Perhaps because I started my career in 1987 trading defaulted and restructured bank loans during the LDC Crisis, I have spent the last 30 years as a finance history junky, obsessively reading everything I can about the history of financial markets, banking and sovereign debt crises, and international capital flows.My book, The Volatility Machine, published in 2002, examines the past 200 years of international financial crises in order to derive a theory of debt crisis using the work of Hyman Minsky and Charles Kindleberger.

No aspect of history seems to repeat itself quite as regularly as financial history.  The written history of financial crises dates back at least as far back as the reign of Tiberius, when we have very good accounts of Rome’s 33 AD real estate crisis.  No one reading about that particular crisis will find any of it strange or unfamiliar – least of all the 100-million-sesterces interest-free loan the emperor had to provide (without even having read Bagehot) in order to end the panic.

So although I am not smart enough to tell you who will or won’t default (I have my suspicions however), based on my historical reading and experiences, I think there are two statements that I can make with confidence.  First, we have only begun the period of sovereign default.

The major global adjustments haven’t yet taken place and until they do, we won’t have seen the full consequences of the global crisis, although already Monday’s New York Times had an article in which some commentators all but declared the European crisis yesterday’s news.

Just two months ago, Europe’s sovereign debt problems seemed grave enough to imperil the global economic recovery; buy cialis online.Now buy cialis online, at least some investors are treating it as the crisis that wasn’t.

The article goes on to quote Jean-Claude Trichet sniffing over the “tendency among some investors and market participants to underestimate Europe’s ability to take bold decisions.”  Of course I’d be more impressed with Trichet’s comments if pretty much the same thing hadn’t been said before nearly every previous crisis. Before the decade ends, I am pretty convinced, there will be several countries, including European, struggling with the process of debt restructuring, and some of the victims will surprise us.

The second statement I think I can make with some confidence is that there is no threshold debt level that indicates a country is in trouble.  Many things matter when evaluating a country’s creditworthiness.

As a rule anything that increases the chance of a sustained mismatch between earnings and debt servicing undermines the creditworthiness of the borrower.  But what really matters is not the expected outcome so much as the probability of an extreme outcome.  The expected variance, in other words, is more important than the mean expectation, which is another way of saying that a country with less debt and more variance can be a lot riskier than a country with more debt and less variance.

What are the risk factors?

I would argue that there are at least five important factors in determining the likelihood that a country will be suspend or renegotiate certain types of debt:

1 – buy cialis online.Of course debt levels – perhaps measured as total debt to GDP or external debt to exports – matter.  As a general rule buy cialis online, the more debt you have, the more difficulty you are going to have servicing it.

But we shouldn’t get too caught up in nominal debt levels.  Coupons matter too.  So, for example, as part of the Brady restructuring of the 1990s, most loans were exchanged either for “discount bonds”, which included an explicit amount of debt forgiveness via a reduction in principle, or “par bonds” which included no explicit reduction in principle, but the coupon was reduced.

In fact par bonds and discount bonds implied the same real amount of debt forgiveness, but this debt forgiveness did not show up as a lower nominal debt level in the case of the par bonds.  It showed up as a lower nominal coupon.

This Brady-bond talk may seem largely academic, but it has a very important modern-day implication.  It means that financial repression also matters a lot – even though it gets little attention in discussions about sovereign credit risk.  In some countries, most notably Japan and China, interest rates are set artificially low – much lower than they would be by the market.  Local central banks can do this because the financial systems in these countries are heavily banked (i.e.most savings and financing occur through the banking system), there are few investment alternatives, and the financial authorities determine deposit and lending rates.

Forcing down interest rates in this way has exactly the same effect as the lowered coupons on the “par bonds” described above.  It implies significant (and hidden) debt forgiveness, so when we look at Japanese and Chinese debt-to-GDP ratios we must remember that we should conceptually reduce the nominal debt levels to reflect the fact that the interest coupon is artificially low – perhaps reducing nominal debt by as much as 30-50%.

This is why Japan was able to raise its nominal debt level to what seemed unimaginably high (and why if it is ever forced to raise interest rates to a more reasonable level, it will face real difficulty), and why although I believe China has a debt problem, I do not believe this problem will show up in the form of a banking or sovereign debt crisis (instead it will show up as lower consumption, as I explain in my July 4 post).

2.The structure of the balance sheet matters, and this may be much more important than the actual level of debt – buy cialis online. In my book I distinguished between “inverted” debt and hedged debt.  With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times.  With hedged debt, they are negatively correlated.

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline.  This makes the good times better, and the bad times worse. Long-term fixed-rate local-currency borrowing is an example of hedged debt.  During an inflation or currency crisis buy cialis online, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become.

Inverted debt structures leave a country extremely vulnerable to debt crises, while hedged debt helps dissipate external shocks.  Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.  I discuss this a little more below when I talk about virtuous and vicious cycles.

3.The economy’s underlying volatility matters. Less volatile economies can safely bear more debt because their earnings are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability.  This is especially a problem for countries whose economies are highly dependent on commodities.  Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse.

This is a deadly combination for highly indebted economies with big commodity sectors.  Commodity importers, however, benefit because their volatility is negatively correlated to market conditions (unless of course they have stockpiled commodity prices in a misguided decision to “hedge” themselves – effectively reinforcing inversion in their balance sheet).

It is possible to create a measure that adjusts debt levels according to underlying economic volatility.  The first academic piece I ever published, in 1993 I think, looked at 1975-80 external-debt-to-export ratios for a number of developing countries and found no predictive ability.  In other words if you had used these ratios back then to predict which countries would have defaulted on their external debt in the 1980s and which didn’t, you would have done no better than if you simply tossed a coin.

But when I used an option formula to adjust the ratios to incorporate the volatility of their export earnings, suddenly the predictive ability of the adjusted ratios became extremely good.  The more volatile the country’s export earnings, in other words, the more likely it was to default for any given amount of external debt.

4 – buy cialis online. Buy cialis online: the structure of the investor base matters. In my opinion contagion is caused not so much by “fear”, as most people assume, but by large amounts of highly leveraged positions (including leverage through forwards, options, and leveraged notes), which force investors into various forms of “delta hedging” – i.e.buy when prices rise, and sell when they drop.

This kind of trading strategy automatically reinforces price movements both up and down and spreads them across asset classes.  Highly leveraged markets are highly susceptible to contagion, whereas markets with little imbedded leverage almost never are.

5 – buy cialis online.The composition of the investor base also matters – buy cialis online.A sovereign default is always a political decision buy cialis online, and it is easier to default if the creditors have little domestic political power or influence.  Unless foreign investors have old-fashioned gunboats, or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals.  It is also easier to “default” on households via financial repression than it is to default on wealthy and powerful locals.

One corollary, by the way, is that the total value of assets owned by a government does not matter in determining likelihood of sovereign default as much as many might assume.  Governments are not subject to corporate or bankruptcy law.  In any individual country you will often hear optimists say that in spite of high debt levels the country will not default because the government owns more assets than it has liabilities.

You should ignore this argument.  This is muddled thinking on many counts (for example how easily can you sell assets in a liquidity crisis?), but rather than go into detail, let me just point out that throughout history defaulting governments have almost always had significantly more assets than the value of their liabilities (in fact I cannot think of any exception).

There is usually, however, a significant political cost to relinquishing those assets – that is usually why the government owns them in the first place.  If that cost is greater than the cost of default, the government will default.

Beware virtuous cycles

What does all this tell us about the probability of a country’s being forced into default or restructuring?  Perhaps not much except that tables that rank countries according to their debt ratios are almost useless in measuring the likelihood of default.  This would be true even if those rankings were accurate, but not surprisingly countries hide a lot of their real obligations, and the riskier they are the more likely they are to hide them, so the inaccuracy is always biased in the wrong direction.

It also suggests that investors really need to look very carefully into each country’s underlying economic volatility and, most importantly, the country’s debt structure, since the structure of the balance sheet, and the correlation between asset values and liability values, may actually be more important than the outstanding amount of debt.  Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong.

Lots of hidden and off-balance sheet debt is also a very bright red flag, because these structures nearly always implode just when economic conditions sour.  One of the main points of the IADB’s Living with Debt (2006) is that nominal debt levels just before a crisis often seem reasonable, but suddenly surge because of an unexpected (but easily predictable in retrospect) explosion in contingent liabilities.

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets.  These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated.

Remember this when someone argues that Country X is doing very well and has even locked itself into a virtuous cycle, in which a good event causes other good events that are self-reinforcing.  There are few things as risky as highly virtuous cycles, which are almost always caused by inverted balance sheets.  Many of my Brazilian friends, for example, wince whenever they hear about virtuous cycles, because they know first hand how virtuous cycles can quickly collapse into vicious cycles.

Until 1997, for example, Brazil’s biggest credit problem was its huge fiscal deficit, more than 100% of which was explained by interest payments on short-term debt.  As global conditions improved during the middle of the decade, Brazil was caught up in a powerful virtuous cycle.  The improving external position caused local interest rates to decline, which dramatically reduced the projected fiscal deficit, and so boosted confidence, causing interest rates to decline even more.

Inverted structures are toxic

It was wonderful – and happening very quickly – with real interest rates dropping from the 30-40% range to the 20-25% range in a matter of two or three years.  But the 1998 crisis set off a devastating reversal of that process.

