Bury Keynesianism
By Weiying zhang: Dean of Guanghua School of Management of Beijing University http://www.gsm.pku.edu.cn/default_en.html
Feb 8th, 2009, speech at the Forum for Chinese Entrepreneurs
Mr Weiying Zahng, born in 1959, graduated from North West University in China 1982, major in Economics. Received the master degree in Economics 1992 from Oxford University, and received Doctor Degree in Economics 1994 at Oxford University. Strong supporter of Austrian School of Economics, strong advocate of no-intervention from the government. And he believes that the financial crisis was caused by the government.
Understand the crisis is more important than providing solution
The world is full of uncertainly. This is an old saying, but still reminds us deeply. One year and half ago, the economy confidence index from Chinese entrepreneurs was reaching the highest point since last 8 years. Even till early 2008, the index was still among the highest points since last 8 years. But later last year, the index dropped to the lowest point since last 8 years, and much lower than any time during last 8 years. Same as the confidence index from the Chinese economists. However, the survey number showed that the confidence collapse from the economists was one quarter earlier than from those entrepreneurs. And today, both the economists and the entrepreneurs are no longer as optimistic as one year ago!
The change of the confidence does reflect to the changing situation of Chinese economy. During last 12 months, the industrial growth index had 2 typical Characteristics: first, the growth speed has been going downward very fast, seems that all industries were doing something wrong at the same time; second, heavy industries were dropping faster than light industries, it means that the fluctuation of material production industry is bigger than the consumption material industry. Those 2 Characteristics are also the typical ones for all economy recessions. It should be said, that our economy is moving into a very difficult time, or the recession of growth.
The change in Chinese economy is the miniature of the world economy, despite our problem came little bit later. Now everyone is talking: when will the Chinese economy bottom out? Where is the bottom? Some people say it is V shape, some ones say it is U shape, and some others say it is W shape. The most pessimist ones say that it will be L shape. However, I think that the more important thing is that we should understand: why could this worldwide economy recession happen? There would be different answers to this question. But what I think, that the fundamental problem is: Is he failure of the market the root cause of this crisis? Or the failure of the government is the root cause? Put another way, did the problem come from the "invisible hands" or from the "Visible hands"? Different answers and understanding would lead to different options of policies. And it's not just our current policy; this will also decide our future economy system, and the future direction of the economics.
In general, the western economics divide the market confidence (trust, belief) into 4 layers. First one is "no any confidence to the market economy", and with no trust to the market economy at all, this is the traditional Marx economics. Second one is the suspects, with constant swing, sometimes has confidence, sometimes not, this is the Keynesian economics, or called the interventionism from the Government. Third one is full confidence with market economy, but also believes that the government should intervene when necessary, this is Chicago school of economics. Milton Friedman believed that during recession, the government should take positive monetary policy to get the economy out of bottom. Fourth one is full confidence with Market without any doubt, this is Austrian economics represented by Mises and Hayek, and the major players are now based in US.
Some people are blaming the market for this economy crisis, and especially the result of free economy. It's true that the Keynesian's intervention policy is in dominance all over the world after the crisis. However, the fact and logic reveals that this crisis was not caused by the market, but rather by the failure of government policy. Not by the "greed" from the business person, but rather by the wrong decision from the ones who are responsible of the monetary policy. In my opinion, this crisis is the opportunity to revive the Austrian economics and bury the Keynesianism.
Review the explanation of the great depression by Austrian economics
Let's review that great depression occurred 80 years ago, even though the background of this crisis is different from that one, especially with the globalization and the rise of emerging market, like China, but there are still a lot in common: before the crisis, one side is the technology innovation, the surge of productivity, high speed growth of economy, stable price level and even moving lower, everything seems normal; and on the other side, continuous credit expansion, excess liquidity, lower interest rate, strong investment of fixed asset, severe bubble in stock market and housing market, seems unsustainable. The Japanese recession starting in early 1990s and the financial crisis in East-south Asia in later 1990s had the same symptoms.
