In response to Professor Kenneth Rogoff's article "Is China Really Immune to the Crisis?" on Project Syndicate
(Dated February 19, 2009)

Professor Rogoff is right when he points out several shortcomings of the Chinese model of economic growth. However, it is only in the long-term (over 12 years) that the Chinese model is quite suspect. The main problem with the Chinese economy, in the long-term, is that its demographics is not favorable to its growth. Having pursued a one-child policy officially for several decades now, China finds that its demographic profile is skewing more and more towards an aging population. The second problem is that with a communist political framework firmly in place, China's economy is going to encounter serious difficulties when it graduates, in the coming years, from an economy based on manufacturing to one that is based on services and information, and further on towards an innovation-based economy. The third problem, which Professor Rogoff also mentions, is that there needs to be a serious alternative for exports, as an engine of economic growth. Relying only on exports for achieving rapid economic growth is an unsustainable policy in the long-term. The majority of China's population is poor, and lives in rural areas with inadequate infrastructure. The consumer demand among this section of China's population should rise fast enough to offset the slow-down of China's exports. This is a very challenging goal indeed.

In the short term (0 - 4 years), thanks to the freebies handed out by the American intellectual establishment, it seems quite certain that the Chinese economy is poised for 8%+ growth of annual GDP in real terms (i.e., after correcting for inflation). These freebies are mainly in the form of lax monetary policy and excess domestic spending -- 4 trillion dollars and counting -- in America, and are meant to ward off the ill-effects of voodoo spirits on the American economy and to suffuse it with animal spirits instead. This reckless spending has empowered China to announce its own two-year spending program, for an amount of 586 billion dollars at current exchange rates. As Premier Wen Jiabao explained at the World Economic Forum on January 28, because the Chinese government has carefully chosen to spend this money mainly on the poorest areas in China, one could expect that this spending would result in a dollar-for-dollar impact on the GDP, which, by itself, would ensure an 8%+ GDP growth for the next two years. Since China's own housing industry and its finance industry have not been seriously affected by the recent financial crisis in America, the Chinese government is free to focus its spending program to get the maximum effect for its money. Moreover, with over 2 trillion dollars of reserves, China's economy has already produced the resources in the past, that are required to finance this new fiscal spending program of the next two-years, and even further to six or seven years into the future. In addition, the phenomenal savings rate of Chinese families ensures that China need not worry at all about financing its deficit spending, unlike the United States. Most importantly, China can carry out this $586-billion spending program in the next two-years, and still engineer a mild appreciation of its currency against the US dollar, in case there are any complaints that it is manipulating its currency to keep it artificially depreciated.

In the medium term (4 - 12 years), the picture is less clear, only because the freebies handed out to China could lead to a protectionist backlash in Western economies. Nevertheless, the continuation of the 8%+ growth path seems a very real possibility for China. As such, the GDP of the United States for 2007 was about 14 trillion dollars, and that of China was 3.5 trillion dollars (in nominal terms). So, provided that the Chinese government does not get involved recklessly in any unilateral military adventures, there seems to be room for a doubling or a tripling of China's nominal GDP in the next 12 years. In any case, the Chinese intellectual establishment appears to have taken to some such forecast with a mission-critical focus, and is surely going to employ all its resources towards achieving that target. Broadly, two scenarios are possible in the medium-term.

Scenario I: There could be a re-enactment of the run-up to the East Asian crisis of 1997. Please recall that during the recession in the American economy of 1990-91 also, the banking system in America was mired in a serious crisis -- the Savings & Loan crisis. The losses in this crisis extended to hundreds of billions of dollars. To ease the pain caused by failed property loans, the US Federal Reserve pumped huge amounts of liquidity into the US economy in the early 90s. With money available so freely at so low interest rates, investors and fund managers were looking for new avenues of investment that would beat the creeping inflation. At this point in time, the Latin American countries had already been bankrupted in the previous decade due to high volatility in the interest rates that the Fed under Paul Volcker had set to combat the high inflation of the 70s. So, this time, the American financial industry had to look to far-off East Asia which had been demonstrating rapid economic growth for 20 years or so by then. In the five year period, 1988 - 1993, the market capitalization in all of East Asia had leapt 10-fold to over $870 billion. This inflow of dollars would only accelerate after 1993. With risk premia down to an absolute minimum, there was a super-charged, manic environment where billion-dollar deals were frequently done in minutes. Unfortunately, the East Asian and Chinese economies were not mature enough to present shovel-ready infrastructure projects or hand out consumer loans in the massive scale that the inflow of dollars demanded. So, the situation became inherently unsustainable.