A global flight to quality caused Brazilian interest rates to rise.  Rising rates dramatically pushed up the government deficit (the financial authorities had not bothered to lock in the low rates, believing that the game would go on until domestic interest rates were at an “acceptable” rate), which caused confidence to drop.  Declining confidence forced interest rates higher, and so on with the result that interest rates spiraled out of control as each event reinforced the other.  Brazil was forced into a currency crisis in January 1999.

It was a similar process for the countries participating in the Asian crisis of 1997.  During the early and mid 1990s it seemed obviously clever to borrow in dollars to fund local operations since dollar interest rates were much lower than local currency rates, and moreover the dollar was depreciating in real terms.  The more locals borrowed dollars and converted into local currency, the more local asset markets boomed and the lower the real cost of the financing (compared to borrowing in local currency).

It seemed like such an easy way to make money, until it stopped.  At some point the risk caused by the massive currency mismatch (a highly inverted structure) became unbearable and the market went into reverse.  Suddenly, and just as local asset markets were collapsing because of capital flight, so did the value of the local currency.

With the collapse of local currency values, all the once-cheap dollar debt went toxic, soaring in relative terms until one company after another faced bankruptcy.  Of course each company made overall conditions worse by trying to hedge its dollar debt – buying dollars simply pushed local currency even lower, and increased the cost of the dollar debt.

The Asian wreck was magnified by another inverted debt structure: asset-based loans in the banking sector.  When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e.loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise.

Buy cialis online: but once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.  The fact that this has happened a million times before, most spectacularly in Japan in the 1980s, never seemed to affect anyone’s evaluation of the risks.

The extent of the carnage in Asia shocked everyone, but it shouldn’t have.  We were lulled into overconfidence precisely because balance sheets were so inverted, and made good times so much better, but the very fact of the inversion determined the speed and violence of the balance sheet contraction.

So who is at risk?

If investors want to know, then, which countries are vulnerable, they should look not just at overall debt levels, but also at the relationship between liability and asset values and the ways in which leverage among investors tie different markets together.  They must determine, in other words, the extent to which when things go bad they all go bad at once.

And they shouldn’t forget to consider how the political pain will be distributed.  If you were a policymaker in some southern or eastern European country, for example, would you be more worried about very high levels of domestic unemployment persisting for several years, or about the risk of causing deep damage to German or French banks?

No hate mail, please, I am just asking, but I did notice an article in Monday’s Financial Times which reports that a number of senior officials from very large European banks are terribly worried that “the stress test exercise of 91 banks will produce a skewed league table of institutions based on misinformed comparisons of financial strength.”

The banks in question are generally recognised to be among those that will pass the test.  “It is not a question of whether we will pass,” said one finance director.“It is that the market will compare our stressed capital ratio with others that have been calculated in an entirely different but untransparent way.”

It’s not that I don’t sympathize – when people dislike me I, too, worry that they’ve simply been misinformed.  My European friends in the know, however, seem more worried that the “stress” conditions, about which we are given next to no information, are not nearly stressful enough, and may not sufficiently distinguish between good sovereign holdings and bad ones.  I guess we’ll know Friday.  The FT article reports however that “even some regulators admit in private that the process has been chaotic and could backfire.”

Now there’s a confidence booster.

The Greek crisis may in many ways seem unprecedented, but of course it isn’t. I think by now everyone already knows that Greece has spent much of the past 200 years – more than half by some counts – in default or in one form or another of debt restructuring, but in fact there are plenty of other periods of sovereign default and restructuring that can tell us something about what is happening and what will happen; online viagra. I would suggest that there at least five things we can “predict” with some degree of confidence from looking at historical precedents:

1 – online viagra. The euro will not survive in its current form.

We should always have been skeptical about the survivability of the euro.  There is a history of currency unions from which we can draw two reasonable conclusions.  First, without fiscal integration such as occurred in the US after the Civil War or in the German Customs Union under Prussian dominance, currency unions are no more permanent than other forms of monetary integration, such as adherence to gold or silver standards – online viagra.

Without robust mechanisms to absorb imbalances that emerge in different parts of the economy, and Europe embodies many very different economies, countries normally are forced to rely on monetary adjustment.  The European currency union eliminates this type of adjustment mechanism, leaving countries with only two, brutally difficult options for adjustment besides opting out –  sovereign default or long periods of deflation and unemployment.

So along with very high levels of capital mobility (which Europe possesses to some extent) and labor mobility (of which it has much less), Europe also needed to assign a substantial amount of fiscal sovereignty to some entity.  I have already explained elsewhere why I think this was always very unlikely.  Difficult as it might be, opting out of the euro is likely to be much less unpalatable for many countries than sovereign default or long periods of high unemployment.

Second, when currency unions are successful, it is almost always during periods of rising global liquidity and expanding international capital flows – online viagra.  Online viagra: no currency union has been able to survive the great monetary contractions that spell the end of a globalization period.  The 19th Century’s Latin Monetary Union and the Scandinavian Monetary Union, to take the most obvious examples, were both once considered great successes, but were forced into retreat when global monetary conditions turned sour.

So when will countries opt out of the euro?  Ernest Hemingway once described the process of going broke as “Slowly. Online viagra: then all at once.”  That is not a very precise description, I know, but I would guess that support for the euro will erode very slowly until suddenly it seems inevitable and then the process will happen breathtakingly quickly.

2. This is the big one

One of the myths that we often hear repeated is that financial crises have been occurring with increased frequency in the past one or two decades.  Online viagra: i think we only believe this because we remember the big crises of the past, which seem to occur every twenty to thirty years, and then look back all crises of the past two decades – Mexico in 1994, East Asia in 1997, LTCM and Russia in 1998, Brazil in 1999, the Internet Bubble in 2000, the Sub-Prime crisis in 2007, and Greece in 2010 – and conclude that there are an awful lot more crises nowadays.

But in my book, The Volatility Machine, I made sure to distinguish between the short-term liquidity crises that occur within globalization cycles, of which there are a lot and seemed to occur every two or three years, and the long-term liquidity contractions that spell the end of each of the major globalization cycles. The former can be brutal online viagra, but they are usually short-lived and the overall market recovers very quickly.

So, for example, although most of us know that the world experienced a deep and long-lasting crisis in 1873, which began a long period of contracting international trade, reduced capital flows, and the massive bankruptcies of the high technology companies of the period, including most notably the railroads, very few people seem to know about the Overend Gurney crisis of 1866, which seemed pretty horrific at the time but from which the markets recovered fairly quickly. Likewise the great and well-known LDC debt crisis beginning in 1982 was preceded by several smaller crises, most importantly I think in 1976 by a Mexican peso crisis, which two years later had all but been forgotten by the market.

In my opinion the current set of crises, beginning with the sub-prime crisis in the US and spreading throughout the world, is not a short-term liquidity crisis like LTCM, the Asian Crisis, or the Mexican crisis of 1994. I think this is likely to be one of those big events, one that represents a major re-adjustment in the world during which time the massive imbalances that had been built up during the long globalization cycle that started around the late 1980s and early 1990s are finally worked out.

Not only will Greece, in other words, get worse, but it is by no means the end of the crisis – online viagra.  Online viagra: a lot more countries in Southern Europe, Latin America and Asia are going to be caught up in this before it ends.

3.  Online viagra: the European crisis will be accompanied by a trade shock.

Online viagra: in the early 1980s Latin America countries were suddenly cut off from funding during what was subsequently called the LDC Debt Crisis, or the Lost Decade.  These countries had been running large current account deficits, and of course current account deficits require capital account surpluses.  These surpluses were financed by the the huge petrodollar recycling of the 1970s, when commercial banks around the world made staggeringly large loans to many developing countries.

Of course after 1981-82 it became clear that the loans exceeded the repayment capacity of the borrowing countries, and suddenly financing dried up – almost overnight.  What’s worse, the debt crisis had already been preceded by flight capital, so that when financing dried up, a capital account surplus quickly became a capital account deficit.  Of course once Latin America began to experience capital outflows, its trade deficit necessarily had to become a trade surplus.  This is exactly what happened.

The deficit countries of Europe, whose combined trade deficits are nearly two-thirds the size of the US trade deficit, will also be forced into a rapid contraction in their trade deficits for the very same reasons – they are going to find it hard enough simply to refinance themselves, let alone receive net capital inflows; online viagra. Online viagra: without a capital account surplus, however, they simply cannot run current account deficits.  This contraction must, one way or another, be absorbed by the very unwilling rest of the world.  I describe what this will entail in a May 19 entry.

4. The economic recovery in the countries hit by crisis will not begin until they are recognized as insolvent and receive debt forgiveness from their creditors; online viagra.

Preceding every sovereign default is the fiction that the obligor country is simply facing a short-term financing problem, and that with a lot of discipline and a little bit of good will it will be able to work its way out of the crisis.  During this period a number of restructuring “solutions” are proposed – all of which involve increasing debt, and often in the most financially destabilising way – which inevitably make the final resolution of the crisis much more difficult and which sharply raise financial distress costs.  The most notorious recent example of these terrible “solutions” was Argentina’s disastrous debt swap in 2001, in which it dramatically increased the country’s total obligations while it desperately tried to maintain the fiction that it could somehow grow its way out of its impossible debt burden.