Did anyone predict that worldwide recession during 1929-1933? Yes, 2 people did, only 2 people, even though they didn't give the exact timeframe. One was Mises, another one was Hayek, both of them was leading Austrian economists, and Hayek got Nobel Economy prize in 1974. The reason they were able to predict the economy crisis in 1929, was because that they had a complete, and more scientific business cycle theory. Based on their theory, the monetary expansion policy by Federal Reserve during 1920s sets the interest rate at very low level; it caused the bubble of the credit, and the final result was the great recession and depression. Why? Because the low interest rate distorted the resource allocation signal, so the business persons invested in some projects which should not be considered, especially some heavy industry, housing industry that require heavy capital investment, and very sensitive to the change of interest rate. The stock market bubble caused Excessive liquidity that would help fuel the investment of fixed assets and led to overinvestment. More and more investment demand led the price surge of raw materials and the salary, thus caused the investment cost went up, and eventually brought no profit to the investments. At that time, the government was not able to continue the monetary expansion policy as they did before, then the housing and stock market bubble blew, the investment capital was stuck as non-cashable fixed assets(like factory building and property), which caused the lack of capital(liquidity), all investments projects started to suspend and stop, then the great depression started. Based on Mises and Hayek, in any economy, any artificial boom would cause a big recession later on. The big boom and big recession are the 2 sides of a coin. Their theory also told us, to judge whether an economy is over heated, we should not be observing only the surge of the price, we should focus on the interest rate and the credit expansion, because there is a time difference (gap) between the credit expansion and the price surge, and when the inflation comes, the great depression comes along.
Different from Mises and Hayek, Keynes thinks that the great depression was caused by the lack of effective demand, lack of effective demand was caused by excessive residential savings, and the pessimistic to the future from the entrepreneurs, and unwilling to invest.
The 1929-1933 depression made birth of Keynesian economics. During the 1930s after the crisis, both Austrian economics and Keynesian economics could become the mainstream economics, but the Austrian economics has been edged. Keynesianism had the dominance over the world economy for several decades, till 1980s, people started having doubt about it. Why Keynesianism could become the mainstream? Put it simple, Keynesianism provided a good theory base for the government intervention: lack of demand, market stopped working; the solution is to have the government intervene the market, increase the demand, and lead the economy out of recession. However, the Austrian economists believe that the recession is the necessary correction of the market itself, which helps resolve the existing problem in the economy; the government intervention will only make things worse. In fact, without the intervention from Hoover government (including expansion of public investment, set salary and trade protection legislation), the depression would not last that long. So the government always likes Keynesianism. Of course, many economists like him as well, because, if Keynesianism is right, the government would create lots job opportunities for those economists. If the Austrian economics is right, those economists would have nothing to do in the government. Since we advocate non-interventionism, the market will adjust itself. The economists are also beneficiaries; I think that is one of the reasons why Keynesianism could dominate for long time.
With this background, let's take look at this: Greenspan wrote <Gold and Economic Freedom> in 1966, in that book, he had the explanation for that economy crisis during 1930s. He said: When business underwent a mild contraction, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. The Federal Reserve succeeded, but during the money printing process, it almost destroyed the world economy, the excessive credit created by the Federal Reserve was absorbed by the stock market, thus stimulated the investment activities, and caused another false boom. The Federal Reserve tried to withdraw those excessive reserves, in hope of suppressing the boom, but it was too late, the imbalance caused by the speculation failed the contraction attempt by the Federal Reserve, thus led to the loss of business confidence eventually, and the final result was the collapse of USA economy.
The explanation of the great depression by Greenspan 40 years ago was almost the same by Mises 80 years ago. However, the pity is after 40 years, his behavior is not much different than the one he criticized early on. People would behave differently while on the stage and off the stage.
What's the root cause of this crisis?
Let's take look at this crisis we are facing now, is there anyone who predicted this crisis? In fact yes. There is one investor whose name is Peter Schiff, academy type of investor, at 2006 or even earlier, predicted that the crisis would be coming soon, and USA economy will be going into great depression, and economy will collapse. At the same year, the chief economist from International settlement Bank, William White also wrote that, worldwide economy crisis was coming. Also, the economist form US Mises Institute, Krassmir Petrov wrote an article in 2004, he compared the Chinese economy at that time with the US economy back in 1920s , and predicted that China will have great depression after 2008. These 3 economists are all Austrian economists, or its supporters. Their theory framework of economy analysis is originated from Hayek's business cycle theory. William White thought, Austrian economics is more practical for analyzing global economic problem. Of course, there were some other non-Austrian economists who had same type of warning.
