The International Financial Crisis and the Rise of China

The author is a former Mayor of London’s Director of Economic and Business Policy, equivalent to the present position of Deputy Mayor Visiting Professor at Antai College of Economics and Management, Shanghai Jiao Tong University, China

The contrast of China and Russia over 18 years

I want to start with an article I wrote in March 1992. Its title is self-explanatory - ‘Why the economic reform succeeded in China and will fail in Russia and Eastern Europe’. Equally as important as the title is the date – the article was written in March 1992 and published in September 1992. As this is an article written 18 years ago it is not a post facto commentary on events which had happened but a prediction on what would take place – happily in the case of China and unhappily in the case of Russia. For those who are interested it is possible to read it in Russian here
http://ablog.typepad.com/keytrendsinglobalisation/1992/03/index.html
and in English here
http://ablog.typepad.com/keytrendsinglobalisation/1992/04/index.html.
This is part of my blog ‘Key Trends in Globalisation’ which is at
http://ablog.typepad.com/keytrendsinglobalisation/.

As the test of any theory is that it predicts what will happen I believe that the 18 years which have taken place since this article was written, and the events in Russia and China which it predicted, validate its overall conclusions and make it worthwhile to return to this analysis – including for what it reveals about what will take place in the future . I want to examine the reasons why it was possible to predict these trends in advance and analyse what has taken place since.

China and Russia as seen in 1992

I came to Moscow for the first time in December 1991, I moved here in March 1992 and lived here for eight years. The reason for being here was because it was perfectly possible to foresee that an economic catastrophe was going to take place in Russia if the policies that were being pursued at that time were followed and that there was an alternative model which could have been adopted - the extremely successful economic reforms which were carried out in China.

I think it will be fair to say that the majority of people to whom I presented this view in 1992 found this idea fantastic. As I was told on several occasions, both by the government of the time and by the ‘opposition’: ‘there is nothing which Russia can learn from China.’

I remember having a debate with Alexander Lifshits, who at that time was the economic adviser to the president, in Oryol. He was so agitated when I said that there was a great deal to be learned from China that he especially demanded to come back onto the stage to contradict such a view - as I had spoken after him.

18 years later the balance sheet of what occurred is very clear. China has become the second greatest economic power in the world and has had the most rapid economic growth in human history. Unfortunately the catastrophe that it was perfectly possible to foresee in advance in Russia did occur - between 1992 and 1998 Russia suffered the most rapid decline in its economy in any major country in history. I was a personal witness to something which I did not like seeing - which was economic catastrophe and decline in Russia.

After 2000 I had to return to Britain as I was in charge of economic policy in London, as the Mayor of London’s Director of Economic and Business Policy, equivalent to the present position of Deputy Mayor. And I am now in China as Visiting Professor at Antai College of Economics and Management in Shanghai’s Jiao Tong University - where I see the immense drive of the Chinese economy at first hand.

Western and Chinese economic theory

I want to describe here an economic policy in China which has been not only extraordinarily strong as regards its macroeconomic principles but also as regards its practical economic management. I could describe this in two ways – one 'Western’ and one ‘Chinese’. But in reality I believe they describe the same thing. I also want to link this description to the current events in the world financial crisis.

The first description could be made in the terms used by John Maynard Keynes in The General Theory of Employment, Interest and Money. He said: ‘a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.’ This was the conclusion of one of the great figures of Western economic theory.

I could also describe it in Chinese terms. Deng Xiaoping, one of the greatest economic geniuses in history, described it in quite different words to Keynes. He described a process he termed ‘socialism with Chinese characteristics’ ("a socialist market economy" as they call it today in China).

It’s not very interesting in my opinion which words you use to designate the process because they are describing the same thing.

In the recollections of her father Deng Xiaoping, by his daughter Deng Rong, there is a very moving passage on the first page in which she explains the unleashing of the cultural revolution in China and the chaos that this lead to. She explained that because people were trying to avoid universal economic laws they led China into ten years of setbacks . And one of the greatest achievements of her father was to sort out this mess and to bring China back to its very successful path.

Similarly the reason that it was possible to see in advance both the catastrophe in Russia and the extraordinary growth of China was because they were the results of universal economic processes which nobody can escape. Of course each country is a specific combination, and so Britain or Russia just as much has ‘British characteristics’, or ‘Russian characteristics’ as China has ‘Chinese characteristics’. It follows that no country can successfully mechanically apply the policies of another. But these specific combinations in each country are made up of universal elements.

So what I’m going to describe is analysed not in Chinese terms, or in Western terms, but in universal economic laws. And that is also why it was possible to see what was going to happen in advance both in Russia and in China. To bring this analysis up to date I want to look at how these processes are related to present economic events.

The international financial crisis

Let us start with the present international financial crisis and examine the way in which US has responded to it and the way which China has responded to this. It will be possible to see from this the connections to the economic processes which have taken place in China and Russia in the last two decades.

To briefly summarise the scale of current international financial events Slide 1 shows the size of what are now the largest bank rescues in history. The most important figure is the one on the right at the bottom showing the scale of the financial bailouts given to the major banks as a result of the financial crisis. As can be seen it amounts to about 25% of world GDP. That gives the type of scale of intervention by the state that has occurred into the major economies of the world.

Slide 1

Slide 2 shows what had been occurring prior to this crisis. It graphs the capital ratios for the US and UK banks – that is how these banks had become progressively more decapitalised, i.e. in a riskier position.

Slide 2

Slide 3 shows the number of bank crises and the number of deposit insurance schemes from the 1960 onwards – it illustrates the trend toward bigger crises.

This directly financial dimension, however, is the superficial, outward, part of what is taking place. It is necessary to go deeper into the mechanism of what is taking place and driving the financial crisis.

Slide 3

The scale of the decline in production

Turning to the productive economy it is first necessary to show, as overheated rhetoric is unhelpful, that it is no exaggeration to say that this is the most serious economic downturn in post World War II history.

Slide 4 shows the movements of GDP in the combined G7 countries in the main business cycles since World War II. It shows the decline in GDP in the business cycle after the 1973 oil price rises, during the 1980 recession under Reagan, after the bursting of the dotcom bubble and finally the movement of GDP of the present crisis. As you can see the present decline is of a wholly larger scale than any of the previous ones – that is a downturn of production of a completely different order to anything since World War II.

Slide 4

Slide 5 shows the same trend in industrial production. It shows the index of industrial output in the G7 countries since 1960. The fall in industrial production is of about 20% - again far larger than any downturn seen since World War II.

Slide 5

The effect of the financial crisis on different countries

Turning to the impact of the financial crisis on individual countries Slide 6 shows countries, which have come well through the financial crisis, and the major economies, which have done particularly badly. It shows the decline in production in the US, Japan, Germany and other G7 countries and the two countries that have come most strongly through the crisis – India and China.

Considering China, it achieved 8.7% GDP growth in 2009 and its economy was accelerating – growth in the 4^th quarter was up 10.7% year on year. I therefore want to examine what is the connection between China’s overall economic policy and its ability to come so strongly through the financial crisis.

Slide 6

Reality and myth about the international financial crisis

The first thing which it is necessary to do is to see clearly the nature of what is happening in the international financial crisis - as opposed to some myths about it.

Sometimes it may be read that the crisis is due to some problems of the American consumer or perhaps it’s only caused by unwise loans by banks in the US to people buying houses. In that case it would be rather easy to deal with. But in reality these are not the causes of the crisis, they are simply its symptoms. Nor are they the way that the crisis is working itself out. Nor, therefore, can they be the way to deal with the crisis.

In order to show what’s actually happening in the financial crisis l first consider as comparison the most classic of all economic downturns – the post-1929 depression in the United States. Slide 7 shows the movement of the components of US Gross National Product (GNP) after 1929. Taking first GNP itself the fall was very severe – almost 30%. Consumer expenditure followed GNP rather closely. Government consumption continued to rise throughout the depression - incidentally not only under Roosevelt but also under Hoover.

What drove the depression, however, was what happened to investment. If the fall in GNP is about 30%, the fall in investment was almost 80%. That was therefore an investment collapse. This was the driving force of the US Great Depression after 1929.

Slide 7

Turning to what is taking place currently, Slide 8 shows what is happening to the components of US GDP in the present economic downturn. You will see that the pattern is almost exactly the same, as after 1929 – not, of course, the magnitude of the shifts. The graph commences in 2006 because it was at that point that the downturn in US investment started.

The decline in US GDP was 3.8% at its worse, and the fall in consumer expenditure was 1.8%. As after 1929 government expenditure rises continuously. The situation is again dominated by a huge downturn in investment. Not of course the 80% downturn in investment that occurred after 1929 but still a downturn in investment which approached 35% of GDP. It is quite clear that it is this downturn in fixed investment which dominates and is driving the recession.

Slide 8

In order to make this trend still clearer, and to put it in money terms, Slide 9 shows the changes in US GDP in dollar terms – since this graph was made revised official figures have been issued which show exactly the same trends but in an even more dramatic form.

Between the beginning of the US economic downturn, after the 2^nd quarter of 2008, and the 4^th quarter of 2009, US GDP, in current price terms, declined by $82 billion. US personal consumption, however, increased by $14 billion. US government expenditure increased by $19 billion. US net exports rose by $308 billion. However US fixed investment fell by $448 billion. In short the entire decline in US GDP was accounted for by the decline in fixed investment.

Slide 9

In other words if you read certain Western commentators, and I imagine it’s repeated in the Russian press, that the economic downturn is something to do with the ‘exhaustion of the US consumer’ this is simply factually untrue. There is no serious downturn in the consumption in the United States. But there is a large scale collapse of investment in the United States.

Let’s go now go on and look at what is happening in the other countries.

(next part)