Greece, and probably two or three other countries, simply cannot repay their outstanding debt amounts.  Ultimately they are going to default, and then in the restructuring process they will receive enough debt forgiveness that allows them to return to a sound footing and with a reasonable repayment prospect.  But as long as they maintain the pretence that they can and will repay the full outstanding amount, and struggle with the burden, the resulting distortions in the economy will mean that businesses will disinvest and the country will not grow; online viagra.

Online viagra: historical precedence makes it clear that as long as the sovereign borrower is forced to struggle with an unrepayable debt burden, it will not grow.Eventually, as has happened in nearly every previous case, creditors and borrowers will acknowledge reality and will work out a debt forgiveness plan that will allow the economy to return to growth.  Until then, expect weak growth, high unemployment, and constant battles over debt.

How long will it take for the world to recognize the inevitable?  That leads us to the fifth thing we can learn from historical precedents.

5; online viagra. Greece’s insolvency will not be recognized for many years.

When most of the obligations of an insolvent sovereign were widely dispersed among a wide variety of bondholders, market forces acted relatively quickly to force debt forgiveness.  Defaulted bonds trade at deep discounts, and it is a lot easier for someone who bought the debt at one-quarter its face value to agree to 50% debt forgiveness than for someone who made the original loan.

But things are different with the current crop of insolvent European sovereign debts, as they were with the sovereign loans of the 1970s.  They are heavily concentrated within the banking system, and the banks cannot recognize the losses without themselves collapsing into insolvency; online viagra.

That cannot be allowed to happen.  The LDC debt crisis of the 1980s raged on nearly a full decade – a decade of stopped payments online viagra, capital flight, and agonizingly low growth – before creditors formally acknowledged that most struggling borrowers could not repay their debt and would need partial debt forgiveness.  The first formal recognition of debt forgiveness occurred with Mexico’s Brady Plan restructuring in 1990.  Growth returned to most countries only after it became clear that they would receive debt forgiveness.

Why did it take so long? Were the banks stupid?  No, banks knew full well that they weren’t going to get their money back as early as the mid-1980s, but to have acknowledge this would have required them to set aside more capital to absorb the losses than most of them possessed.  The recognition of the obvious had to wait nearly a full decade so that banks could build a sufficient capital cushion to absorb the losses.

So too with the European crisis.  Much of the Greek debt is held by European banks, and they simply do not have enough capital to absorb losses on Greek debt, let alone if Greece were to be joined by Portugal, Spain and others.  The banks will need first to rebuild their capital bases before they can admit the obvious, and this could take several years.

So we are condemned to spend much of the next decade postponing a resolution of the crisis while banks rebuild their capital base.  Until they do, we will all pretend that Greece isn’t insolvent and that other European countries will not face a crisis.   Meanwhile none of these countries will be able to grow.

At first all this might not seem to be a subject to fit into a blog called “China financial markets,” but aside from personal interest – I was born in Spain, and spent most of my youth there (and my family still lives there) – what happens to the euro will matter to China.  Weakness in the euro will make a US export adjustment much more difficult, and this will increase trade tensions between China and the US.  More intriguingly, the trade imbalance within Europe that is at the heart of the euro crisis is replicated globally, and is just as much at the heart of the global crisis.  Both are going to be equally difficult to resolve.

On this subject I recently called a Spanish friend of mine who studied in the US and currently lives in China.  He likes living in China a lot but has often thought about returning to Spain and beginning a career in politics.  During the call I told him that if he ever wanted to do so, now was the time.  There are two issues which I am certain will move to the center of the political debate in Spain within a few years, and if he were to stake out radical positions on both positions now, his prestige and visibility would quickly soar.

The first issue is Germany’s role in the crisis.  Cialis on line: i am convinced that over the next few years, fairly or unfairly there will be a crescendo of blame directed at Germany and German policies, and this ire will be magnified by the fact that many Germans seem oblivious to their role in the crisis.  The German press in fact seems to delight in wagging a disapproving finger at the shameless profligacy of the south, and this can’t make southerners very happy.

Blame Germany

Critics of Germany will argue that this moralistic posturing is thoroughly misplaced. European monetary policy, which was driven largely by Germany, was incompatible with German trade and labor policies that effectively suppressed German consumption, forced a large trade surplus onto its neighbors, and together made a southern European debt crisis almost inevitable.

The strong euro and burgeoning liquidity it brought on meant that much of Germany’s trade surplus had to be absorbed within the eurozone, forcing especially southern Europe into high trade deficits.  These deficits were dismissed, very foolishly it turns out, and against all historical precedents, as being easily managed as long as the sanctity of the euro was maintained.  A very false analogy was made with the US, in which it was argued that because European countries all use the same currency, trade imbalances within Europe are sustainable in the same way they are sustainable between states in the US.

But states in the US are not like states in Europe – cialis on line. Labor and capital mobility in Europe is very low compared to the US cialis on line, and the Civil War in the US ensured that sovereignty, including most importantly fiscal sovereignty, resided in Washington DC, and not in the various state capitals.  The US is clearly as much an optimal currency zone as any large economy can be.

This isn’t the case in Europe.  In fact I would argue that the existence of a common currency in Europe, the euro, is only a little more meaningful than the existence of various currencies under the gold standard, and it was pretty obvious under the gold standard that balance of payments crises could indeed exist.

So why not also in Europe under the euro?  As I see it, domestic German policies, perhaps aimed at absorbing East German unemployment, forced a structural trade surplus.  The strong euro, along with the automatic recycling of Germany’s large trade surplus within Europe, ensured the corresponding trade deficits in the rest of Europe – unless Europeans were willing to enact policies that raised unemployment in order to counter the deficits. As long as the ECB refused to raise interest rates, southern Europe had to accept asset bubbles and rapidly rising debt-fueled consumption.

This couldn’t go on forever, or even for very long.  Now southern Europe is paying the inevitable price, and of course the moralists are accusing the south of being shiftless and lazy, confusing the automatic balancing mechanisms in the balance of payments with moral weakness.

This is not to say that it is all Germany’s fault (although I’m sure I will be accused of making this claim anyway), but rather that the existence of the euro seriously exacerbated the problem by making it very difficult for certain countries to adjust to Germany’s domestic policies, which generated employment growth at home at the expense of Germany’s trading partners; cialis on line. There is no question that a long history of fiscal irresponsibility in southern Europe made things much worse cialis on line, but the imbalance could have never gotten so large without Germany’s role, and since in a crisis it is always easier to blame foreigners, bashing Germans will become a very popular sport in much of Europe.

Abandon the euro

The second issue that will divide Spanish politics of course is Spain’s future within the monetary union.  Spain simply cannot remain within the euro without making radical political changes.  American economist Barry Eichengreen argued in his book on monetary policies during the 1920s and 1930s, Golden Fetters (a book I never tire of recommending), that the democratic enfranchisement of workers made a return to the gold standard impossible because workers, who had traditionally borne most of the burden of gold-standard adjustment through rising unemployment, would no longer passively accept those policies.

Spain is in just such a position.  Although most Spanish politicians continue to insist that Spain’s joining the euro is irreversible and a symbol of its modernity, in order to adjust within the euro I suspect that Spain is going to have to suffer unemployment of 20% or more for several years.  Spanish voters, correctly in my opinion, will not tolerate such an outcome.

The argument will be made by establishment politicians that to reject the euro will be seen as an indication of contemptible irresponsibility and will condemn Spain to developing-country status for the foreseeable future.  Without the euro, Spain is a third-world nation, they will insist, and because many Spaniards are still sufficiently insecure about their status as “real” Europeans, this criticism will carry some emotional weight.

But the strength of this argument can only survive a few years of high unemployment. It was the same argument made, by the way, in France in the 1920s, when the value of the franc collapsed against other currencies, and the dour governor of the Bank of France, Emile Moreau, was forced to re-establish the link between gold and the franc in 1928 at a humiliating 80% discount to the pre-war parity.

I am not sure France’s subsequent experience justified the negative assessment.  France struggled after the huge inflation of World War 1 to return to the pre-war gold parity and its economy suffered badly in the process. Bankers and the rich argued that maintaining the old pre-war parity was vital to France’s international standing, but to no avail.  The cost was too high.  France had no choice but to accept a devalued franc, while the rest of the world poured scorn on France for its spineless irresponsibility and predicted economic disaster.

But they were wrong.  During the period of franc weakness France had regained its competitiveness and became one of the stronger economies in Europe, while those who had condemned France’s spinelessness were forced into their own humiliating devaluations after struggling mightily with unemployment and economic contraction.  France also had a milder experience during the depression of the 1930s than other large economies, although as other countries devalued their own currencies against gold, France lost its competitiveness and slid into deeper economic contraction.

The virtues of irresponsible behavior

In fact by my reading it seems that during the 1920s many of those countries that were quickest to behave “irresponsibly” – to recognize that orthodox monetary policies were untenable – suffered the least during the subsequent years of the great economic crisis.  This is not a vote for beggar-thy-neighbor devaluations, by the way, although it may seem like that; cialis on line. Rather it is a vote for recognizing when monetary conditions cannot be maintained, and then acting quickly to resolve them. The foreign exchange rate value of the currency matters.

