A New Perspective on the Global Economic Crisis II:
Fear of Reverse-colonization Did It

I. Introduction

This is the second part of my article, "A New Perspective on the Global Economic Crisis". In Section II, I explain why my perspective on the global economic crisis is new. That is, we see how the consensus opinion among academic economists that focused on global imbalances led them to believe that, in the worst case scenario, if all else fails, the losses in the American financial system could be transmitted to the rest of the world by engineering a dollar devaluation.

Consequently, the global imbalances approach taken by academic economists prevented them from seeing that the American financial system is capable of solving the crisis on its own, for example, by employing the price adjustment mechanism that I had proposed in the first part of this article. Moreover, the financial crisis seemed to them to be a prelude to the Great Depression, rather than a 'stress-test' which indicated that the American financial system needs to be de-centralized as much as better regulated.

In my opinion, academic economists continue to believe in doomsday scenarios because of a deep underlying fear of reverse-colonization. I try to make this point clear by discussing, in particular, Professor Barry Eichengreen's latest article, "Can Asia Free Itself from the IMF?" on Project Syndicate. However, there is plenty of other evidence that a sizable number of economists are doomsday-believers. See, for example, Professor Paul Krugman's book, "The Return of Depression Economics and the Crisis of 2008". It is definitely the responsibility of the emerging market economies in Asia and Latin America to assuage such fears of reverse-colonization among Western intellectuals.

In Section III, I explain how the devaluation of the dollar would transmit trillions of dollars of losses from the American financial system to the rest of the world. We recall here that the price adjustment mechanism that I had proposed in the first part of my article, could provide an alternative to devaluing the dollar as a way of getting out of the financial crisis.

In Section IV, I pursue a question posed by Professor Michael Spence as the title of his latest article, "Does Growth Have a Future?", on Project Syndicate. I explain how my new perspective on the global economic crisis, combined with a new approach on durability of economic theories, would make it possible to provide estimates for growth in the world economy, that are substantially better than the "new normal for growth", that is being projected by the bond-traders on Wall Street.

In the last section, I use my new durability approach for economic theories, to examine some issues raised in Professor Dani Rodrik's latest article, "The Bumpy Road Ahead" on Project Syndicate.

II. How Come My Perspective on the Global Economic Crisis is New?

In his article, quoted above, Professor Eichengreen expresses concerns that Asia's efforts to form its own monetary fund (the Chiang Mai Initiative and its follow-ups) may run into trouble. Nevertheless, he opines, it is important for Asia to succeed in this effort. As he explains, "This scheme won't solve all of Asia's problems. But it would at least head off one danger, namely the urge to accumulate even more reserves. Recent volatility reinforces this temptation. If Asian countries succumb, global imbalances and all their associated problems will return. Pooling regional reserves as a way of making them go further is a better alternative". Certainly, the Asian countries have a serious responsibility for assuaging fears of reverse-colonization that seems to have been afflicting intellectuals in the Western countries for the last few years.

Indeed, as has been well-documented, ever since its inception in 1944, the IMF has been heroically shouldering the responsibility of preventing any chances of reverse-colonization ever occurring. In a recent article in the Financial Times, Professor Olivier Blanchard, the chief economist at IMF, explains "In 2007, worried about the growing size of current account imbalances, the International Monetary Fund organized multilateral consultations to see what should be done about it. There was wide agreement that the solution was conceptually straightforward. To caricature: get US consumers to spend less. Get Chinese consumers to spend more. This will be good for the US, good for China, and good for the world." To hear Professor Blanchard tell the story, "It was an impressive piece of global macroeconomic planning ...".

This concern about global imbalances that the IMF raised in 2007 seems to have spread quickly to the community of academic economists. For, within the first few weeks after the financial crisis hit, Professor Bradford DeLong remarked on this situation in an October 2008 article "The Wrong Financial Crisis", published on VoxEU.org. As he put it, "All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the `Balance of Financial Terror' between Asia and America to collapse and produce chaos." By the time the real financial crisis hit in September 2008, the economists had already arrived at a consensus among themselves that, to solve the crisis in the balance of financial payments that they had expected, the only way out was to devalue the dollar, especially with respect to the Chinese Renminbi-Yuan.

As it so happened, the cause of the real financial crisis did not involve global imbalances at all. The sub-prime mortgage crisis, which came to light in January 2007, spread to the whole of the housing sector and finally transformed into a full-fledged financial crisis with the government takeover of Fannie Mae and Freddie Mac in September 2008. Taken by surprise, economists scrambled to find the cause of the financial crisis. However, it was too difficult to develop a new framework for the rapidly unfolding financial crisis. It was much easier to simply fit the new problems posed by the real crisis to the old framework of global imbalances.

As a result, they announced the coming of a massive credit crunch. I tried to explain in my "FAQ on the Current Financial Crisis" that the crisis involved the accumulated capital rather than the working capital of the United States. But the economists would have none of it. They lobbied the world governments to cut interest rates drastically and in a coordinated fashion, and to spend trillions of dollars through lax monetary policy and deficit spending. They proclaimed the coming of the Great Depression and a prolonged deflation. Nine months later, they have gone through one solution after another -- buying toxic assets, equity injection, debt-for-equity swap, temporary nationalization, PPIP, TARP, TALF, buyback of treasuries and mortgage securities, etc -- but the crisis persists.