In my opinion, the root cause of this crisis is no big different from the one in 1929. The low interest rate policy and credit expansion by the Federal Reserve, distorted the market signal, people who should not borrow money borrowed money, people who should not buy the house bought the house, the projects that should not be invested started, thus caused the fast growing housing bubble and stock market bubble. The subprime borrowers were attracted by the low interest rate and housing bubble, and bought the house that they should not have bought, but it's only the fuse of explosive, not the root cause. When the interest rate signal was distorted by the government, No matter what financial assets and fixed assets are, their pricing scheme all stopped working, i.e., the P/E ratio was no longer the appropriate measure for evaluating the stock pricing, because the profit itself was distorted. The profit was distorted, because the product pricing was distorted. And there was nothing to do with financial regulation.
Another very important reason was that the loan was guarantee by the US government for the housing market. The reason that Chinese government was willing to buy a few hundred billion dollars of debt from Freddie Mac and Fannie Mae, and lent money to them generously, because those 2 institutions are guaranteed by US government. If they were not guaranteed by US government, we would not lend money to them. With government's guarantee, the lender will not worry about the credit score of the borrower, and his ability to pay back, the borrower would get loan easily since it's guaranteed by the government. This is the moral hazard and risk caused by the government; the same reason that caused East Asia economy crisis.
However, from another point of view, this crisis has a big difference from the one in 1929. At that time, China had very small economy power, but now China is completely different. We have to add this element into it while understanding today's economy crisis. Without understanding of Chinese economy, we will not be able to fully understand the cause of this crisis, without understanding of China's position in the world; we will not be able to get out of the crisis.
Some international analyzers think that this crisis was caused by China. Because Chinese people don't spend, and that made American people spend. This is of course not right, like we cannot blame the US creditors for the East Asia economy crisis. But we need to think why they came up with this question, instead of counter attack with emotion. China's export surplus has reached 7-8% of the GDP; foreign currency reserve was 100 billion in 1996, 200 billion in 2001, 1 trillion in 2006, and 1 trillion 950 billion in 2009. In the Global economy system, what kind of influence would bring to the global economy with this type of fast growth of our foreign reserve? Would it be this severe if the crisis occurred 5 years ago? I think not, Americans could not even spend this much of money even if they liked to, because nobody would supply to them. If we have more freedom with our financial system, we could have a free floating Exchange rate system, the appreciation of Renminbi would warn the Chinese companies at that time, and make our entrepreneurs pay attention to the quality of our products, instead of simple export with our cheap labor and resources, and we would have less export surplus, less foreign reserve, and our money supply would not grow this fast, with less overinvestment. So if US economy has problem, we would not face the great difficulty like this.
Economy crisis is always the results of multiple behaviors. The lenders, the borrowers all have responsibilities, not just a single one. The key is what caused this type of behavior. The difficulty that Chinese economy is facing now is not too much freedom with US financial system; instead, it is too little freedom with our own financial system. No matter what, it's related to the failure of the "visible hands".
Government should save the Market? Or let it adjust itself?
When the economy has problem, people usually ask the government for help, and the government thinks that's its job (to save the economy).
Is that possible to save the economy from the recession by increasing the credit and expand the demand with Government's help? I doubt it. Why the crisis in 1929 lasted so long? It was because of too much of government intervention. Now people are talking that Roosevelt saved US economy with his New Deal, he actually had not much of "new deal", his policy started since Hoover took over the white house. There is plenty of evidence now that Hoover government increased the public construction investment, raised the tariff, set the salary, all started before Roosevelt took over the office, and led to the failure. Based on the analysis by the Austrian economists, it was because of the government's policy to save the market, that prolonged the market's self-adjustment, and made the depression last longer. The Japanese government's policy to save the market during 199s caused the same failure. Zero interest rate policy plus large amount of public investment did not lead Japanese economy out of depression.
How about our current policy to save the market? Will it succeed? I think that there might be short term effect. However, what's the best solution? It's the market's self-adjustment; the policy from the government may postpone the market's self-adjustment. i.e. the current economy is like a drug addictive, and the prescription from the doctor is morphine, so the final result will be much worse. With excessive investment, it may not take long for the economy to drop again, and even more miserable.
Let's take the housing market as example; I agree to eliminate all the policies and regulations related to the increase of trading costs in the housing market, let the market function more on itself, that's it. I don't agree with the government bailing out the market. With free trade, the price will drop to whatever level it works, the government should not intervene. If the government wants to inflate the price, which should be at $750/square meter, but if we want to keep it at $900/square meter, it will look like it's up there without dropping, but no one wants to buy it. So the housing market will not grow. If we do the opposite, and let it drop to the bottom (the right level), $750/square meter or even $450/square meter, the housing market will revive again. Not only the housing market, will the same logic apply to all industries.
The bailout of the bankrupted companies by the government, not only it destroyed the punishment mechanism of the market, prolonged the industry restructure, it also made small problem bigger. Since the government is only willing to solve the big problem, not the small ones. The bailout policy by the government also lowered the self-bailout enthusiasm by the companies, and led more speculation and more bad loans. The more capital the government invest, the scarcer of capital.
Now, every government is Keynesianism: Stimulate the demand. But this does not make sense in theory. Since they think that the crisis was caused by the overspending from Americans and overinvestment from Chinese, how can they resolve the crisis by more spending and investments?
Some people say that Chinese people only save and not spend; the saving rate is too high. But in fact, during last few decades, the saving ratio in the income by the Chinese family is decreasing, from more than 30% in 1996 to around 25% in 2000, with no big change after; the ratio of residential spending in GDP was 20% in 1996, and only 15% in 2000, 16% in 2006, much lower than 22% by Indian people. Of course, the saving rate by Chinese is the highest in the world, but mainly from the companies and the government, not the families. High saving rate are reasonable with some companies, but not with some others. Why state owned companies have very high investments? Because to them, the profit could be given out as bonus, with no need to give to the government and families, the capital cost is zero, even negative (the capital will have to return back to government if not used), so why not invest? Then the result is ineffective investment on one side, and no money to spend by the families, on other side. This is the reality in China.
The Chinese statistical yearbook calculated the "contribution ratio" to the GDP by spending, investment and net export, some critics often use this number as reference. But this number is hard for people to understand. If we review the GDP from last 30 years with this number, we discovered that "spending contribution" and "export contribution" are negative growth compare to the GDP growth; only "investment contribution" shows the positive growth along with GDP growth. It means the more spending and more export, the lower growth of GDP, the more investment, the higher the GDP growth. So if only for the GDP growth, should we stimulate more investment, or spending, or export?
This problem shows that Keynesianism's demand economics can't provide the answer to our question. We should know that the economy growth depends on the production, supply, not the demand; it's supply that creates demand, not the other way around. If stimulation of demand could help the economy growth, we would be in communist society very early on! When Deng Xiaoping traveled south, and gave speech, he didn't mention how to stimulate the demand, but our economy had new surge right after. Why? Because Deng Xiaoping expanded the freedom of individual option, individuals can have opportunities to create jobs, can have private business, then the economy can grow naturally. This though still works today. So we should act as the Austrian economics recommends, stimulate the production through the reform of ownership rights and incentive system; Instead of stimulating the demand and considering the saving as crime (evil). This would be the best option. The only way to increase the residential spending is to increase their income, when their income grows, the spending will grow naturally.
Release people's energy earlier and faster
I would like to propose the following:
First, Move forward with the market reform, liberate the productivity. Only reforming the market, breaking the monopoly, opening up the market, reducing the bureaucrat procedures, and let the private business to compete freely and fairly with state owned companies and foreign companies, could release the energy of Chinese economy, and make our entrepreneurs confident to the future. If attempting to stimulate the investment, we should stimulate more investments for the private sector, instead of the ineffective investment for the state owned companies.
Second, Move forward with financial reform, especially the reform of Exchange rate market. If we had the Exchange rate reform a few years ago, the crisis would not be this severe. It means that if we don't reform, it will be hard for us to lead out of bottom. The Exchange rate reform should have started in 1997, but the Asia financial crisis made us to be too prudent, thought that it's safe with the foreign reserves in our hands, and hesitated to reform, thus dragged for more than a decade. Right now, it seems that excessive foreign reserve is as harmful as insufficient foreign reserve.
Third, move forward with the labor market reform. To judge whether a policy works or not, we should make judgment based on its effects, not the nobly goal. When we say that a policy is bad, it means that its effects are conflicting with its goal. The labor contract law is a typical example. The goal of the new labor contract law is to protect the interest of the labor, but it causes most of the damage to the regular workers and the farmers looking for jobs, because it reduced dramatically the job opportunities. The labor contract law is not only harmful to the economy by the costs; it's also harmful to the enterprise's culture. Now, it's getting more and more difficult for the companies to manage the people, and going back to the old situation like "The squeaky wheel gets the grease". So I suggest stopping the execution of the regulation of contract freedom in the new labor contract, and giving more freedom to the labor contract.
Fourth, transfer the wealth from the state to the people. Economics is focused on the research of the wealth of nation, not the wealth of state. In our country, too much wealth is in the hand of the government, not in the hands of the people. I think that we could use this crisis to transfer our national wealth to the people.
So we should consider reducing the tax, especially the value-added tax, UK already reduced to 15%, China should reduce as well. I'm against the discriminatory preferential treatment of any sort, because that would cause the corruption and counterfeit. Reduce them together, including the company's income tax and personal income tax. Tax reduction is not simply the revenue redistribution; it should help increase the nation's wealth through raising the enthusiasm (interest of work). Tax reduction should help increase the government's total revenue in deed.
Then we should distribute certain amount of stock shares from the state owned companies to the people. Zhiwu Chen, Guozhong Xie recommended the same thing, I agree completely, that the stock shares of the state owned companies should be packaged and distribute partial of them to the people, and let people participate in the revenue redistribution. The total capital assets of the public companies controlled by the government are about $2.2 trillions。The government owns about 70-80%, if we take 40%, which would be about $0.9 trillion. We are not giving people an egg; we are giving people a hen. If the local level (province and city) government could distribute the stock shares from the companies they control, it would have the wealth effect, and will help with spending increase. And this will not affect the government's controlling power, because the government is still the biggest shareholder. This will not lead to the unfair distribution of wealth by the Russia's government's assets' privatization, because the stock shares have market value, their shareholders understand that the fair trade is possible, and it is impossible to be bought by minority at cheap price. Also, we could reduce the income gap through the distribution of stock shares. If we distribute the wealth based on the current income level, the simplest way is giving 2 shares to the farmers, and 1 share to the people in the city; 2 shares to the poor, 1 share to the rich. Of course, we could research and detail the operation procedures, but what I'm trying to say is: right now, portion of the nations' wealth should be distributed to the people. In short term, this could bring in the wealth effect, stimulate the spending. Since people has money to spend; in long term, it could reduce the operation pressure by the government, and reduce greatly the income gap.
The crisis and the surge of the great nation
I also want to emphasis that the companies should adjust themselves, and proceed with necessary bankruptcy and sell off. If so, after the crisis, and necessary M&A, larger size and more competitive international companies will emerge. I believe, that after this crisis, no matter which industry, a huge change in the industry structure, and company structure will occur.
The enterprise should have its core capabilities. Without it, the company would have problem next time, despite it survived this time. I found a strange problem during my investigation, that some big foreign companies, do not give OEM directly to Chinese companies, instead, outsource through the middleman. Why? Because the Chinese companies have very poor information technology, with no way to supervise and control the manufacturing process. If we can improve our information technology, and earn more trust, they will give us orders directly. This is a technical question, but directly involved our core competition ability. And of course, eventually, we should have our own brand product. During this crisis, the companies with their own brand product had less trouble compare to the companies with no own brand and with only OEM manufacturing. I think that it's also a lesson we learned.
As a Chinese, we don't have to be that pessimistic. Our economy potential has not yet fully released yet. After 1929 great depression, US became the economy powerhouse to replace UK, maybe this recession is the opportunity for China. Before 1929, UK was the economy powerhouse, the Sterling was the international currency reserve, but UK was the debtor, US lent money to UK, since UK had to borrow money to keep its empire status. Today, US is the economy powerhouse, China is rising country, China is lending money to US. It's possible that the change of world structure after 1929 crisis will reappear after the crisis in 2009. After 20 years, 30 years, or may be 50 years, China may be able to replace US, become the number 1 economy powerhouse in the world. So from this perspective, this crisis might be a good opportunity to China. All the great countries surge from a specific opportunity.
Of course, this needs our own effort; we need to continue our reform toward market economy.
Chinese government needs to listen to this man ASAP.
It seems AE are much more popular in "Communist" China than in the "Free Market" West. You are hard pressed to see a scholar learned in AE giving a speech to anything more than a libertarian/classic liberal circle. At the very best you see somebody feebly criticizing the so called New Economy but that's about as far as mainstream will go.