By the mid-90s, the technology boom back in the US took off in earnest. The low-priced Chinese manufactured goods kept inflation very low, so that the American economy could function at rates well below the Non-Accelerating Inflation Rate of Unemployment (NAIRU). These factors enabled a sustained technology boom, which in turn provided a viable alternative for the dollars that were flowing into East Asia. As a result, there was a sudden flight of massive amounts of capital out of East Asia. Though the East Asian countries had built up large reserves of foreign exchange, they could not handle this sudden and drastic outflow of dollars. The Thai baht was the first to devalue, forcing Thailand to acquiesce to an IMF bailout in 1997. The financial contagion spread to the rest of the East Asian countries one-by-one, putting an end to the 25-year economic boom in this region.

Fast-forward to 2009. The Fed has cut interest rates to the minimum possible range. There is a flood of liquidity in the economy. After two more years of fiscal spending, it could happen that the US government has succeeded in preventing prolonged deflation, and has gotten the economy out of recession but only into a mild recovery. Serious long-term prospects for economic growth are nowhere to be seen, not even in the alternative energy sector or the hi-tech sector. So, once again money, in search of better returns than treasury securities, heads out to the fast-growing economies of China and East Asia. However, this time around, the American financial system has been taking massive losses in the mortgage crisis. So, there is going to be a steady stream instead of a flood. For their part, the economies of China and East Asia are much more mature now and would probably be able to absorb the inflow of a trillion or two of capital from the United States.

There is also an in-built stabilizer in this scenario. If the Fed resorts to a monetary policy that is too lax, and the politicians resort to protectionist backlash, then this would result in an all-too-rapid slowdown of exports from China. In return, China could abandon the US dollar, and finance its domestic spending program by printing more of its own currency. This would result in a race to the bottom. On the other hand, if the Fed, the US government and the private sector work in close co-ordination with China, then the American finance industry could get good returns on its capital investments in China. These rates of return would probably be high enough to offset the negative impact of inflation which could creep up anytime after this year. These high returns in the financial sector, in combination with the mortgage sector, the alternative energy sector and the hi-tech sector, could provide the foundations for robust economic growth in America for the next decade or so. Hopefully, two or three years from now, the three domestic sectors mentioned here would show healthy prospects for sustained growth. In addition to these growth-enabling factors, with a China-friendly foreign policy, America has the new possibility of exporting millions of its citizen to China and East Asia as consultants in business, sports and politics, and as teachers of the English language.

Scenario II: A group of proximate countries either from Africa, Latin America or Eastern Europe could give China a run for its money, as the manufacturing base of the world. With the United States spending trillions of dollars to upgrade its infrastructure and to shore up its own manufacturing base, this new group could negotiate an effective partnership with America, and possibly also with the European Union, to successfully keep out Chinese goods from Western markets. If this situation is achieved purely through more efficient production processes and not through any protectionist backlash, then China would have no choice but to rely solely on its internal demand to sustain rapid economic growth. However, one should note that the emergence of such a competitor group would take at least a decade. In the cases of the East Asian Tigers, China and Japan, each of these economies had been growing rapidly for 20 years or more, before they were considered as serious threats to the world order existing then. Hence this scenario seems less likely to occur in the medium term than Scenario I.

In partial response to Professor Keneth Rogoff's January 2009 article, "Has America Lost Its Mojo?" on Project Syndicate
(Dated: February 9, 2009)

America has not lost its mojo. However, the members of the American intellectual establishment -- in academia, in government, in the media, the Federal Reserve and the industry captains -- need to understand that they don't have an eternity and a blank-check to fix the crisis in the American economy that began as early as 2007 and has steadily gotten out-of-hand ever since.