It now seems obvious that the only serious way to solve the financial crisis is to establish a direct channel of communication between the Wall Street banks and the property owners, as explained in the first part of my article. Every other solution that has been proposed fails to address the massive arbitrage opportunity that the Fed and the Treasury have created for the Wall Street banks (see Section IV in the first part for an explanation of this). Thus my perspective on the global economic crisis is new, because professional economists had been pre-occupied with a different framework for the crisis, a framework that had focused on global imbalances.

III. Dollar Devaluation

Through the devaluation of the dollar, there are essentially two ways** by which the losses to America in this financial crisis can be transmitted to the rest of the world. For the first way, we note that America's Net International Investment Position (NIIP) at the end of 2008 was -$3, 469.2 billion (source: http://www.bea.gov/newsreleases/international/intinv/intinvnewsrelease.htm). In fact, the gross external debt of America, as of September 2008, was $13.6 trillion (source: wikipedia). With the dollar devalued, the interest payments that foreigners receive, in dollars, for their holdings of America's gross external debt, would be equivalent to a reduced amount, when converted to their local currency. So, the foreigners would take huge losses in this way.

As an aside, we also note that, after a devaluation of the dollar, the interest payments that America receives in foreign currency for its loans given to foreign countries would be equivalent to an enhanced amount, when converted to dollars. Since the devaluation of the dollar is achieved by printing money and flooding the American financial system with excess dollars, the benefit that America obtains from the dollar devaluation is that these extra dollars that were printed could be used to provide vast quantities of cheap money to American banks so that they can get out of the financial crisis.

For the second way, we note that the unemployment rate has been very high (over 7%) in the last year, reaching 9.4% recently. Hiring decisions are made by firms only after they are certain that their business sector is picking up sustained demand. Moreover, hiring itself is a slow process requiring interviews, salary negotiations and re-locations. Hence, unemployment would continue to be high (over 9%) for another year or more. So the economy would continue to have enormous slack. With under-employed consumers not having as much income to make purchases, the threat of inflation is quite mild now, and it would remain so for another year or more.

However, the threat of inflation is only one factor affecting long-term interest rates. There is also the growth in economic output (GDP), and concerns about the long-term debt of the government which is set to rise rapidly during the next decade because of huge fiscal deficits. Here, rising long-term debt of the government has been successfully portrayed as a dire necessity to get the American economy out of the risks of repeating the Great Depression.

Moreover, by constantly pronouncing doomsday predictions that America is headed for a depression, liberal economists and the Federal Reserve had made it possible to achieve a consensus estimate of "new normal" for growth in the medium-term in the world economy. This "new normal" projection for growth was then taken up by the bond-traders on Wall Street, who appeared regularly in the media with patriotic fervor, to diligently educate the general public about this vision of "the new normal".

As a result, the Fed is not going to raise short-term interest rates, from its current range of 0 - 1/4%, for many more months. Figuring that cheap money is available for the asking in America, investment managers are going to borrow hundreds of billions of dollars and invest the money in the high growth emerging market economies (somewhat as a repeat of the run-up phase during 1992-96 for the Asian financial crisis of 1997-98).

With this situation, if the dollar gets devalued over the course of one, two or three years, then American fund managers would obtain higher returns when the profits in local currencies they make from their investments in foreign countries is converted back to dollars. In this way, by making available cheap money for investment managers in America and de-valuing the dollar, the growth opportunities in emerging economies can be channeled into America. This makes up for the losses in the financial crisis in America. In this transaction, the emerging market economies would bear the extra volatility caused by the cross-border movement of huge capital.

** Added in revision (Jul 10, 2009): There are two other ways by which the losses to the American financial system would spread to the rest of the world. The first way is that foreign banks operating in America would take losses on their balance sheets by writing down the values of the toxic assets that they hold. By far, the largest transmission of losses would occur through this way. But this way does not require the devaluation of the dollar. So I did not list this way in this section.

The second way is that by devaluing the dollar, exports from America would become more competitive in global markets. Thus the American economy would benefit while the economy of the rest of the world would be able to sell less to America. But this situation is quite complicated, because it is not clear how or whether the manufacturing industry in America would be able to take advantage of the dollar devaluation. So, I did not list this way in this section.

IV. Does Growth Theory Have a Future?

Professor Michael Spence explains in his article, "Does Growth Have a Future?" on Project Syndicate, that after the financial crisis is over, the world economy would not be able to go back to its pre-crisis level of growth. This is because the damage caused by the financial crisis is too extensive. Hence he suggests a "new normal" of lower growth for the world economy in the medium term. I presume that Professor Spence defines the term "growth" in a much broader sense than the bond-traders would, for he says in his article, "At the moment, the majority view in most countries is that the financial system failed badly, but that the incentives and dynamics of the broader market-based system in a relatively open global architecture remain the best avenues for wealth creation, poverty reduction, and the expansion of opportunity".

