A riposte to the Dollar Crisis essay

In response to Richard Duncan''s essay the Dollar Crisis, we received this counter-argument from New York.

The Editors received the below from Sam Baker, Director/Asia group of Trans-National Research:

Duncan's conclusion rests on flawed premises that financial and/or economic bubbles are bad, and that deflation is bad. Let's take a closer look.

First, though, I'd like to set the record straight regarding Duncan's assumption that deflation has been a permanent part of the Chinese economy since 1998. In fact, CPI has been in positive territory for about a third of the time since then, and returned to positive territory again in the past couple of months.

Even if Duncan's premise about deflation being a chronic part of China's economic landscape were true, his worries here are over stated. Deflation in China is for the most part good deflation, reflective of higher productivity and higher living standards.

Private consumption has remained on an upward trend as a percentage of the economy since 1998, with multiple anecdotal points of evidence supporting this idea. For example auto sales grew 50% last year while power consumption grew over 10% the past two years.

"Creative destruction" seems to be insensitive if not politically incorrect term to use at cocktail parties nowadays. So unrefined! However, no matter how much baggage Schupeter's concept carries today, its underlying principals still apply in the real world. Positive economic developments and effective public policy often comes in the wake of economic crisis.

In fact, the reorientation of economic policy throughout Asian governments has been profound since the Asian crisis. China especially has focused on boosting private consumption, but other countries have also focused efforts here, such as South Korea and Thailand.

Japan is a notable exception to this general rule in Asia. Japanese policy makers and notable economists such as Duncan continue to do a disservice to the Japanese economy by making excuses for its deflation problems by putting the problem on China or the US as Duncan does in his new book.

The fact is, if Japan had a more flexible labour market and fewer protections for domestic services, then Japanese businesses would adapt, like their US counterparts did in the 1980's and continue to do today by outsourcing production to low cost countries while redeploying human and physical capital into more productive areas. The doomsday warnings about the hollowing out of the US industry never happened.

In fact, the outsourcing phenomenon has created higher standards of living across the globe including in the US over the past two decades and counting. This is not to dismiss the near term dislocations caused to laid off workers from global competition.

Surely, the micro impact of macro shocks from globalization and international capital flows can be harsh and real. Policy efforts should be consistent in time and money aimed at dampening the effects of what can be very painful transitions for the job casualties of unbridled globalization, competition from low-cost producers or the inevitable booming and bursting of financial and economic bubbles.

One thing that can be done - that has been done across Asian in the wake of the Asian crisis - is an improved social safety net. Unemployment was a non-issue for Asia for so long there was just no infrastructure to limit damage of such an economic shock as happened in the Asian crisis.

But this has changed dramatically with South Korea a great example of a country that has implemented an unemployment insurance scheme. More needs to be done, but the changes in government attention if not action has been profound in the area of improving social safety nets throughout the region.

Of course important policies can be implemented in the area of bank oversight for example that are effective in limiting the worst excesses of financial and economic bubbles. But it is just not practical to talk about using public policy to prevent financial and/or economic bubble. Sure like we said, public policy can be extremely effective in limiting the excesses of the next bubble.

However, if you kill the ability of an economy to create a bubble, then you simultaneously kill the sources of growth in an economy - i.e. innovation and risk taking. The less volatility you want in your economy and in your financial markets, the less economic vitality you'll get as a result. Of course there are realistic tradeoffs that can be worked out between economic dynamism and growth. But Duncan doesn't make this trade off explicit.

He glosses over what it would "cost" an economy if policy efforts were focused on limiting bubbles. In fact, I'd argue that growth comes from the same place that bubbles emerge - the willingness and ability of entrepreneurs to take risks and deploy capital. If either the willingness or ability of businessmen to take risks is meaningfully dampened, the result will clearly be lower economic growth over the long term.

Not all bubbles are created equal: meantime, let's take a look at Duncan's implied premise that financial bubbles are bad. In the late 1800's we had several rounds of railroad bubbles. investors piled into railroad projects, too much capacity was built, and then crash ... only to be repeated. The result, however, was dirt cheap transportation that facilitated the rapid growth of the US economy.