Like France in the 1920s, the sooner Spain – and by extension the rest of southern Europe – admits that current monetary conditions are untenable, the less damage it is likely to suffer.  The current system, in which fiscal authority is concentrated in Madrid and monetary policy is determined by the needs of the euro, will create insurmountable political opposition as many years of high unemployment turn the population to more radical solutions.

Spain will almost certainly have to choose.  Either it gives up fiscal sovereignty – including, most importantly, taxation authority – to Brussels, or it gives up the euro.  The alternative, several years of difficult adjustment borne mostly by workers, is politically unlikely.

Can Spain give up fiscal sovereignty?  Actually that might be easier than many people think.  Already there are strong separatist movements in many parts of Spain, and a number of regional governments might be happy to reassign sovereignty from Madrid to Brussels in exchange for real relief from the burden of adjustment.  I would imagine that Catalunya and Euskadi (the Basque provinces) would not find it so difficult if economic conditions deteriorated.  Other regions are also likely to consider it a viable prospect.

The problem with this strategy might actually be Germany.  Although one can posit a scenario in which regions in Spain and other southern economies (for example Italy, with its own regionalist movements, especially in the north) reassign sovereignty to Brussels, unless Germany does the same the viability of a United States of Europe would be doubtful.  It is hard for me to imagine, however, a situation in which Germany assigns fiscal sovereignty to Brussels.  In that case the only real European entity with any chance of viability might be the United States of Germany.

Could this happen, and European regions assign sovereignty to Berlin?  Maybe, but aside from the near impossibility of imagining France agreeing to a United States of Germany, if I am right about rising anti-German feeling in many parts of Europe, this will make it tough even for the smaller countries to swallow the prospect.

So these are the options as I see them; cialis on line. Spain might choose closer integration into Europe, including giving up fiscal and tax sovereignty, although it is not clear which European entity this would entail. Spain might choose to disenfranchise the working class, but the probability of this is close to zero, I think, and would be morally unthinkable.  Cialis on line: or Spain might choose to give up the euro.  This is just another restatement of Dani Rodrik’s “inescapable trilemma of the world economy”, by the way.

If you do decide to follow my advice, I told my Spanish friend, I wouldn’t bet too heavily on the first two outcomes.  It would be much safer politically to become vociferously anti-German and to demand that Spain exit the euro.  It might be a little sleazy, but it would lead to a very exciting political career, and isn’t a certain amount of sleaziness useful to a politician?

It may seem strange to be reading an August article in March, but in fact I often find myself a year or more behind in my reading.  This may seem a little perverse, but it does let me see what the smartest people were thinking at the time while knowing what subsequently happened.  Among other things this makes it clear how often informed consensus gets bogged down in the minutiae of everyday events while trying to understand the bigger picture.

In the case of this particular article, however, what triggered my interest is that it was about Japan’s post-1989 rebalancing, and among other things discusses why, in spite of every attempt, Japan has not been able supposedly to rebalance the economy and achieve any real growth during the two lost decades after 1990.  Private consumption never took off to drive economic growth.

Many of these reasons for low consumption we have heard before, and no doubt will hear again, but I am not sure how meaningful they are.  According to the article, the Japanese don’t take enough holidays, they are aging, exporters squirrel away profits to replace households as a source of savings, small companies are too inefficient, government supports big business, the Japanese don’t like to borrow, house prices are too high, and so on.  Maybe these really are the causes of the failure for the surge in consumption, but many sound like variations on accounting identities, and as such they are as likely to be consequences as causes of low growth.

But what interested me is that in spite of the fact that Japan’s economy didn’t grow, and contrary to the article’s claim, some serious rebalancing actually did take place, at least as I understand it.  Japanese gross national savings declined from around 35% of GDP in 1990 to around 23% last year.  The household savings rate dropped too, from around 10% in the 1990s to around 2%.  Neither declined in a straight line, but decline they undoubtedly did.

Household consumption, according to the article, nonetheless failed to grow meaningfully – in the past two decades it only grew by 1-2% annually – and this is much lower, presumably, than consumption growth in the 1980s.

But it was nonetheless higher than GDP growth, and that is exactly the point: consumption growth may have been low, but it exceeded GDP growth.  Rebalancing in the context of Japan (and China) does not mean that consumption growth must surge.  It just means that consumption must grow faster than the economy so as to become a bigger share of GDP and a bigger driver of total growth.  Put another way, it means that the savings rate must decline.  If this is what actually happened, then in fact Japan did partly rebalance.

But, mysteriously, in spite of the fact that Japan may have experienced real rebalancing and a real growth in the relative share of household consumption, the Japanese economy stagnated during the past two decades.  If you had predicted in 1990 that Japanese household and national savings would have declined so sharply as a share of GDP, and that consumption would have risen, you probably also would have predicted that Japan, after a couple of tough years, would resume rapid growth (or at least growth more in line with other rich economies) as surging private consumption pulled Japanese growth forward and away from its over-reliance on net exports.

But you would have been wrong on two counts. First, Japan did not grow very quickly at all; cialis.It stagnated as consumption growth actually declined.  Second, its reliance on net exports did not decline; cialis. The current account surplus remained high as a share of GDP.

Why didn’t Japan grow more quickly?  One reason may be obvious from the very fact that the current account surplus did not decline.  Although Japan certainly rebalanced by some measures, its current account surplus dropped from its peak of 4.2% of GDP in 1986 to 1.5% at its trough in 1996, only to turn around and surge, eventually to reach 4.8% in 2007, dropping to 3.1% in 2008 on the back of the collapse in international trade (and albeit on a much smaller economy as a share of global GDP than in 1990).

Since the current account surplus is another name for the excess of savings over investment, obviously this means that national investment declined as sharply as did national savings.  The article helpfully provides us with the numbers for both in an accompanying graph, and this confirms that investment indeed dropped, from a peak of around 32-3% in 1990 to around 22% last year.

With investment such an important part of Japanese growth prior to the bursting of the bubble, the fact that it declined so dramatically seems to have had a huge impact on Japan’s subsequent lack of growth.  So although in some important ways Japan “rebalanced”, for two decades it was nonetheless unable to grow even with a still-very-high and rising trade surplus, largely because investment declined sharply.

I am not an expert on Japan by any means, even though in the past two years I have been giving myself a crash course on recent Japanese economic history, but my Asian-development-model story suggests at least one explanation of what happened.  After many years of excess investment driving growth, Japan’s rebalancing process, which occurred after corporate, bank and government debt levels prevented the investment party from continuing, locked the country into many years of slow growth because it had to grind through years of debt-fueled overinvestment.

In fact Japanese investment jumped in the last two years of the 1980s, after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth, from an already-high 28% to nearly 33% three years later.  In other words Tokyo seems to have responded to the collapse in the US by increasing its already-high level of investment to counteract the impact on the trade surplus.  This is what happened in China too, after the 2007-08 banking crisis in the US.  This jump in investment seems to have kept Japanese growth going solidly for another two years after the current account surplus began its steep nine-year decline.

But growth in investment wasn’t maintained.  After 1990, when investment growth could no longer keep up, perhaps because Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.

The government tried to continue subsidizing growth over the subsequent decades by keeping both wage growth and interest rates low, not to mention maintaining the undervalued currency, as we know.  This unfortunately may have slowed the growth of both household income and household consumption, while maintaining the high trade surplus.  This also may explain why the drop in household savings was partly matched by the rise in corporate savings – households continued seeing transfers of income to the corporate sector.

But ultimately in spite of maintaining some of the old trade-related policies that kept manufacturing growth so strong for so long, there was nothing Tokyo could do to combat the effects of the decline in investment.  Had they allowed a more rapid rebalancing via higher wages, interest rates and the currency in the first two or three years, perhaps they would have had a tougher time early in the 1990s, and a lot more liquidations, but ultimately they might have pulled out of the slump a lot sooner because they would have transferred income to households more rapidly (although of course had they done this too aggressively, unemployment would have soared and consumption collapsed).

So where am I going with all this?  I am not completely sure, and no doubt I am oversimplifying the Japanese story.  Certainly I am not smart enough to figure out all the inner workings of Japan’s economy.  Just trying to keep the accounting identities in line and, making sure that everything that is supposed to balance actually does balance, is tough enough.

But this macro approach might have some benefit in that it shows how the overall system can constrain the micro-developments that we all hope for.  At the macro level, in other words, it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector, as they did not in Japan – cialis. Rebalancing must occur cialis, but as an accounting-identify matter it can occur both through good ways (a surge in consumption) and bad ways (a drop in growth).

In Japan it occurred the latter way.  Cialis: without a serious attempt to redistribute income more rapidly back to households, Japan rebalanced, but not via a surge in consumption.  Since it could not maintain investment levels, on which the economy was too dependent, and in fact increasingly dependent after 1987, it rebalanced via a sharp slowdown in growth.  Either way achieves rebalancing – which only means that consumption has to grow as a share of GDP – but of course the former is much better than the latter.

Japan’s experience suggests one of the risks China faces.  It is easy to talk about rebalancing as a solution to the underlying problem China faces, but as the Economist article points out, rebalancing can be “tricky,” and it does not lead automatically to growth – that depends to a significant extent on how quickly consumption grows, and can take many years before that happens.

Will China rebalance?  Of course it will.  It is not a question of if but rather of how.  The same was true of Japan.  No economy the size of China’s can be so heavily dependent on exports to absorb its excess production, especially once unemployment in the rich countries reaches significant levels.  And no large economy can keep investment rates so high – and the allocation process so constrained by governance issues – for very long without running into the problem of capital misallocation.  But there are many ways rebalancing can occur.

