Nice done. Your article gives another layer of abstraction.

Using a bit less of abstraction, the drivers were:

1.) Global wage arbitrage: the US (global!) consumer buying cheap products, undermining his own economy, buying from cheap Asian workers thereby getting relatively high(er) wages. Exacerbated primarily in the US by:
2.) Cheap US credit.
3.) Lax credit and financial regulation in the US.
4.) “everyone should own a house” mentality by political officials in the US (and, I think, even in Spain)
5.) As I have heard — Chinese officials trying to prevent direct connections between domestic production and consumption. Why? Maybe because of the Asian crisis as you mentioned. Maybe because of unsustainable live style that would have developed thereby (pollution, high oil consumption etc.).
6.) Chinese demand for high-quality production enterprises in order to accelerate their technical evolution.
7.) Missing wage arbitrage regulation in front of the background of neoliberal thinking distributed by officials at the IMF, Worldbank etc. etc. etc.

According the Galbraith, one of the most devastating drivers of imbalances are social moods boosted by officials (US housing, for example) and accompanied by ccoresponding liquidity generating actions.

My actual point is: beware of the politicians. Their regulations form the world much more than anything else.

Posted: 28 Aug 2009 03:00 AM PDT

Menzie Chinn, one of my favorite bloggers, and Jeffry Frieden have a short and highly readable article up on the causes of the financial crisis.

Chinn is not given to ideological ranting and is a great believer in actually looking at data, so I place significant weight in what he says.

Chinn and Frieden place the emphasis on excessive American borrowing, by both the public and private sectors.

This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash.

They have little patience for the idea that the financial crisis was the fault of Chinese over-saving:
“It is necessary to dispense with the view that all this excess saving from the rest of the world was “forced” upon us. The rest of the world’s capital flowed to us, in part, because we wanted to borrow, and we wanted to borrow because of the Bush administration’s emphasis from 2001 to 2008 on cutting taxes while still spending.”
They do endorse as exacerbating factors the low interest rates set by the Federal Reserve earlier this decade, and the growth of a large and unregulated financial sector:
“Essentially, the development of an unregulated financial sector has circumvented the entire panoply of banking regulation created in the wake of the Great Depression. This made the financial system vulnerable to traditional “bank panics,” or “runs” on the financial system. The abdication of regulatory oversight (particularly in allowing high leverage) in the presence of too many institutions “too large to fail” meant the buildup of implicit financial liability on the part of the government”

Second point: the fact that the Fed could have stopped the process by raising interest rates and didn’t, was probably a mistake, but there was anyway a cost to doing so. If the increase in liquidity was indeed caused by the savings glut mechanism, one consequence would have been a rise in US unemployment as the tradable goods sector in the US shrank to accommodate the expansion in the Asian trade surplus (this is Martin Wolf’s argument, by the way) and the Fed had to choose between higher unemployment and too-loose money. They may have made the wrong choice, but it is not obvious that they were fully responsible.

The fact that, before the crisis, credit and liquidity spreads were historically narrow suggests that the driver of the imbalance between China and America was a greater investor demand for lower-quality US debt, probably fostered by financial innovation. Although demand for this debt displaced US treasuries, these loans financed increased housing investment and consumption, drawing in more goods imports from China, which given the renminbi peg (at, incidentally, a level set well before the Asia crisis), prompted China to buy dollars and thence treasuries. China’s reserve accumulation was an automatic reaction to a US domestically-led boom. The alternative explanation, that US investors responded to Chinese buying with a “search for yield” would require, since the yield on spread product fell by proportionately more than on treasuries, that US investors had an irresponsibly strong preference for yield over safety (from credit risk or illiquidity).

While musing about a “saving glut” driving down long term yields, the Federal Reserve itself was in fact the biggest central bank holder of treasuries (to supply and collateralise their own currency) until about 2006. At the time the Fed would have argued that treasury yields were set by monetary policy expectations so that their open market operations did not shape the yield curve, but the Fed’s present quantitative easing strategy of buying long term debt to lower long term yields suggests that the Fed would now accept that they could have done something to resist falling long term yields before the crisis if they had wanted.