Without the railroad bubbles, the economy wouldn't have benefited from the rapid build out of rail capacity. The same can be said of the tech bubble. Huge excess capacity in fiber optic wire caused by over investment is now facilitating the emergence of a whole new internet economy on the back of inexpensive bandwidth. The money "lost" by investors in the Nasdaq crash was not just "lost." Some went to building excess capacity that some day will be needed and in the meantime is providing inexpensive bandwidth for consumers and businesses.

The money "wasted" on dotcoms also trained a whole new generation of American entrepreneurs, not to mention attracted the best and brightest minds around the world. Of course now we are seeing reverse brain drain back to places like India and China, but that is a win/win for the world and US economy as globally minded businessmen with world class skills seed those countries.

The Japan bubble of the late 1980's is different. This bubble created excess manufacturing capacity for goods the world didn't need as well as a huge real estate glut. The creative destruction part of the bubble aftermath was not able to happen in Japan based on lack of flexibility in labor markets, and a protection of home service industries. Bad loans have stayed on bank balance sheets and not enough new companies have replaced the deadbeats creating a vicious cycle where banks don't lend and the economy staggers along.

This is a home grown problem in Japan. Imported deflation from China and/or the US is a convenient excuse for the economic ills of Japan. Look at China -- the country is experiencing dynamic growth despite deflation. Japan could do the same if not for inflexible labour markets and a non competitive service sector caused by well meaning but destructive protectionist policies. Of course, governments should focus on the micro level dislocations caused by global competition and do everything feasible to help individuals deal with the pain and suffering caused by "lost" jobs to foreign imports.

However, the answer is not as Japan has done to protect labour markets ex-anti from the pain caused by external competition. What that does is constrain growth by not letting labor and capital flow to productive enterprises. People are saved jobs in the Japan model, but the overall economy suffers. This is the real danger to the world economy.

While Duncan warns of the dangers to the current "arrangement" whereby Asia supplies the US with cheap goods and then finances the US current account deficit by buying US assets, the economic structure of the Asian regional economy is changing, ex-Japan. There is a secular trend toward growing private consumption in Asia, centered on China, that is helping fuel and in turn a parallel secular rise of regional trade.

China learned an invaluable lesson from the Asian crisis that Japan still has not learned, that private consumption is an important leg of a domestic economy. As China's economy grows and if boosting private consumption remains a policy focus of china's government then one day China will graduate from the ranks of the current account surplus countries. this is a natural evolution whereby China would then be able to take on a roll similar to the US, that is becoming a net current account deficit country. Japan has short circuited this natural evolution through its own ill conceived policies that encourage protectionism and domestic savings over consumption.

This does not mean that the world is stuck in this mode forever. The dollar can gradually adjust as countries transition from current account surplus to current account deficit countries. Duncan's view of the world assumes a static scenario where China and India remain huge current account surplus countries forever, an erroneous assumption based on Japan's bad example caused by home growth policy failures.

There is nothing inherently right or wrong about current account deficits or surpluses. Context if everything. If economies transitioned like the US to current account deficits over time, as Japan clearly could and should have done over the past decade, then the looming "crisis" Duncan talks about would merely be a natural progression and evolution for the global economy.

Just because Japan has been stuck in a policy paralysis that has stunted growth and fueled deflation, it doesn't follow that China, India and Russia will follow this path. China has demonstrated an enormous capability to learn from others mistakes as evident in its focused efforts to boost private consumption post Asian crisis, including such measures as raising civil servant pay, facilitating consumer credit institutions (e.g. mortgages, auto finance, credit cards), commercializing bank lending, improving consumption boosting infrastructure (e.g. roads and access to power), etc.

There is a happy ending to the story Duncan characterizes as an inevitable tragedy. It follows from two secular trends that have emerged in Asia over the past 10 years - notwithstanding a temporary pause coincident with the Asia crisis - including the growing importance of private consumption as well as the rise of regional trade patterns with China at the centre of both.

If you wish to order a copy of the book The Dollar Crisis please call Randhir Prakash on (852) 21225228 or email him on [email protected]

The book costs US$30 and is published by John Wiley. To read Duncan's essay click on the related article link below.