Lezione alla Domus Academy di Milano
26 gennaio 2009
How a conference on economic issues could hold the interest of a non economist?
Perhaps, if what is happening in the economic world shows its own rationale. Needless to say, the rationale in my opinion. Note that in my view nobody is a bad guy and nobody is a good guy. The main character is the economic mechanism.
The conference is divided in three sessions: the asian and the anglosaxon legacy, East and West, and, finally, the 2008 crisis and the outcomes.
The Asian and Anglosaxon growth legacy. East
- At the beginning of the eighties, China decided to modernize its economy, i.e. an export led economy to absorb the urbanisation of some hundred million peasants. An export led economy is a competitive economy, combining technology and free trade. Technology had to be imported, and combined with a disciplined labor force. (Just a look at the XIX century negative experience of India and Egypt).
- The massive foreign investment (factories and machineries) had to be protected. The “gunboat diplomacy” could not be effective as it has been into the XIXth century: China was (and is) too large and populous. Then, the “de facto” solution: physical capital in China and Chinese credits into the US. Credits as US public debt owned by the Central Bank of China: The property rights are guaranteed. If China confiscated the foreign plants, the US (specifically, the President) could quickly grab in retaliation Chinese properties, i.e. the Treasury bills and bonds they own. Given that the investments in China have been made by a lot of different countries, the US are the “public good” into the international domain.
- Chinese interest in having a stable exchange rate has an explanation: if you (“you” as a manager or an entrepreneur) know the value of your investment in China (in yuan) and in your own currency (dollar) in the years to come, everything being equal, you invest more. And you invest in China, because you have a cost advantage. The physical capital is the same everywhere, but Chinese cost of labor is low. (An open question is the effect of the cost of transportation volatility on global trade). At the end, you don’t take the currency risk, and you earn more thanks to the low cost of labor.
- In the period 1980 – 2007 the Chinese rate of growth has been impressive, in the order of 10%. The “golden” growth rate to obtain the peasants absorption is around 7%. Under this figure the risk of creating an underclass into the urban areas become significant.
- Export led growth and infrastructures growth. New cities, bridges, railroads, ports, etc. are at the origin of the massive Chinese development. Take note: Export (EX) and Investment (I), not Consumption (C) or Public Deficit (G-T). The account identity of national income (Y) is:
Y = C + I + (G-T) + (EX – IM), then the Chinese drivers have been I and EX > IM
The Asian and Anglosaxon growth legacy. West
- Let’s start from the accounting identity. In the case of the US we have had in the last years a growth led by consumption (C). Investment (I) has been weak and below the companies’ current cash flow. Public Deficit (G-T) has been around 3%, not too much. The foreign trade balance has been negative, as the US imported a lot of foreign produced goods. (To have an idea, the estimated 2009 US trade deficit is around 250 B$ with China, 150$ with Europe, and 100B$ with the Oil Countries).
Y = C + I + (G-T) + (EX – IM), then the US driver has been C with EX < IM
- Two questions immediately arise: how to consume a lot, i.e. the consumption’s rate of growth becomes higher than the rate of growth of income, and how to pay for the foreign goods.
- In the consumer goods domain we have had deflation. The price of goods either collapsed or stayed very stable, taking account for the quality increase. Example: Electronics and cars. In services we have had a stable and low inflation. If something can be internationally traded, it comes under price pressure, otherwise no. Example: I (if I were economically rational) don’t take an expensive plane to go to a barbershop in China, because of the low cost of an haircut. Globalisation does not affect the western coiffeur but it hurts the unskilled western blue collar. Symmetrically, globalisation does not support the eastern coiffeur and it helps the unskilled eastern blue collar.
- At the end, the rate of inflation has been low, and even more important, stable. Stability means that the average inflation has been 2,5%, with an upper band of 3%, and a lower one of 2%. Inflation rate has been low and, even more relevant, predictable. The risk premium on bonds (more on the technical matter) went down. Therefore the real absolute level of the bond yield dropped down (more on the technical matter). In the US, the private bond market is the market for the debt of households. The financial industry supplied bonds (backed by mortgages and credit cards) to the US (and world) savers at decreasing interest rates. At the end, money was picked up cheaply and lent to the households (the borrowers of last resort) for consumption.
- Summing up, Chinese production pushed down the prices of manufactured goods. Chinese purchases of US bonds pushed down the rate of interest on bonds (whose technical name is yield). The Anglo-Saxon consumer became able to buy more goods, both because of lower prices, and the low cost of debt. (The propensity to increase the debt is high amongst the Anglo-Saxons, but is very low in Europe. An hypothesis: everybody wants to show here and now, even through a high debt, how hard and successfully he has worked, in a world where the legacies of the class of origin have disappeared).
- Chinese companies earn dollars from their exports, but they have to pay both the wages to the manpower and the suppliers. They need yuan. The central bank changes their dollars at a fixed rate into yuan. The central bank invests these dollars into the US public debt. So the US received dollars from China in order to import from China. The US accumulates debt and China credits.
- In the last decades several hundred million people in Asia became for the first time well off, meanwhile the Anglo-Saxon consumers stuffed themselves with plasma TV and SUV. That was the world till 2007.
The 2008 crisis and the outcomes
- The growth driven both by the household debt and the international debt (i.e. the very huge and increasing foreign central banks holdings of US public debt) has two breaking points: how strong is the collateral needed to sustain the household’s debt, and how much can grow the propensity to bear the currency and interest rate risk by the foreign central banks.
- Through a debt (mortgage) of 100 dollar I buy a flat for 100 dollar. The mortgage to real estate ratio (MRER) is 100%. The price of the flat goes, to simplify let’s suppose in real time, to 200 dollar. The MRER becomes 50%. I can increase my debt for consumption or education. I can borrow more money, due to the higher price of my flat. Even if my debt increases to 200, the MRER stays at 100%. Furthermore, if the interest on debt becomes 4% from 8%, the debt burden is unchanged. This is the “virtuous cycle”. Let’s now imagine that the price of the flat collapses to 100. My MRER doubles to 200%. The value of the collateral (the flat) is now insufficient to sustain the debt. Furthermore, if the risk into the system increases, the interest on the debt increases as well. The “vicious cycle”.
- The price collapses because too much flats have been built, and because the price to rent ratio has become so high that it is convenient to rent the flat rather than buying it. (An “arbitrage” emerges). The glut of flats emerges clearly in 2006, and the above any historical average of the price to rent ratio emerges, again clearly, in 2005. After a couple of years, the US real estate market started collapsing. The largest share of the mortgages have been financed through the issue of bonds, subscribed by banks and other investors. Therefore these bonds collapse. (A technical note: the crisis emerges because of the “return the key” system. Into the US, when the house price goes under the mortgage value, you can simply leave the flat. In most of the European countries you can’t “divorce” from your debt, whatever the price of your flat in comparison to the mortgage is).
- You are a US citizen. If your savings have been small and you are not so far from the retirement, as happens to the most part of the US middle class, you are in trouble. You can’t sell your flat at a higher price (i.e take a smaller flat, then spend the difference as a kind of pension). Furthermore, the value of your stock portfolio has halved: You must save for your retirement. Hence, the first prediction: In the coming years the US saving rate will increase, in other words the US consumption growth will be low. Hence, the second prediction: The driver of the US growth in the last decades will disappear.
- Let’s suppose that China, for financing its export led development, will continue to accumulate a lot of US debt. In order to control the growing risk, China can increase its domestic consumption and export less (=accumulate less US debt). Hence, the first prediction: In the coming years the chinese consumption growth will be higher. Hence, the second prediction: The foreign cheap financing of the US growth will disappear.
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