Here is a quote from the FT article on IRON ROOSTER: “Yet over the next three years, the railways ministry plans to add 20,000km of track to the existing 80,000km, with a total investment of more than Rmb2,000bn. At this rate, China’s rail network will this year overtake that of India to become the second-longest in the world, behind the US.”

Overtake that of India this year? What an astonishing achievement for China! Don’t you find a little irony in this statement? Doesn’t it tell you something about the status of China’s railway (and the necessity of the investment)?

The author of the article has formed an opinion and went out to collect information to “prove” his point; in the process he either collected wrong information or simply misinformed.

For example, the author quotes that China’s passenger vehicles stand at 38 million (vs 230 million in the US). With China’s automobile sales projecting to exceed 11 million this year and have been close to 10 million sales in the last few years, don’t you think the number of 38 million is a bit suspicious or fair (why include only passenger vehicle only)? I’m sure everyone understand you don’t build infrastructure for this year or next year, particularly with the growth that China has had.

The quoted number that “China’s high-speed road network would expand to 180,000km in the next few years” is misleading. The number 180,000km is combined total of PROPOSED by the provincial governments, not something planned or budgeted for the next few years. One thing is for sure: it’s NOT going to happen. And, if you remember, last year when central government announced the 4 trillion stimulus package, the combined total PROPOSED projects submitted by the provincial and local governments is 18 trillion!

The provincial and local governments’ zeal in investments is nothing new. But there are check-and-balance built into the system. Large infrastructure investment projects have to go through a set of processes to get approved, with China Development and Planning Commission serving as the gate-keeper (large airport projects will even need to be approved at the Premier’s regular meeting). Take another example, twice in the last 15 years, the State Council has put a freeze on all city metro projects when local governments were getting out of control, once in 1995 and once in 2002.

There have been a lot of wasted infrastructure investments in China in the past (the most notorious being the Zhuhai Airport); there are wasteful spending in the current wave of infrastructure investments and I suspect there will be stupid infrastructure projects in the future. The important thing is to keep some perspective, put it in the right context, and look at the big picture (even though the execution is equally important).

The Western Investment Drought, as you call it, is also interesting. We locate factories near the resources they require. Pittsburgh comes to mind; located on a good river system where ore can come from the Great Lakes, coal from the Appalachians, and lime which somehow I remember as being necessary to the process. Improvements in communication, to use the word in the French sense, have created new possibilities. Now we have spent 2 decades off-shoring our industry to locations that had an abundant labor resource. And we’ve gone one further. We have created “flat” business models in which several business entities handle the SAME component of production. Example: Dell Computer. Production itself becomes a commodity and you can often source your production more easily and more cheaply than if you were to do it yourself. Why should I capitalize a factory when I can source my production so easily? We don’t save just on labor. We save also on capital costs. So, there’s a limit to how much and where tradable sectors investment will recover in the west.

So, what I’m trying to do is to highlight this view in which China is just one more of those entities within that flat business model which handle a part of the multi-national production process. Investment in tradable goods sectors must be made there. How that gets integrated financially without creating imbalanced capital flows, and the stresses which follow, is beyond me. That’s why it amuses me to read these blogs. But it’s also why I think rebalancing must come from Chinese demand.

John Ross, I am not sure my proposal represents an extreme innovation so much as a fairly well-understood accounting identity, and I suspect that if you weren’t still playing this silly and very tedious game of “gotcha” you would have tried to understand the statement within its context, and probably would have managed to do so. If the savings rate rises, and GDP declines, total savings can rise, stay they same, OR decline, depending on how fast the savings rate rises and GDP declines. This is just arithmetic. Please don’t expect me to play this sill game every time you propose it.