Chinese household consumption will undoubtedly rise as a share of Chinese GDP over the next decade or two, but the process nonetheless can be disappointing for growth.  It depends on lots of other moving parts, most importantly perhaps the change in investment and the speed with which income is transferred to households.  And the change in investment might depend on debt capacity constraints and the extent of earlier overinvestment.

This has some relevance to China’s long-term economic and social prospects, and is a topic that I have discussed a lot with my students.  In fact it is almost a subtext in Frederic Wakeman´s book.  To put it simply, one of the great strengths of the US is its ability to change quickly and dramatically, even though this ability necessarily comes with a sometimes brutal insensitivity to the short-term social costs of the change.  As Manzi puts it,

An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. Buy viagra online no prescription: this is not so much a matter of anti-market ideology as of the painful realities of economic change.Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.

It is therefore natural for people to organize to prevent the spread of significant innovation; buy viagra online no prescription.The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms – buy viagra online no prescription.In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation – buy viagra online no prescription.It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition – buy viagra online no prescription.But for that economy to prosper, the unease and opposition must be overcome.

A big question for me is how China decides in the future to face the continuing trade-off between social stability and rapid change.  In the past it is pretty clear that China has experienced wrenching social change.  This change began from a widespread recognition during the 1970s that the Chinese model simply was not working, and that without a dramatic transformation, China was likely to collapse.  It took the brilliance of Deng Xiaoping to understand how to steer China forward without risking an even worse crisis, and the economic rewards for this transformation have been dramatic, even as the social cost of such rapid change has put increasing pressure on the political and social systems of the country.  How is China likely to face the continuing trade-off in the future?

This is not just an abstract and very macro question.  It addresses much more specific things such as the liquidation process following a financial crisis.  For example, if we were to see a break in the housing bubble, there are broadly speaking two ways to address the problem.  The so-called “Anglo-Saxon” model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses – buy viagra online no prescription. 

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger. Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the “Japanese” model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers’ expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful.

When I discuss this with my students at Peking University their responses, not surprisingly, vary.  A number of them insist that Chinese have learned long ago to suffer disruption, and they will be forced to continue absorbing the costs of change since there is a widespread consensus among the leadership that China must continue in its forward rush.  Others, the majority, think that although socially the Chinese are used to absorbing the cost of rapid social change, the political system itself is less able to do so.  Most interestingly to me is that whenever we have these discussions it becomes pretty clear to me that for most of my students our discussions are not the first time they have thought of this or related issues.  This is something that many students, at least within the elite schools, have thought about.

This discussion extends into the whole issue of financial reform, and not just for China.  Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.  Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect “Anglo-Saxon” financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms – buy viagra online no prescription.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up – buy viagra online no prescription.which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn’t matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the “Anglo-Saxon” model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim “Never again!”  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during “normal” periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy; buy viagra online no prescription.  Buy viagra online no prescription: so in China’s case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.  Buy viagra online no prescription: china´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth.  But no matter how well-designed it is, the regulators should have a plan for the inevitable crisis, because it will come.  The interesting question is not how China can avoid problems, but rather how it should deal with them when they come.

There was something else I thought was interesting in Manzi’s article discussed at the beginning of this entry.  The graph below reproduces data about the recent history of manufacturing in the US.  One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power.  The US used to make real “stuff”, according to this argument, but now it no longer does so.  What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.

The huge (and hugely disruptive) surge in manufacturing productivity in the last sixty years has dramatically reduced the share of American workers employed in manufacturing, but manufacturing’s share of GDP has barely budged. 

The decline in US manufacturing labor has created a sense of crisis in manufacturing, but it mostly means that labor productivity has risen sharply.  That is unquestionably a good thing.   Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited.  China´s growth is not hollowing out US manufacturing.  There are certainly problems with imbalances that need to be addressed, but they need to be addressed rationally with a clear understanding of the difficult issues each country faces within the relationship.

By the way, and on a different subject, for those who are interested in demographics, the US Census Bureau released its latest projections.  According to the release:

China’s population is projected to peak at slightly less than 1.4 billion in 2026, both earlier and at a lower level than previously projected.Meanwhile buy viagra online no prescription, India’s population is projected to surpass China’s population in 2025, according to new data being released by the U.S.Census Bureau.  These figures come from the population estimates and projections for 227 countries and areas released today through the Census Bureau’s International Data Base.This release includes revisions for 21 countries buy viagra online no prescription, including China.

The latest projections indicate that by 2026, the population of China will begin to decline.Population growth in China buy viagra online no prescription, the world’s most populous country, is slowing and currently stands at 0.5 percent annually.China surpassed the 1.2 billion population mark in 1994 and reached 1.3 billion in 2006.  According to the latest revisions buy viagra online no prescription, India is projected to become the world’s most populous country in 2025. Buy viagra online no prescription: the population growth rate in India currently is about 1.4 percent, nearly three times that of China.The difference in the growth rate between the two countries is explained by fertility.India’s total fertility rate — the number of births a woman is expected to have in her lifetime — is currently estimated at 2.7 and projected to decline slowly buy viagra online no prescription, and that is driving population growth in the country.

The slowdown in China’s population growth is the result of declining fertility.China’s total fertility rate is estimated to have been 2.2 in 1990, 1.8 in 1995 and less than 1.6 since 2000.China’s fertility rate is currently half a birth below that of the United States buy viagra online no prescription, which is more than two births per woman.Key evidence for the new fertility estimates comes from analysis of data from China’s recent census and surveys.  One of the consequences to China’s declining fertility rate is that the number of new entrants to China’s labor force may be near its peak; buy viagra online no prescription.The population ages 20-24 is projected to peak at 124 million in 2010; buy viagra online no prescription.This peak is earlier than in India, which is projected to reach 116 million in 2024.

Despite a shrinking younger population, China’s labor force may continue to grow for several years since the population ages 20 to 59 (prime working ages) is not expected to peak until 2016 at 831 million, an increase of 24 million from the current estimated level – buy viagra online no prescription.“ Buy viagra online no prescription: these changes in China’s age structure may affect its economic growth and competitiveness in the world market,” said Daniel Goodkind, demographer in the Census Bureau’s Population Division.  Given that China and India together account for 37 percent of the world’s population, their demographic trends have major implications for worldwide population change.  The Census Bureau’s International Data Base includes projections by sex and age to 100-plus for 227 countries and other areas with populations of 5,000 or more and provides information on population size and growth, mortality, fertility and net migration.

So much for 2009.  In two days I return to Beijing in time for the crazy end-of-year festivities at D22.  I wish you all a great 2010.

Recent declines were led by financials.  Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement.  Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more “huge” losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies.  Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on. 

As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines – but this sounds like nothing more than a complicated name for a long forward position to me.  The company explained that this derivative position was to hedge a convertible they had earlier issued. 

Now let’s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me.  Selling a convertible is like selling a call option on your stock.  This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only “lose” (sell your stock below its current market value) if your underlying conditions improve – i.e – where to buy viagra online.your cost of capital declines.  That is how I define a hedge – the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.

But CHS decided to “hedge” this hedge.  In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position.  But CHS decided to go one better.  They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward – which of course implies a much higher delta – perhaps disguised with some fancy bells and whistles.  The problem is, as most finance geeks know, you don’t hedge a short call option with a nominally-equivalent long forward.  If you do, you end up with nothing but a short put position.  CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.

This is most certainly not a hedge.  On the contrary, it is a doubling up of your own bet – you make money if things go well, but if things go badly you double your losses.  I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%. 

The aim here is not to make a big deal of CHS’s exposure, but rather to point out that nearly every derivatives “hedge” I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company’s underlying business.  Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock – these range from useless to actually negative as far as hedging strategies go. 

I am sure there is a lot more of this stuff hidden under various rugs.  In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet – go long stuff that tends to outperform in a rising market flush with liquidity – and unfortunately these bets all tend to go wrong at the worst possible time; where to buy viagra online. They also indicate more serious underlying problems in the various corporate and banking portfolios. 

After all where to buy viagra online, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets?  Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses.  This was not an isolated incidence of bad luck.  These almost always go together.

Of course the stock market drop was not just all about hidden liquidity bets.  Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages.  The government is in a frenzy to stop the decline in real estate prices.  They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes. 

Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock. All of these involve trying to support prices by allowing riskier buying strategies – i.e; where to buy viagra online.more leverage.  Where to buy viagra online: the rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power.  If the problem here turns out to be small and manageable, this strategy will look very smart.  Where to buy viagra online: if it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.

Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing’s moves to boost the property market.  He lists and extends the following three:

¨          Housing transaction taxes and fees were cut at the margin.  The real estate contract tax was reduced by 0.5 percentage point to 1%.The stamp duty tax was cut from 0.05% to zero. 

¨          Starting October 27, the interest rate floor on mortgage loans will be reset to 70% of the benchmark lending rate from a level of 85%.  Given that the current benchmark lending rate is 7.47% for a 5?year term or beyond, mortgage interest rate will be cut by about 112bp. 

¨          In addition, the minimum down payment will be reset to 20% from 30% for the first residence.  The down payment ratio for a second residence was kept unchanged at 40%. 