Does the theoretical study of economic growth promise to shed light on the path the world economy is going to take in the coming years? Would the tools and techniques that this topic of study employs, help economists to anticipate growth opportunities and prepare for them? Or would the world economy muddle along without any clear policy guidelines, unable "to avoid non-cooperative behavior and suboptimal equilibria"? Or perhaps should policy-makers abandon their focus on economic growth, and instead, promote social policies -- like income equality, health, sanitation, education and environmental preservation?

Such questions on economic growth can be profitably addressed, based on the concepts that I had elaborated in my recent article "A New Perspective on the Global Economic Crisis". The main argument to use for this purpose is that in different parts of the world, the underlying foundations for the prospects of growth are of varying durability. That is, the prospects for economic growth that the emerging market economies are enjoying come with secure foundations provided by a theoretical framework that has been in development for over a millennium. Whereas, the growth that advanced economies can expect would depend on relatively new and recent developments in economic theory, whose durability remains suspect. On the other hand, the predicament of the poor countries shows that securely founded economic theory alone could not guarantee sustained economic growth.

The focus on durability that I propose is in contrast to the concerns of investment managers who treat all assets uniformly under the risk-reward framework of modern portfolio theory. Their view treats asset classes as differing only in their risk-reward profiles, without any implications for systemic risk. No particular significance is attached to the transience or permanence of economic wealth, as the case may be. Whereas, with the durability approach, it is possible to study the requirements for generating growth in the advanced economies, which are markedly different from the requirements in the developing economies.

Taken together with this durability approach, the new perspective on global economic crisis that I had proposed in my recent article, opens up much better prospects for world-wide economic growth, in the medium-term, than those indicated by the "new normal" predictions of the bond-traders. At present, it could not be possible for me to develop such a wide-ranging theoretical frame-work as is plainly required before one can discuss, in a comprehensive manner, the issues concerning world-wide economic growth. However, if I receive a job offer for exploring the prospects for economic growth full-time, then I would be sure to take it up.

V. "New Normal" for the Efforts to Reform the Global Financial Infrastructure?

Professor Rodrik finishes his article, quoted above with, "It would be a mistake to respond by trying to take globalization to the next level. The economic and political obstacles that block deep integration cannot be wished away by exhortations. It would serve us far better to take these limits into account and scale down our ambitions." In this section, I use the durability approach to economic theories to provide further evidence that Professor Rodrik's conclusion is the right one. Basically, one should note that China's economy relies heavily on the industrial production process. The communist political structure in China is especially well-suited for an industrial economy.

The industrial production process has been intensely studied for nearly three hundred years now. It was the search for markets for Britain's industrial production in the 18th century, that resulted in Adam Smith's famous work, "The Wealth of Nations" which advocated free markets and globalization. In the 19the century, Karl Marx had studied the production process so thoroughly that he tried to build a whole new social theory based on it. In the 1930s, John Maynard Keynes envisioned "Economic Possibilities for our Grand Children" based on technological improvements in the production process. In the 1940s, Joseph Schumpeter thought about the production process and concluded in his famous book, "Capitalism, Socialism and Democracy" that capitalism could deliver on wealth creation, even if 10% of the working population is unemployed.

China's economy is currently on a secure growth path that is not only based on exports, but also the symbiotic relationship between a communist polity, a homogeneous society and an economy driven by factory-based manufacturing. It would be extremely ill-advised to try to disrupt the run of high rate of economic growth that China has been enjoying for the last 29 years or so. It is simply too dangerous to put pressure on China to replace its export-dependent growth model. One can be certain that the result of such pressures would be a strong political backlash from China. Instead, if the Western powers would wait for several years, then China would be in a position to address their concerns about trade, exchange rate, environment and geopolitics.

In a few years time, China's economy would graduate from an economy that is predominantly based on manufacturing, to a service-oriented economy. As early as five years from now, there would be upwards of 50 million Chinese people trying to break-free from a middle class existence, straining at affluent lifestyles. These newly affluent people would begin to have the same concerns about the environment as the Westerners do. Moreover, the government's policy of promoting consumption would bear fruit in five years or so.

Hence, the theories about global imbalances would stand a better chance of success, if they are pursued several years from now. For now, it is important not to de-stabilize the global financial architecture. Moreover, exchange rate stability is the policy that is being pursued by China as well as the European Union. Hence, it would be far easier for America to pursue the same policy, instead of raising concerns about global imbalances.


Notes: 1. Section IV. "Does Growth Theory Have a Future?" given above is essentially the same as the earlier post "In response to Professor Michael Spence's article "Does Growth Have a Future?" on Project Syndicate".
2. The 'It' in the title "A New Perspective on the Global Economic Crisis: Fear of Reverse-colonization Did It" does not refer to the global economic crisis. It refers to the oversight of academic economist -- their failure to see how the American financial system can solve the crisis by itself, without transmitting trillions of dollars of losses to the rest of the world.