) - unless Larry also intends at the same time to recommend measures to discourage other categories of spending, and by more than he proposes encouraging consumption. Surely it is much better to wait until the economy goes into a cyclical downturn before opening the fiscal sluice gates?
Finally, I am not at all convinced that the yuan/renminbi is overvalued in real terms, let alone significantly overvalued. With a more open capital account – one that would allow Chinese private savers to diversify into financial portfolios that offer a risk-return combination that is vastly superior to what is on offer at home – a market-determined yuan would be as likely, indeed more likely, to depreciate (in nominal and real terms) than to appreciate. The accumulation of a stock of official foreign exchange reserves of around $1.2 trillion, is not evidence of real undervaluation. It tells us that China saves a lot and that its external savings are invested very poorly – the result of leaving foreign investment decisions to the state and, even worse, to the central bank.
In addition to boosting domestic consumption (at a cyclically appropriate moment) China should continue to reform its banking system and to liberalise access to foreign financial instruments by Chinese institutional and individual investors. It should also encourage the development of domestic financial markets and non-bank financial institutions. The quickest way to achieve this would be to permit unrestricted access by foreign financial institutions to the Chinese market. By permitting domestic interest rates to be market-determined, conventional monetary policy instruments could replace the distortionary, inefficient and increasingly ineffective use of the command-and-control methods of old China.
It may be necessary to throw the protectionist lobby in the US a bone in the form of some modest and gradual appreciation of the yuan. Much of the Democratic party and a growing number of Republicans talk as if they believe that the Chinese current account deficit is destroying American jobs (rather than financing investment in America) and that appreciation or revaluation of the yuan would reduce the current account deficit. Both beliefs are wrong. My support for for a modicum of yuan appreciation (not much more in 2007 than during 2006, however) is prompted by political economy considerations and not by what makes sense in a world with rational interlocutors.
Posted by: Willem Buiter, London School of Economics | March 2nd, 2007 at 7:58 pm | Report this commentAkio Mikuni: I would like to add a few more comments. Japan’s effective exchange rates (real) has been largely unchanged in the post Bretton-Wood system. This corresponds with her world largest accumulation of current account surplus, one of those errors made by Japanese officials.
Posted by: Akio Mikuni | March 5th, 2007 at 5:34 am | Report this commentJapan exports capital to offset inflow of current account surplus for the purpose of keeping the yen exchange rate stable and her net export intact. Capital exports have to be funded with existing yen liabilities, which reduces both purchasing power of the economy and reserve deposits at Bank of Japan. This is a root cause of Japan’s entrenched deflation.
In order to create additional yen liabilities to counter deflationary pressure, BoJ guided banks to lend aggressively and inadvertently created bubbles in asset prices in 1980s. In 1990s the government went into massive deficit spending, resulting in peace time accumulation of government indebtedness relative to GDP approximating 200 per cent, comparable with the extremely high level toward the end of the Second World War. In the 2000s wages have declined so as to keep Japanese exports competitively priced and at the same time to increase “non-consumption” or savings in the entire economy, resulting in increased yen deposits at the corporate sector through large profit increases. This time, the feeling of ordinary Japanese to be impoverished despite soaring profits at exporters could change a political landscape, although they do not see clearly yet the close link between their economy and the yen exchange rate.
Lawrence Summers: I am grateful for all these comments. A lengthy paper on lessons of the Asian experience for China should be written before too long by someone.
Perhaps I will make an attempt. Responding to some of the issues raised:
(1) I agree that of China’s many priorities, capital market liberalization is hardly primary and should be carefully sequenced. I am sorry to see the emphasis attached to it in the current US-China dialogue. On the other hand, I am surprised by Barry Eichengreen’s analysis of Korea. I would have placed much more emphasis on Korea’s allowing itself to be denuded of reserves through its fixed exchange rates. I also would have been inclined to blame the distorted pattern of liberalization in Korea which encouraged short term flows but maintained barriers to long term and equity flows for Korea’s build-up of short term liabilities.
(2) Barry Eichengreen is right to emphasize the political aspects of reform and to raise questions of democratic legitimacy. I am uncertain what weight to give democratic election vs. the ability of a government to break free of traditional encumbrances. Japan was democratic all through but the nexus of LDP loyalties surely complicated economic policy.
(3) Perhaps I am too Keynesian in orientation but while I agree with Monty Graham on the importance of pro-competitive structural reforms in China and on the significance of MITI’s failures I am not sure of their macroeconomic importance. With proper macro policy perhaps they translate into slower growth but not the kind of deep malaise that Japan suffered in the 1990s.
My admonition that it is easier to fix the roof while the sun is shining does however clearly apply in this area as well.
(4) I appreciate Ron McKinnon’s kind words but I am much closer to Brad Setser and Barry in believing that more damage was done in Japan by trying to prevent exchange rate appreciation than was done by allowing it to occur to excess. I think this is an absolutely central issue in the global debate because my sense is that the McKinnon reading of the Japanese experience has gained considerable traction in China. I am very skeptical of the view that exchange rate expectations were determinative of Japanese interest rates in the early 1990s as opposed to central bank actions. It would be valuable to think of empirical tests that had the potential to change people’s minds.
(5) Mike Dooley is right to point out that China is poor and that export led growth has been a historically more successful route to modernity than anything else. The question is how much longer can it take place without excessive financial distortion in China and I doubt there is that much more room - hence the need for adjustment. If adjustment is inevitable it is far from clear that there is a case for delay. International monetary history records many many instances of currency adjustments that were inappropriately delayed. I find it difficult to think of any that were inappropriately accelerated.
Posted by: Lawrence Summers | March 5th, 2007 at 12:41 pm | Report this comment