1) Role of China: Several weeks ago, the Chinese government announced a two-year fiscal spending program of 4 trillion RMB Yuan, which in recent Dollar-Yuan exchange rates is equivalent to $586 billion. At the time of announcing this program, there was widespread skepticism about China's ability to maintain its GDP growth rate at above 8%, given the current worldwide economic crisis. However, on January 28, at the World Economic Forum in Davos, the Chinese Prime Minister, Wen Jiabao, explained the rationale for their growth target of 8% for 2009. China's finance industry and housing industry have not been affected by the mortgage crisis and the subsequent financial crisis in America. This leaves China free to spend the entire amount of $586 billion on its infrastructure, and to stimulate its consumer demand through tax cuts and subsidies. Thus the expected fall in its exports as a result of the fall in consumer demand in Western economies due to this worldwide economic crisis can be entirely replaced by this fiscal spending program announced by the Chinese government. Now, the nominal GDP of China for 2007 was around $3.5 trillion (in exchange rate terms). So, $586 billion is just over 16% of China's 2007 GDP. Thus merely by instituting a two-year fiscal program China can maintain an 8% annual GDP growth for the next two years.

China has been empowered to carry out such a huge fiscal program purely through the reckless spending of trillions of dollars by America, under the cheer-leading of its intellectual establishment. To my knowledge, the extra spending in America, that can be attributed to the prolonged crisis in the American economy, is already over 4 trillion dollars -- (i) TARP: $700 billion, (ii) Federal Reserve balance sheet expansion in the last nine months from $900 billion to $2.2 trillion, (iii) fiscal stimulus package for 2009: $800 billion, (iv) various stimulus packages under President Bush since January 2007: $300 billion+, (v) fiscal deficits for 2007-09 (including that part of the Iraq war expense that is financed through debt): $1 trillion+. Please note that this spending of $4 trillion, spread out over three years (2007 - 09), is just over 28% of the $14 trillion figure for the GDP of the United States for 2007.

Apart from this $4 trillion of spending, the Federal Reserve has been engaging in off-balance-sheet activities like bailouts of AIG, Bear Stearns and Citigroup. Another important point to note is that the Federal Reserve has undertaken extensive currency swaps with the central banks of Europe, England, Japan, Germany and other countries. Because of the widespread perception so far, that the financial crisis that originated in America is global in scope, there has been a flight to safety to the US dollar in the last six months. However, as time goes by, the experts are going to recognize that there are islands of strength in the world economy that have not been affected by the economic crisis in America. This would mean that it is going to get more and more difficult for the Federal Reserve to print dollars and release it into the global economy to finance its expansionary monetary policy. Also, the central banks of other countries are not going to be so eager to enter into currency swap agreements with the US Federal Reserve, if they find out in several months that their own economies are not directly affected by the mortgage crisis and the financial crisis that originated from the United States.

In the last two decades, world trade has been growing at a much faster pace than the average growth rate of annual GDP among the nations of the world. As a result, there has been a big surge in the demand for a world reserve currency. The US dollar, which has been serving as the de facto reserve currency of the world for the past fifty years, has been the direct beneficiary of this surge in world trade. This has been the most important reason why an expansionary monetary policy has not led to the drastic weakening of the dollar, even after taking into account, this $4 trillion of spending during 2007-09. America has been seen as the world's sole superpower from an economic and a military perspective, after the end of the cold war in the late 80s. However, starting from its economic liberalization in the late 70s, China has been emerging as an alternative economic giant, slowly and surely.

The American intellectual establishment needs to realize that it is not by accident that China has come to hold US treasury securities worth trillions of dollars in its reserves. Through its imperial mandarin system, China has acquired highly qualified, well-educated and very intelligent people in the upper levels of its bureaucracy. It would not be possible for America to simply transfer the negative effects of this current financial crisis to other countries by just printing up more dollars. Rather than buy these additional dollars for lack of any alternative, countries like China are going to take this opportunity to institute their own spending programs and to stimulate their own consumer demand, through tax cuts or subsidies. This also means that China would not have as much need for US dollars in the future to finance its exports, since exports would be a smaller proportion to domestic consumption.

Contrary to what the new US Treasury Secretary Timothy Geithner said in his confirmational hearing at the US Congress, a more accommodative policy towards China is in the long-term economic interest of America. Rather than unleash trade wars and currency wars with China, it would be far more sensible for America to get China to open its own hi-tech areas to foreign trade. Under the dire economic circumstances that America is currently in, a 'Live and Let Live' policy towards China is highly recommended.


