Sunday, August 07, 2005

oops...A Tale of Two Nations

I guess if you want to wax poetic on China when it is fairly apparent that its leaders are remaking its imagine in the minds of world decision makers you can't take a few days off or a bunch of people will steal all the obvious allusions. For instance here's my Zheng He allusion in the Asia Times. I guess I'll just have to pick a different approach....

Strictly from the perspective of a quantitative economist, China, in 1978, was marginally visible on the world stage. It seems kind of strange to me as I think of it now, but there really was a time when China didn't much enter into consideration, in the world of western finance, that is. Of course, once one shifts perspective outside of that particular myopia, China has always been a vast, populous and dynamic place. Let's take a look at the relative choices of Chinese and American policy makers since the IMF's 1978 liberalization of international exchange rate policies. I choose the date because, in hindsight, the 1978 decision of the Chinese to open its markets to trade and investment dovetails so nicely with the IMF policy shift.

For most of the world the first few years of the new exchange rate regime was tough sledding. As an old FX guy myself, it is hard to imagine that prior to this time FX desks at banks had been more clerical than profit center oriented (then again, from what I hear, things may be coming full circle, but that is another story). The infrastructure, if you will, of floating exchange rates had yet to be built. Indeed, the entire infrastructure of unrestricted finance was in its infancy back then. Volatility was rife for the first 3 years of the new regime as inflation, exchange and interest rates fluctuated wildly trying to find equilibrium levels.

By 1983 the US$ based prices of commodities finally seemed to find that equilibrium level, holding there until 1999 (as per US PPI raw materials index). Besides the most pressing agenda of stabilizing US$ based inflation, broad US policy directives included increasing military investments financed from abroad. China also took advantage of capital account liberalization, although far less aggressively than many other developing nations.

By the mid 80s a sense that certain financial trends had become "unsustainable" led to the first real test of the new system, by which I mean the first attempt to bring the anchor nation back into external account equilibrium. The 1985 Plaza Accord announced US$ devaluation eventually created enough pressure in the capital markets to engender the crash of 1987. It is from this point that the differences between US and Chines economic policy are, in my view, particularly relevant for understanding today's state of play.

In the US, the policy choice was to paper over as much of the pain as possible. Newly appointed Fed Chairman Greenspan led the decision to flood the credit markets with money to avoid the "cascading defaults." An economic downturn, as measured by GDP statistics was avoided for a few years and, in my view, reduced dramatically. That is, US policy makers opted to insulate the economy from market pressures. Civil unrest, while flaring up on occasion, most notably in connection with the Rodney King trial, was by and large avoided in the US.

The Chinese, however, chose a very different path-that of strict economic orthodoxy. From 1987-1989, domestic prices subsidies were removed, import and credit controls were tightened, state investment levels were cut dramatically and the RMB was devalued by roughly 25%. This led to the lowest rate of GDP growth since 1982 and was in part responsible for the Tiananmen Square confrontation between the students and the state. While US politicians made hay moaning about Chinese repression, US corporation heads started to see a great place to do business. By 1993, the inauguration of Bill Clinton set the stage for an amazing economic transformation.

Was it but 12 short years ago that the papers were filled with woe about the "jobless recovery"? It is amazing, for me at least, to recall that while the 90s ended with an economic roar in much of the West, they began with a whimper. Faith in the equity market had been dented but not broken by the crash of '87, but that faith was nothing like what was to be seen later in the decade. As Americans have been seeing now only on a larger scale, the price for keeping the equity market afloat was a series of bubbles in financial markets from Milken's Junk Bonds, via the Savings and Loans to Real Estate. To the credit of the first Bush Administration, policy makers did eventually opt to force some sort of resolution. For their troubles they were voted out of office.

Bill Clinton may have run on a platform which included being tough on China, but off the public radar his administration ran a very open trade and investment policy with the Middle Kingdom. The last devaluation of the RMB occurred early in 1994 and from then on investment poured into China. I remember Phil Knight of Nike, one of the more prominent visionaries of a corporatized China telling the world that 1 Billion Chinese means 2 Billion feet!

Of course, it wasn't just the US that was in need of an economic shot in the arm in the early 90s, Japan's corporations too decided they needed cheap labor. The Asian Crisis we recall was the fruit of those investment flows in the early to mid 90s, as European, US and Japanese corporate forms, and cash, were exported to China and the Asian Tigers.

As the Asia Crisis tore through the region, the earlier evidenced ability of China's leaders to stick with economic orthodoxy and keep their external accounts balanced over the long haul paid handsome dividends. I can remember when market players and policy makers were fearful of yet another RMB devaluation in 97-99. Yet, unlike some other Asian nations, by the time the crisis hit in 1997, China's FX reserves equaled its external debt, most of which was long term, not the short term, hot money that flowed quickly out of Korea, Thailand and Indonesia.

By the time the Asian Crisis began to spill over into the rest of the world, the US solution was already a decade old ingrained habit, flood the market with money, mitigate the effects of the resolution. The result was a brief dip in measured US growth, a significant expansion of the US trade deficit and ignition of the late 90s equity boom. A secondary result of this policy choice was the emergence of China on the world stage as a real economic player- the producer of last resort, if you will.

The attacks of 9/11 and consequent fears of economic decline were met once again with the tried and true method of flooding the market with money and letting the trade deficit widen still further. The sensibilities that informed the implementation of some mechanism to settle international imbalances were left to the growing hordes of western economic bloggers and the Asians.

Over the years between 1978 and today, Chinese and US leaders have chosen very different paths. The Chinese throughout have acted as if external account balances matter, even to the point of a willingness to brutally repress dissent while forcing their resolution, while US leaders have grown increasingly cavalier, as VP Cheney's "deficits don't matter" comment makes abundantly clear. In Washington pundit-speak, changing Social Security used to be known as the "third rail" of political issues, "touch it and you die", an allusion to the third rail on a subway track. In my view the real third rail issue in American politics is economic adjustment to market forces.

This isn't to argue that the eventual resolution of current international imbalances will only hurt the US while leaving China unscathed. Rather, I think the Chinese economy will adjust to the new reality much more quickly than will that of the US. China now has a quarter century old habit of adjustment when necessary while the US has exactly the opposite, ergo the "drug addicted economy" characterization from James Grant et alia.

A century ago, the British Empire was the economic envy of the world. Yet, with the benefit of hindsight that economy was, in fact, dying, living on its past glories and very unwilling to adjust to the changing world. It was the US that was the nimble newcomer, firmly committed to liquidating imbalances when necessary and the swing producer on the world stage. This is the way of things in the world.

Over the past 500 years, the Spanish, French, English and Americans have justifiably laid claim to being the dominant nation on the planet, thus setting the stage for the decline. The signs of the inevitable decay; deficit finance, military expansion and a cultural superiority complex which makes adjustment difficult were all evident in the first three on our list, and in my view, in America as well. Continued competition for oil resources will force economic adjustments. Those economies which react to those force nimbly will outperform those that do not. There is a Buddhist saying that goes, thought becomes word, word becomes deed, deed becomes habit and habit becomes character. The relative economic characters of the US and China have been a long time in the making. We will see which type thrives in the new environment.