He is not terribly optimistic that these moves will have much impact, writing that “despite these seemingly bold measures, however, we believe that they may have limited effects in stimulating demand and holding back the ongoing price corrections.”  The best the government can do, he thinks, is to slow down the housing price correction, not reverse it, and in my opinion this may actually cause more medium-term pain than a fast correction, although I suspect that we are going to see a two-tiered correction.  The formal banking system will correct Japanese style, without sudden liquidations and over a longer period, and with more wasted capacity, whereas the informal banking sector will correct much more quickly and involve liquidations.  I don’t really have any idea of how this resolves itself because I don’t have much historical knowledge of corrections in a system with such a heterodox banking system as China’s.

Let me allow Xinxin his own words as to why he isn’t terribly optimistic:

¨          Due to extremely loose monetary conditions in the past few years, excess liquidity and housing speculation have already created a significant real estate bubble – where to buy viagra online. Official figures show that prices have at least doubled since 2004, making property unaffordable for a large share of households in many big and secondary cities.  The housing price-to-income ratio in these cities remains above 10, while even at the peak level of the latest US housing bubble, the same ratio in many US cities was around 6-8.  Given the deteriorating external and domestic environment, this housing bubble may come to an end. 

¨          Now the market consensus is that average housing prices will drop by at least 20% before real demand picks up.  This 20% sounds dramatic, but a 20% drop would return prices to the level prevailing in late 2006 and early 2007.  In comparison to still-high housing prices, the marginal drop in transaction and mortgage payment costs still are quite limited steps; where to buy viagra online.

¨          From the policymaker’s perspective, the most difficult challenge is how to deal with market expectations.  If potential buyers are expecting that both housing prices and interest rates will drop further, why don’t they hold back and delay home purchase plans for a few more quarters?

¨          Moreover, there is an oversupply problem in many regional housing markets.  It is reported that in the aggressive housing expansion, real estate developers have accumulated as-yet-incomplete housing projects of 1.1bn sq meters, equivalent to China’s housing supply in the past two years.  This means it may take a couple of years for the housing market to absorb the excess stock of land and housing projects. 

I won’t quote the rest of his research report but recommend that anyone interested talk directly to him about it.  Getting the property market right is going to be key to understanding what happens next in China’s economy and financial systems.

I want to mention three other things before closing.  First, the further restructuring of the Agricultural Bank of China prior to its IPO was announced last week.  Central Huijin (a sub of the CIC) will inject $19 billion in capital in the form of equity into the bank.  I believe these will be in the form of US dollars, and ABC will not be able to convert them into RMB. 

In addition the government is creating a fund that will be managed by ABC and the MoF which will pay about $120 billion to purchase all of ABC’s NPLs.  These represent about one-quarter of the bank’s total loans but, lest anyone think the bank will emerge from this clean as a whistle, there is a lot of disagreement about whether Chinese bank NPL classifications are strict enough.  Most analysts worry that there is a lot more garbage in there, under gentler classifications, and this will become especially evident in a downturn.

If the NPL purchase (at face) is funded in the same way as the other AMC purchases, it will be funded by the purchasing fund via a bond issue guaranteed by the MoF.  I am not sure what the recovery value of these loans is likely to be, but as I understand they consist mostly of a lot of very small loans to bankrupt farmers.  One friend who understands these things better than I do says he thinks they will be lucky to get 10 cents on the dollar, and may easily get less than 5 cents.  I think NPLs at the other AMCs, which are generally considered to be of much higher quality, collected an average of 22 cents on the dollar on those portions that were sold or liquidated, but much of that consisted still of the best of the NPLs in the portfolio.

I mention this because of course the uncollectible portion should be added to the government’s debt when we calculate the total obligations of the government.  On a related note, recent government data releases show that fiscal revenue growth slowed sharply in September as corporate taxes declined and tax benefit measures increased, so that in the past two months the fiscal balance has swung into deficit (RMB 19 billion in August and RMB73 billion in September).

The second thing I wanted to say before closing is that I haven’t mentioned in a long time that one of the few blogs that I read religiously is Brad Setser’s blog.  The October 21 entry (The End of Bretton Woods II) is a particularly good entry and of obvious interest to anyone interested in China’s position in the macro-economy.  I am thoroughly convinced that it is a waste of time trying to figure out what is going to happen to China without placing it in the context of the unraveling of the old global balance-of-payments relationships and the evolution towards a new one.  China was a fundamental part of global imbalance (indeed the US-China relationship was at the heart of it), and any meaningful change will require both countries to adjust their relative positions sharply.  Brad’s blog is required reading if you want to try to figure this out.

Finally, and more as a way of introducing a little humor, let me mention a statement by Thailand’s Deputy Prime Minister, Olarn Chaipravat, about the recently completed Asia-Europe Meeting (ASEM).  “The message of this initiative” he said earlier this week, “is for China to consider whether or not China would open up its banking system and allow the strongest currency in the world, which is the Chinese yuan, relative to anybody, to be the rightful and anointed convertible currency of the world.” 

It is perhaps a little too easy to take potshots at world leaders who discuss economic and monetary issues, but I found these comments to be particularly funny.  It was always unlikely that China would open up its banking system and allow the currency to become fully convertible in such treacherous times, when it has steadfastly refused to do so when both its own economy and financial system were in better shape and the global environment was a lot more benign.  Doing so now would almost certainly cause a domestic financial collapse – where to buy viagra online. More importantly where to buy viagra online, the RMB is only “the strongest currency in the world” if you consider it to be the most undervalued.  The RMB’s rise is a function largely of its having been undervalued for so long that it caused serious monetary headaches domestically. 

Not surprisingly, the final statement issued by the 7^th ASEM contained no such revolutionary new proposals.  I think the most striking thing about it – but hardly unexpected – is that China and Asia are apparently falling behind European proposals for greater regulation of the global financial system. 

This was an inevitable consequence of the crisis – every financial crisis in modern history (and pre-modern, I suppose) leads to the same calls for stricter policing of the banks and brokers, and a ferocious attack on the structures and securities that were at the heart of the crisis, but no real discussion of what links the most recent financial crisis to the hundreds of almost identical crises that have come before it.  Where to buy viagra online: nothing changes.  It is as if this is the first time we have ever seen a financial crisis, and since this is also the first time we have seen the explosion in sup-prime loans, the surge of complex derivatives, and off-the-charts compensation for young traders, then it is pretty obvious that one caused the other.

Of course the most fun part of the aftermath of the crisis is the accompanying demand that the guilty, meaning anyone involved in the financial system, be punished.  On my flight back from Shanghai Wednesday I reread Charles MacKay’s “Extraordinary Popular Delusions…” and came upon this passage about events nearly 300 years ago:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England.He arrived on the 11th of November where to buy viagra online, and Parliament was summoned to meet on the 8th of December.In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin – where to buy viagra online.Nobody seemed to imagine that the nation itself was as culpable as the South Sea Company; where to buy viagra online.Nobody blamed the credulity and avarice of the people – the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors; where to buy viagra online.These things were never mentioned.The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

Punishment was as important as repair, and new measures to ensure that such a calamity would never again happen were, everyone agreed, vital. After the appropriate rogues were identified and punished where to buy viagra online, Parliament subsequently passed a whole series of laws to make sure no such thing ever happened again, including making it more difficult than ever for corporations like the South Sea Company to come into existence (retarding, in the opinion of most historians, the development of the Industrial Revolution), and I am pleased to say that the new rules were brilliantly conceived and England never again to this day has suffered from a financial crisis.

Just kidding.  England continued to suffer from financial crises as regularly as ever where to buy viagra online, even though each crisis brought out a new group of suspect causes that were subsequently eliminated. This time around after we’ve assigned blame we’ll have the same flurry of regulatory activity to protect ourselves from financial instability in the future.  And, weirdly enough, we will continue to have financial crises.  Where to buy viagra online: i know this sounds a little pessimistic, but history makes pessimists of us all.

Fortunately the next round of regulations probably won’t do as much harm as they have in the past, especially if it results in greater transparency and more flexibility in allowing innovation to occur within the regulated system, instead of forcing it to occur outside (although I guess I am doubtful the latter will happen).  If the new global regulations do achieve these two ends, the world’s financial systems will better function during the good times.  However even with these excellent measures they are no less likely to be susceptible in the future to renewed financial crisis. 

This is because the next crisis will inevitably be caused by another period of rapid liquidity expansion, during which time financial institutions will accommodate themselves to the excess liquidity by taking on increasingly risky structures, and in order to do so they will either innovate around the regulatory constraints, grow outside the regulated system, or lie.  This always happens, and will happen again.  But I guess that at least we can all rest happier knowing that the next crisis won’t involve sub-prime mortgages.

Speaking of Maginot lines, according to Reuters today during the ASEM meeting “Sarkozy has told Chinese President Hu Jintao that he fears the United States, which is wary of excessive regulation, would be content if the summit produced ‘principles and generalities,’ according to a French presidential official.”  I read the final ASEM release and I assume that the US is content.  My cynical Chinese friends in government tell me that because ordinary Chinese are still so angry at France over the treatment of the Olympic torch, Sarkozy is eager to build trench camaraderie with China. Bring on the new global financial order – it will make everyone feel good and it might even help a little.