2) Ideal response from the Federal Reserve: Firstly, Professor Ben Bernanke, the Chairman of the US Federal Reserve (Fed), must be commended for bringing tranparency to the Fed's culture of work. Secondly, by responding quickly and forcefully, he has helped to defuse the panic and the tension during some crucial moments of the financial crisis in the months of September and October of 2008. No doubt his active efforts in the last six months to ensure an adequate supply of dollars in the world markets has helped to stabilize the functioning of the global economy. Thirdly, he consulted regularly with his academic colleagues, both conservatives and liberals, and he drew upon his own academic and research experience in dealing with this crisis. These are all very sound contributions from Professor Bernanke and his team at the Fed.

However, when all the factors in this crisis are taken into account, it seems unavoidable that one has to say Professor Bernanke went more-than-a-little overboard. In particular, he paid too large a price for restoring calm in the markets. For one thing, he kept cutting interest rates recklessly. The ideal response would have been that he issued dire warnings about the economy throughout the latter half of 2008, and yet that he cut interest rates only by 50 basis points or less at a time. Moreover, he should have taken an informal break from cutting the rates, starting three weeks before and ending two weeks after the Presidential election on November 4, 2008. He should have aimed to have the Fed's target rate for overnight lending between banks to be at around 2% when the new President took office on January 20, 2009, instead of the current 0 - 1/4% range.

Professor Bernanke did not appreciate that the Fed needs to work in-sync with the political establishment to get maximum affect for its plans to get the economy out of the crisis. The Fed should coordinate its activities with the political cycle, even while retaining its own independence. However, Professor Bernanke seems to have followed a strange interpretation of this policy. This led him to lend moral and intellectual support to the ill-advised $700-billion TARP program proposed by the US Treasury Department. Professor Bernanke went to the extent of appearing on Congressional hearings alongside Henry Paulson, the then Treasury Secretary, with increasingly comical explanations of how the plan to spend $700-billion at the complete discretion of the Treasury Secretary could actually work. Instead of taking up a more political role in this situation, if Professor Bernanke had stuck to his usual scholarly disposition, he would have still retained his credibility as a serious thinker of the modern economy.

Another big mistake that Professor Bernanke made was his complete unwillingness to state that his expansionary monetary policy of the last six months is a temporary arrangement to stablize the functioning of the American economy as well as the global economy. He needed to demonstrate his resolve to rein in all the extra spending once the immediate crisis blows over. Instead, throughout December and in January, even after the Fed's target interest rate could not be cut any more, Professor Bernanke continued to proclaim that monetary policy is not ineffective, that he could always release more dollars into the economy (ref: Quantitative Easing). In short, he was still functioning in the crisis-prevention mode, when it was clear that the Fed needed to step aside and let other institutions -- like the new Presidency, the US Congress and the private sector -- contribute towards the recovery of the economy. He seemed to be thinking that the economy is too important to be entrusted to the politicians.

Next, the currency swap agreements with central banks of other countries ensured adequate supply of the US dollar in the world markets. This in turn had ensured the stability of the exchange rates of the dollar with other currencies, at a time when there was widespread flight to safety towards the dollar. However, the dollars that the foreign countries have received are being used by their trading communities for international trade, whereas the foreign currencies that the Fed has received in these swap agreements do not have as much use, since the dollar is the world's reserve currency. This means that the foreign countries have an incentive to print an equivalent amount of their local currency, without worrying about inflation, and use it to finance their own spending programs. Since the mortgage industries and finance industries in the foreign countries have not been as much damaged as in the US, the foreign countries could spend their money to strengthen the structure of their economies, instead of having to bail out their mortgage and finance industries. In the long run, this means they would come out stronger from this economic crisis than America would.

Moreover, as the immediacy of the crisis wanes, investors around the world are not going to need the dollar as a safehaven. This would lead steadily to an excess of dollars in the world markets, which in turn, would weaken the dollar. This would provide the foreign countries more incentives to print their own money and finance their spending programs, just as China has done recently. Thus the US Federal Reserve should monitor the currency markets closely in the coming months and draw up a plan to wind down the massive currency swap agreements that it entered into during the peak of the financial crisis in September and October of 2008.


To be continued . . .


3) Revisionist History on Lehman Brothers' fall:

4) Solution(s) for the Mortgage Crisis:

5) Neither fiscal stimulus nor tax cuts:

6) Comparison with the 1970s:

7) Conclusion: