The usual concern about the US-China balance of economic and political power is couched in terms of our relative international payments positions. We’ve run a large current account deficit in recent years (imports above exports); they still have—by some measures—the largest current account surplus (exports above imports) ever seen in a major country. They accumulate foreign assets, i.e., claims on other countries, such as the United States. We issue a great deal of debt that is bought by foreigners, including China.
There are some legitimate concerns in this framing of the problem—no country can increase its net foreign debt (relative to GDP) indefinitely without facing consequences. And the Obama administration, ever since the Geithner-Clinton flip-flop on China’s exchange rate policy early in 2009, seems quite captivated by this way of thinking: Will they buy our debt? Can we control our budget deficit? What happens if China dumps its dollars? (see page 18 of the linked pdf)
The real reason to worry about China, however, has very little to do with external balances, China’s dollar holdings, or even capital flows. It’s about productivity and rent-seeking.
China mostly invests in activities that raise productivity, raising the amount of goods and services that they can produce. This could be manufacturing or infrastructure or various kinds of services. Agriculture lags but continues to get some new investment. And of course they pour money into education.
I’m not a fan of the Chinese way of organizing their economy or their society. They no doubt have weaknesses that will catch up with them eventually (including waves of overinvestment in some sectors), and there’s good reason to think they will be the center of a big new “Asia Century” Bubble that is just now starting to emerge.
But contrast their pattern of investment in recent years with ours. What sector in our economy has expanded more than any other? Where should you work if you want both the highest wages on average, potentially very big bonuses, and quasi-retirement by age 40? Finance.
Of course, we need finance and an important part of modern economic development involves intermediating savings and investment. The United States did this well, with some bumps in the road, and built a system that worked through the 1960s or 1970s.
But finance as a share of our activities (i.e., percent of GDP) has roughly doubled in the past 40 years. What has this really added in terms of productivity? The ATM and the credit card were great breakthroughs, but they are old.
What has “financial innovation” brought us since the 1980s? One answer, of course, is “hedging strategies” that lower the cost of doing business for companies large and small. This is plausible, although not likely to be large relative to the economy—send me your favorite study on the cost of capital since 1990 (you choose the definition), and we can talk about whether this effect is significant, sustainable, or even sensible.
Financial innovation has mostly facilitated a big increase in finance. If a sector grows, pays more wages, and rises as a share of GDP, surely this is a good thing? Not necessarily—if this is a rent-seeking sector.
Rent-seeking means effectively a tax extracted by one sector from the rest of the economy. We’re used to thinking of this as something that occurs through trade restrictions and the big breakthroughs in this area came from analysis of tariffs and quotas (Anne Krueger, Jagdish Bhagwati). If a tariff, for example, will make your life cushy, you will devote great resources to getting one established or increased—irrespective of the effects on the rest of the economy (call this strategy “let’s hammer the unprotected consumer”).
Finance is rent-seeking. The sector has devoted great resources to tilting all playing fields in its direction. Consumers are taken advantage of; consumer protection is vehemently opposed. And great risks are taken, with the downside handed off to the government (and the consumers again, as taxpayers). This downside protection allows an overexpansion of debt-financed finance—reaching the preposterous levels seen in mid-2008 and now re-emerging.
Finance in its modern American form is not productive. It is not conducive to further sustained economic growth. The GDP accruing from these activities is illusory—most of finance is simply a tax on what is done by more productive members of society and a diversion of talent away from genuinely productivity-enhancing activities.
The rise of China does not necessarily imply slowdown or demise for the United States. But if they specialize in making things and we specialize in finance, they will eat our lunch.
On an urgent basis, we need real consumer protection against predatory financial practices and an end to all forms of Too Big To Fail behavior—which is actually just the biggest, nastiest form of predation. This is our most pressing national and international strategic priority.
Also posted on Simon Johnson’s blog, Baseline Scenario. The following was posted on Baseline Scenario on August 10:
Credit Conditions in the Absence of Consumer Protection
Even some of our most sophisticated commentators doubt a link between consumer protection and any macroeconomic outcomes. Consumer protection, in this view, is microeconomics and quite different from macroeconomic issues (such as the speed and nature of our economic recovery).
Officially measured interest rates are down from their height in the Great Panic of 2008–09 and the financial markets, broadly defined, continue to stabilize. But are retail credit conditions, i.e., the terms on which you can borrow, getting easier or tougher?
On credit cards, there’s no question: it’s getting more expensive to borrow, particularly because new fees and charges are appearing. Of course, lenders have the right to alter the terms on which they provide credit. We could just note that this tightening of credit does not help the recovery and flies in the face of everything the Fed is trying to do—although it fits with Treasury’s broader strategy of allowing banks to recapitalize themselves at the expense of customers.
But there is an additional question: will these changes in lending conditions be reflected in the disclosed Annual Percentage Rate (APR)? Historically, the rules around the APR—overseen by the Federal Reserve—have not forced lenders to include all charges in this calculation. Why is this OK?
It’s not OK. This would be like cereal manufacturers including only some ingredients on their labels. Or makers of children’s toys not telling you that some dangerous chemicals are involved.
Why has this been allowed to happen? Essentially, because nobody watches out for the consumer of financial products. Our regulation of financial institutions is byzantine and completely out of date; our banks game the system with impunity (e.g., nationally chartered banks are not subject to state usury laws; see this BusinessWeek article, section on payday loans).
Historically, the most powerful overseers of the system thought that this kind of detail didn’t matter–or that any changes in what banks did were a form of “financial innovation” that must naturally benefit everyone. But this is exactly the attitude that brought us to subprime, Alt-A, and other “exotic” (i.e., misleading rip-off) mortgages.
And it is, sadly, the attitude among existing regulators that still predominates today. This implicit attitude towards consumers is in no way helpful, if we want an economic recovery, jobs, and a reasonably stable growth going forward. But it’s what we appear to be stuck with.
Our financial regulatory system is a disaster. The Obama administration should have called it by its proper name, proposed to close it down entirely, and argued to replace it with a more integrated and completely rationalized approach. That at least would have moved the bargaining position of the regulators—they would now be too busy trying to save their jobs to oppose Treasury on substance.