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The PBoC issued 1-year bills, at 3.91%, 9bps lower than last week, and 15bps lower than the annual average 4.06% – authentic viagra online. This pushed up the market like crazy; with yields dropping some 10-20 bps for medium-term treasuries. Obviously the auction indicated that banks were eager to buy bonds. 

What else it can indicate?  Can it suggest a declining willingness to lend money out to corporations authentic viagra online, since bond market and loan market are substitute goods?  Or a great expectation of basis rate cut soon?

Shang Ning seems to have got it right. Seemingly as part of a concerted global effort to support markets, the PBoC announced later that it was cutting interest rates (for the second time in less than a month, after six years of raising rates), with the benchmark 1-year rate dropping from 27 bps to 6.93%.  The PBoC also reduced minimum reserve requirements by 50 bps to 17%.

How effective will these measures be in spurring the economy?  According to the most recent data loan growth has been slowing. I don’t have the numbers in front of me but an article last week in Caijing had this to say:

In the second half of 2008 authentic viagra online, the People’s Bank of China loosened its credit control by five percent.But July and August statistics did not show a rebound for loan growth; authentic viagra online.Even if the quota were further relaxed authentic viagra online, loan growth this year would hardly match 2007’s.

It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow. If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact; authentic viagra online. After all it hasn’t been high interest rates that have constrained borrowing in the past. We will need to watch loan growth figures closely in the next few months.

On a completely separate topic, a journalist friend of mine called me earlier today to ask me what I thought about the popular discussions about whether the current crisis marked a “paradigm shift” that would see a sharp decline in the relative power of Wall Street and London and a rise in the power of one of the Asian financial centers.  Aside from the fact that I am a little allergic to paradigm shifts, I thought this was an interesting question.  I usually get asked where the New York or Shanghai stock markets will close Friday (for the record: I don’t know). 

This is also one of those “big” questions about which I think most of the current debate is a little muddled.  To begin with, I don’t think the current crisis is a paradigm shift at all.  It is simply yet another in the sequence of crises that have marked the six (as I count them) globalization cycles of the past 200 years. Of course there will be big changes in the worlds of commerce, finance, and politics, but these changes won’t represent a brave new world so much as a reversion to a more standard world.

After all, during the great liquidity cycles that underlie the globalization cycles, we always see in the late stages a massive growth in financial transactions and the power of financial institutions – authentic viagra online. During these periods banks get larger and larger authentic viagra online, often though acquisitions and expansion abroad, and financial activity expands dramatically until it seems to become the hub of all industrial, commercial and political activity. 

But it is these late periods which are the anomaly, not the norm – authentic viagra online. Every end of a globalization period (which usually ends in crisis) we experience a sharp deleveraging and a massive reduction in speculative activity; authentic viagra online.  Authentic viagra online: along with that inevitably banks and financial markets become less central and less active. The expected decline of Wall Street and London, in other words, is not a shocking new reality but simply a reversion to more normal times – when it is not the dream of 8 out of 10 graduates of elite colleges to become investment bankers. To tell the truth when I was graduating I didn’t even now what investment bankers did; authentic viagra online. In a few years an awful lot of young graduates will be just as ignorant as I was.  That is probably not a bad thing. 

I suspect that a lot of experienced bankers, academic, and students of financial history will agree with me so far, but here is where I am going to get controversial – authentic viagra online. The debate about the “paradigm shift” seems mainly to be between those who say that the current crisis marks the relative decline of Wall Street as the center of world finance and those who argue that it will maintain its relative position.

But I think the effect of the crisis will actually increase the relative position of New York and London as world financial centers.  Why?  I say this largely because previous global financial crises were just as brutal as the current one, or even more so (1825, 1837, 1873, and 1929 were all more brutal), and yet during the subsequent years the then-global-financial-centers became more, not less, central.

Why this happened is not hard to figure out, I think – authentic viagra online. During the liquidity booms, the great advantage of the primary financial centers – the fact that they are much more liquid than other markets – is usually sharply eroded by the huge increases in liquidity, trading volumes, and financial transactions across the world, and with them, the decline in the value of liquidity.  In fact it was always during the long boom periods that secondary financial centers were able to grow in importance – just as Sao Paolo, Frankfurt, Delhi, Shanghai, Singapore, Dubai and even Hong Kong have all grown dramatically in the past 10 years.

After the booms, however, the sudden reduction in underlying liquidity and the greater value investors and issuers placed on liquid markets typically causes most of the secondary financial centers to die out as trading and issuance migrate to the deeper markets of the primary financial centers.  This is simply a form of the old traders saw – “liquidity draws liquidity.”  If liquidity truly dries up around the world and trading and issuance volumes collapse, the value for investors and users of capital of accessing New York or London will be greater, not smaller.

What about the argument that an Asian financial center will rise in relative importance?  I think this may very well happen, but it will have little or nothing to do with the current crisis. 

An Asian financial center will or will not rise depending on several factors.  These include the liquidity and value of its currency for international transaction, the strength and impartiality of its legal framework, the scope for political and regulatory independence, a clear governance framework (which implies, among other things, that managers are minimally constrained by policy needs), the size of the home market, the openness to foreign markets, the importance of financial markets (as opposed to large banks) in financing, and several other obvious and not-so-obvious things.  Authentic viagra online: the financial center also needs to be perceived as politically (and geopolitically) safe and stable, and especially a safe haven in times of tension, which is not always an easy thing in an Asia which consists of several very large, often heavily armed countries with a long history of mutual distrust and rivalry.

I may be wrong about whether or not New York (and London) maintain their pre-eminence, but I think I am certainly right in suggesting that any argument about what-will-happen-next that ignores the last 200 years of surging and waning global liquidity and the past several globalization cycles is likely to get very little right.  What we are experiencing is dramatic, but it isn’t new

We are still marveling at the technological and theatrical prowess displayed, and in D22 – and in many other bar and restaurants, no doubt – the first hour of the ceremony was regularly interrupted by cheering and whooping, although the nearly interminable subsequent march of 204 national teams dampened the mood somewhat (and is, in my opinion, one of the strongest arguments against the granting of independence to too many small countries). The weather is not very good (in fact as I write this it is pouring rain outside) but Beijing is nonetheless in a festive mood.

The stock market, however, has decided to buck the festive trend; buying cialis online without prescription. On Friday, in spite of the tremendous anticipation is the air, the market had a sloppy day until, mostly in the last hour, sloppiness turned into what seemed like panic selling that saw the SSE Composite drop 121 points, to close at 2606, or down 4.5% for the day. 

Some analysts blame renewed worries about security and terrorist attacks (and I see in the press that over the weekend there were more terrorist attacks in Xinjiang province, with at least five dead), while others claim that investors were anticipating the announcement of additional government measures to shore up the market during the Olympics, and when no announcement was made, they panicked. 

It will be interesting to see what happens on Monday and during the rest of next week – buying cialis online without prescription.  Buying cialis online without prescription: we may see some government-inspired buying, or even patriotic Olympic-related buying, or more measures from the authorities aimed at propping up the markets, but if none of those, I think the very bad mood could be extended. As I’ve said before in this blog buying cialis online without prescription, I think expectations about the transformational consequences of the Olympics are unrealistically high, and I think there is bound to be some disappointment.

In that context I have previously mentioned on this blog the parallels with the 1873 crisis that began in Vienna.  Here is how I describe it in my book The Volatility Machine (Oxford University Press, 2001):

By the beginning of 1873 there was a general sense that the Viennese market was overvalued and unsustainable, but investors were looking forward to the World Exhibition to be opened in Vienna on May 1.  They were irrationally hoping that the Exhibition would change the underlying situation and somehow justify the high asset prices.  During April of that year, in response to a period of weak and declining stock prices, the local banking authorities became concerned about the position of banks and made a series of attempts to support the market.  As a precaution, however, nervous banks were contracting credit and attempting to raise liquidity by calling in loans.  When the Exhibition opened on May 1 and, not surprisingly, nothing really changed, investors lost heart and began selling.

The selling pressure in the market built steadily.  On May 5 and 6, the market began falling and on May 8 it suddenly crashed. Buying cialis online without prescription: with the crash a full-blown panic began in Vienna that was almost immediately felt throughout the country as banks and investors rushed to dump assets. 

I am not implying, of course, that events in China are going to resemble those of Austria in 1873, but 1873’s World Exhibition in Vienna drew some of the same fevered expectations as the 2008 Beijing Olympics have, and it is worth noting the impact of excessively high non-economic-related expectations on the markets.  So much hope has been invested in the success of what is, after all, just a sporting event, that it will be hard for any result, no matter how positive for China, to live up to expectations.  After the Olympics little will have changed.

Still, even during the Olympics work must go on. We should soon be getting a new set of economic numbers for the month of July.  I hear that year-on-year CPI is expected to decline from 7.1% in June to around 6.5% or even lower in July, well below its April high of 8.5%.  Partly this reflects a high base effect, partly price controls, and partly continued food price declines from the very high levels of February and March.  What will be most closely watched is the non-food component of CPI.

In contrast year-on-year PPI, which hit a high of 8.8% in June (from 8.2% in May), is expected to stay high.  I think this may be the worst combination of numbers. Declining CPI will convince many policy-makers, particularly those in the pro-growth camp, that inflation is no longer a problem and excessive monetary growth nothing to worry about.  High and rising PPI, however, indicates that inflation has already spread out of the food sector and will increase inflationary pressures by the end of the year – buying cialis online without prescription.