Glenn M, I think you are right, and that there were many opportunities – none of which were taken – by monetary authorities both in China and the US to put an end, or at least slow down, the self-reinforcing monetary relationships between the two that led to such extremes, but when the party is raging no one likes to take the cocaine away until someone gets a heart attack.

In dealing with my reply to Martin Wolf you refer to two issues – one on saving, one on investment.
Regarding saving you argue that, while agreeing that China could not have been responsible for the origin of the US balance of payments deficits, as China’s large surplus did not begin until 2005 and the US deficit started in 1981, the policies of other Asian states were responsible. But this ignores the very clear causal origins of the decline in US savings. The Reagan administration through the combination of tax cuts and very large increases in government expenditure (mainly military) moved the US budget into large deficit. Unless there had been a corresponding increase in either household or company savings (for which no compensating US policies were adopted), or a radical fall in investment, then this decline in savings could only be absorbed by the international sector – that is by the US balance of payments moving into large deficit (as occurred). But this decline in US savings was clearly inaugurated by internal processes in the US, not by trends in Asia
Regarding investment you state: ‘I also agree with Glenn’s point that you too easily confuse “investment is good” with “capital is not misallocated”.’ It is certainly possible to have situations where capital is overall misallocated and even very high investment produces very low growth. Countries pursuing import substitution strategies (Argentina, the USSR, India prior to its reforms) classically suffer from this problem. But what is at stake is not a distinction in principle, which is recognised, but the actual factual situation with China. The distinction between ‘good’ and ‘misallocation’ is one that can measured quantitatively for the economy via productivity – most comprehensively via total factor productivity. The major studies show total factor productivity in China is either ‘respectable’ (Alwyn Young) or high (Jorgenson). In either case high investment is an entirely rational (i.e. a ‘good’ and not ‘misallocated’ investment) policy because it produces high economic growth.
The final issue relates to the national accounting identities – whose frequent appearance in this discussion is due to the fact that they are the only way to maintain clarity on the quantitative relation between domestic and international balances. There is a point in your reply to Belisarius, related to both savings and investment, which is unclear as it appears either intended as an extreme innovation in economic theory, which therefore should be justified, or as a misformulation which should be corrected so it can be clearly understood. You write: ‘if the world decides to raise its savings rate, without increasing its investment rate commensurately, it will only be able to do so with a contraction in global GDP. There are many ways this can happen, and I can’t go into all the scenarios, but in the aggregate if we all buy fewer things, one way or the other we will all have also to sell fewer things.’
But world (i.e. total) savings, by definition, are necessarily equal to world (i.e. total) investment (a disparity is naturally possible nationally). It is therefore impossible for the world to raise its savings rate without raising its investment rate commensurately. So what are the ‘many ways this can happen’? Your formulation may have been intended to refer to the possibility of lack of effective demand leading to a decline in both investment and savings, or some other point, but it will still necessarily remain the case that world savings and investment are equal. I assume that your statement was simply a misformulation, in which case the discussion is proceeding within a common economic accounting framework, or are you really arguing that world saving and world investment can differ – in which case we are into a totally different level of difference not regarding China but regarding the whole of economics? As the current discussion is excellent and clarificatory it would seem important also to have clarity on this point.
One point of great interest in the discussion is that made by Bob_in_MA. I have commented here previously that, contrary to frequent but inaccurate assertions in sections of the press, consumption has increased as a proportion of US GDP during the financial crisis. Bob_in_MA’s is the clearest outline I have seen anywhere of some of the detailed mechanisms by which this occurred.

I think you are probably right in determining that the result of balanced (thus reduced) trade between Asia and the West could be war. Most probably a cold war. However I think that decision makers are not influenced by this constraint.
They are more likely constrained by democratic elections which form the economic policies in the way of maximizing consumption.
Asian political systems have somewhat different feedback mechanisms and they tend to be optimizing for industrial output.
And there is the underlying fundamentum of labour abundancy in Asia, which puts Asia into a position of competitive advantage for investments and industrial activity.