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A major theme is missing from the central bankers’ annual retreat at Jackson Hole, Wyoming. Everyone is talking about collapse of the US home-price bubble and the danger of recession, but no one is talking about the suckers who financed the bubble, namely the savers of Asia.
Asia will do so no longer. If the United States wants Asian investors to continue to take risk on its shores, it will have to allow them to buy solid US companies, rather than the sort of debt derivatives that blew up this summer.
One exceptional fact accounts for the instability in financial markets during recent weeks: the Chinese and many other Asians save about half their income, while Americans save none of their income at all. Foreigners, mainly Asians, invest US$1 trillion a year in the United States, because their home economies cannot absorb so much investment, or because the political risk attached to local investments is too great.
In the present iteration of Aesop’s fable, American consumers are the grasshoppers and Chinese (and other Asian) savers are the ants. The trouble is that Asians have put their savings into the balance sheet of US consumers.
Outside the US, it seems incomprehensible that the average family would save nothing for retirement or against a rainy day. But God takes care of drunks, small children and the United States of America. In other words, the typical American family expected the value of its house to keep appreciating at nearly 10% a year indefinitely, eventually turning into a retirement fund. US home prices appreciated by 86% between 1996 and 2006; like the Cargo Cults that proliferated in New Guinea after World War II, Americans seemed to think that this would go on forever.
Delusional expectations about home prices justified a trillion dollars of loans to borrowers with poor credit or inadequate income (“subprime” loans), and that is the proximate cause of the bubble. World markets have swooned in response to what the media call a credit crunch – the reluctance of investors to accept the Frankenstein monsters of financial engineering. In the case of US mortgages of poor credit quality (“subprime”), derivatives technology sought to make a silk purse out of a sow’s ear, but it is a purse that still goes “oink” when opened. This has produced consternation across Asia, where many financial institutions invested heavily in obscure and complex instruments that cannot be sold today except at a severe loss.
When the world throws money at a national economy, large or small, credit is easy and stupid investments are made. America’s subprime-mortgage problem uncannily resembles the Asian financial crisis of 1997. Ten years ago, investors couldn’t put enough money into high-yielding investments in Thailand, Malaysia, South Korea and so forth, and financed an enormous real-estate bubble. When the bubble popped in the spring of 1997, Asian stock markets and currencies crashed. Asians have not forgotten the pious lectures about profligacy they suffered from the West just 10 years ago.
Many of the economists who offered opinions at Jackson Hole warned that the bursting of the home-price bubble might lead to a severe recession. If the rout on financial markets turns into economic distress, Western governments will have no one but themselves, and nothing but their own hypocrisy, to blame. After instructing China for years on the benefits of free markets, Washington, Brussels and other Western governments have imposed the strictest sort of mercantilist barriers upon the free movement of capital.
It seems obvious to ask why Asians should have bought exotic debt instruments, rather than buy brick, mortar and machinery in the United States and Europe. The answer is that the US and European governments will not allow them to do so. The specter haunting Western financial markets is not proletarian revolution, but the sovereign funds of China, Singapore, the Persian Gulf states and others, ready to invest hundreds of billions of dollars a year. But the West does not want to allow Asians to control major companies. The Chinese have told the US government that they will buy virtually any large US firm that the government allows them to – but the US government fears the political fallout.
Of course, one feels sorry for autoworkers in the US state of Michigan, who earn $30 per hour and expected to do so in perpetuity. Sadly for them, workers earning a tenth of that amount can assemble cars just as well. If I were a sovereign investment fund, I would buy Ford Motor Co, shut down all of its production facilities in the US, and keep the nameplate as an emerging-markets and European brand. But that sort of rationalization is precisely what any US government will try to prevent.
The excuse Washington and Brussels offer for ring-fencing their companies against Asian investors is that the prospective purchasers are sovereign funds, that is, agencies of the state, rather than private individuals. With the poor development of Chinese and other Asian capital governments, the state becomes the only entity capable of supporting national savings. Singapore created the model for this in its admirable pension program. China has no real pension program, but its more than $1 trillion of foreign-exchange reserves constitutes the rainy-day savings of the Chinese people. The Chinese authorities have begun to permit Chinese citizens to buy foreign securities, but for the moment the savings of the Chinese people are held in large measure by the government.
Why have Americans tolerated China’s penetration of its market for manufactured goods, at the expense of US manufacturing employment? Part of the answer, of course, lies in the fact that Americans are able to buy much cheaper goods. But a more important part of the answer, perhaps, is that China’s reinvestment of its export earnings in US debt instruments forced down the cost of capital in the United States, as Federal Reserve Board chairman Benjamin Bernanke has observed over the years. Cheap capital fueled an asset-price bubble in the US, generating capital gains for US households that made savings seem unnecessary.
If, as some of the voices from Jackson Hole predict, US employment falls as a result, protectionist measures against Chinese exports become quite probable. Cheap Chinese goods at Wal-Mart and cheap loans from the banks make a convincing case for free markets only when one has a job, and a house; if enough people lose their jobs and their homes, their first instinct will be to blame the Chinese. Democratic presidential hopeful Hillary Clinton has already embraced protectionism against China, an ominous sign.
China may have to shift economic gears in a hurry, spending more on its internal market and infrastructure, using if need be some of the foreign-exchange reserves accumulated during the past several years. It will have to seek markets outside the United States, especially in the emerging world. The transition may be painful in the short run for China, but I do not expect the Chinese economy to collapse even if the US throws up protectionist barriers against Chinese imports. China already has moved most of its young people out of the countryside into the cities, and there are reports of a shortage of young workers in Chinese cities.
Americans will have to work harder and save more. If the US wants to remain the magnet for world capital flows it became during the 1990s, it will have to allow the savers of the world to become partners in the US economy, that is, to buy into its first-rank companies. This is not a matter of US discretion; at some point, the United States will have no choice but to allow more foreign ownership. If Washington delays the inevitable, the price of US companies will fall, and Chinese and other sovereign investors will buy them cheaper.