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After stating this thesis Khanna then makes a number of suggestions about how the US should prepare itself for this new world – some commonsense, some irrelevant. Most of his evidence in favor of his thesis is not based on aggregate numbers but rather on the sort of anecdotal and often meaningless examples with which journalists love to exemplify an assertion (“But there are statistics, and there are trends,” he says in explaining why he prefers symbolic anecdotes to data) – cialis alcohol.For example, he points out that Tata is trying to buy Jaguar, London has (had actually) more IPOs than New York, developing countries have more reserves than the US, etc. But the examples are purely symbolic and contain no substance, especially the point about reserves – regular readers of my blog know how much it irks me when people confuse reserves with wealth, especially when dealing with China, where growing reserves are a symptom of serious domestic problems, not rude good health. Anyway when it comes to the hugely symbolic acts of rising powers, I think Japan in the 1980s blows out all of the current contenders – although perhaps Khanna is not old enough to remember.

Khanna supports his analysis by pointing out that in the past two years he has visited forty countries around the world, but at the risk of sounding like a world-weary snob, this does not impress me much – in fact I am a little worried by the Starbucks school of comparative politics. It reminds me of something a Canadian China scholar once told me – for him the biggest difference between China experts who have never visited China and those that visit twice a year is that it is sometimes possible to convince the former when they are mistaken. I would be much more impressed with Khanna’s article if he had a little more sense of history. His comments about Hugo Chavez, for example, suggest he knows little about a very common thread in Latin American history – the very difficult history of what my Latin American friends call fiscal-surplus populism. His claim that Russia will eventually choose to be swallowed up either by Europe or by China, as what he calls a petro-vassal, certainly violates everything I thought I knew about Russian history.

But I have a more fundamental problem with his thesis. I know this is a very contrarian position, but not only do I personally not think we are moving towards a China-Europe-US great power world in my lifetime, I think a very plausible case can be made that the US will be even more dominant by the middle of this century than it is today (and that Europe will be far less). I say this not with pride or glee – I actually think the supremacy the US has enjoyed during the past few decades is bad for the US and may have caused us to undermine some of our strongest values, as President Bush has already demonstrated. To me an increase in US relative power is almost certainly a bad thing for the US, but nonetheless I think it is more likely than the alternative.

With all the recent hype about US decline it may seem a little hard to think otherwise, but breathless predictions of US decline have been made often enough in the past that they have become a little stale. By some accounts the US has been in a state of permanent decline since at least the end of the 19th Century, when some English wit claimed that the US had already passed directly from youth into senility without having gone through a period of maturity. Certainly since the first big recession after WW1 (I believe it was 1919-1921) or at least since the beginning of the Great Depression, it has never been hard to find very serious American and foreign scholars announcing the imminent end of relative US power. More to the point, during my life time the current period of Chinese dominance is only the latest of at least three periods of unstoppable US decline.

The first one was during the 1970s, and that seemed to be a very plausible prediction at the time; cialis alcohol.The US faced a real set of problems unlike any it faces today cialis alcohol, combining the geopolitical (the defeat in Vietnam, the humiliation of Iran, widespread anti-Americanism and the seeming collapse of US foreign policy in general), the political (the Watergate scandal), the cultural (hippies!) and the economic (inflation, stagnation, and a collapse in consumer confidence). At the time you could buy entire blocks of New York City for a few thousand dollars and crime was rising inexorably and shockingly – talk about symbolism.

In those days it was pretty clear to any unbiased viewer that the US decline was all but irreversible, and I spent most of my college years learning that this was pretty much a given and we had all better get used to it. Standing against US decline were the still powerful Soviet Union, which seemed all but impregnable, and the rapid rise of the fabulously wealthy OPEC Arabs (in a world of ever-rising oil prices as far out as the eye could see), who in the popular imagination were rich, secretive economic and political geniuses who were slowly and surely taking over the world with their growing foreign currency reserves.

Only a few years later the OPEC Arabs were all but forgotten and the Soviet Union seemed on the point of collapse, but there was a new, even more terrible threat that promised the end of US domination, and that, of course, was Japan. As well-known as the story is it is still sometimes hard to remember how difficult it was back then for anyone to be taken seriously who doubted the inevitability of Japan’s rise to top-dog status. Japan was truly a miracle economic and political story whose technological prowess, at the time, seemed likely to pose a real and insurmountable challenge to US supremacy.

Today China has replaced Japan, and in spite of the much larger Chinese population, I find the prospect even less likely. Let me qualify that: There is no question in my mind of China’s relative rise, but the relative rise of China will be slower than many think. More importantly, its rise would require the relative decline of the US only if there were no more than two countries in the world. As it is there are more than two, and it is perfectly possible for both China and the US to rise in relative terms at the expense of other countries. In fact I think this is actually a far more plausible explanation of what is likely to happen. I would argue that the rise of China (and India) will be more than fully accommodated by the decline of Europe, Japan and Russia.

There are several reasons for this but the main reason is demographic. If we assume that the six great or potential powers of the world are China, Europe, India, Japan, Russia and the US, it seems that all of them with the exception of India and the US have very serious demographic problems that will seriously undermine their future growth. Take Europe for example. I don’t have the figures in front of me, but today Europe’s population is, I think, about 15% greater than the US. By the middle of the century it will be about 15% smaller, and its median age will have risen from a couple of years more than the US to about 12-16 years more. Projecting the differential per capita growth rates over the past few decades into the future (I know, I know, but what is a more plausible alternative?), Europe’s GDP, which is today larger than that of the US, is likely to be only two-thirds or less than that of the US – and when I ran these projections a few years ago I did them on a per-capita basis, not on a per-worker basis, which would have been much worse..

Khanna will argue (and nearly does) that Europe has an almost unlimited supply of countries eager to join and, by adding them to the European stew willy-nilly Europe can keep its population and economy growing for a long time. This would require that Europe keep adding North African and Asian states to the European Union without domestic opposition, fully integrating them immediately in the Europe political and economic system, and without in any way diluting the cohesiveness and decision-making ability of the European elite. Khanna may have spent several months of those two Starbucks years visiting European countries, but I was born in Spain of a French mother and grew up primarily in Europe, and I think this is, to put it politely, highly implausible.

All the demographic problems facing Europe of course are as true, or even truer, of Japan, with the difference that Japan cannot annex neighboring countries as quickly as Khanna believes Europe can. So Japan, I guess, is out of the running. On the other hand my own unsubstantiated claim is that there will be an economic and military resurgence of Japan soon enough, so perhaps I wouldn’t count Japan out too quickly.

China also faces a serious demographic problem. It has reached the limits of its population size while the US population keeps growing, driving the relative size of the two countries down from 4:1 currently to less than 3:1 by 2050 (and maybe substantially less). More ominously, today China is younger than the US, but by the middle of the century I believe it may be even older than Europe, so the relative change in its working population will be even sharper than that of the overall population. Since the mid-1970s China has benefited from a dramatic improvement in its dependency ratio as the one-child policy wiped out the bottom end of the dependents, but as China ages, the reverse impact of the one-child policy kicks in, so that beginning in 2010-2011 China’s dependency ration begins deteriorating just as dramatically as it improved.

It is a little difficult to say what an equilibrium growth rate for China would be given current demographic conditions, but when the dependency ratio shifts sharply from improvement to deterioration, the new equilibrium growth rate must be substantially lower. For comparison’s sake I once saw a World Bank study that argued that 30% of the growth of the Asian Tigers was accounted for by the improvement in their dependency rations (which have not improved as dramatically as China’s). This suggests to me that nearly all estimates of China’s future growth rates are overly optimistic, even if you believe current levels are sustainable, which I don’t, for a variety of reasons I have discussed elsewhere. By the way, for the curious, I remember reading that the US dependency ratio has actually improved slightly over the past few decades and is expected to continue doing so through the next few decades – although I don’t remember the actual numbers.

The problems China faces are not only demographic, of course. It faces huge environmental, water, and social challenges that make any prediction very tentative and subject to lots of downward revision. Most of all its political structure makes any of the current set of predictions extremely dependent on an unlikely set of political developments.

There are also geopolitical considerations. When it comes to geopolitical conflicts the US is in a great neighborhood and largely unchallenged. However all the rest of the potential powers are neighbors, with long histories of conflict and rivalry, and all with exception of Japan (maybe) nuclear-armed. This hardly suggests to me an environment conducive to relative rise. In my own view of the world, in the East China, Japan Russia and India will all conspire to keep any one of them from achieving dominant status, whereas in the West Europe will struggle with the problems of immigration and integration. None of these predictions can be proven except by time, of course, but I think they are at least as plausible as the alternatives.

In another post I will discuss some of the issues facing China’s long term economic growth. I believe that China will certainly grow relative to the rest of the world – from less than 5% of global GDP today to 15-20% in the next few decades – but I am very skeptical about claims that it will become the world’s largest economy in the next few decades. The problems facing are huge. Surprisingly enough this view, which should be seen as astonishingly optimistic, actually makes me in the eyes of much of the world a ferocious pessimist about China, which suggests perhaps how over-hyped China has become. Still, for those of us who were around in the 1980s and remember the Japan hype, this is not exactly unprecedented.

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