In the Nation's Interest

Acropolis Now Plus the Long, Soft, Great Fall of China

After all of the financial market fuss of this week, it’s a little hard to talk about anything else.

Commentators are screaming vituperatives at one another about Greece.  The Hellenophiles are irresponsible, if I can decode the shouting, and the Hellenophobes are inhuman.  This is one of those unsatisfying disputes where both sides have an element of the truth, and there is no definitive solution.

The situation of Greece in the European Monetary Union (EMU) reminds me of a line in a chess book that I read in my youth.  I just pulled the book off of the shelf; it has a 1946 copyright date and a 1956 release date for the edition I own.  (I confess to being a book hoarder; I was taught in my childhood that books are my friends, and so I have a hard time discarding them.  But I have learned empirically that books tightly shelved on an exterior wall provide outstanding insulation.)  At one point in the author’s analysis of the late stages of an historical game, he critiques a move by saying that it is Black’s best option, but it is not good, because Black has no good moves left.  This taught me two life (as opposed to chess) lessons: first, that what is best is not necessarily good; and second, that we can deplete our opportunities over time if we are not careful.

Greece today is an illustration of these concepts.  The EMU – as it was implemented – was arguably a mistake.  It gave Germany a permanent advantage because it in effect averaged the value of the currency of export-strong Germany with the currencies of its less-strong European neighbors, making Germany’s exports cheaper and more attractive.  Meanwhile, the EMU gave Greece a temporary advantage by increasing its perceived creditworthiness through that nation’s closer association with its wealthy neighbor, Germany.  That temporary advantage now has been fully exploited, and even reversed, as those perceptions have been fully disproved, and the resulting debt burden has become widely recognized.

So now the Greeks argue that their debt burden has become unpayable, and that the only way out is for that debt burden to be reduced in some way, shape or form.  They explain that all of that debt was sold to mature adults, who should be willing to accept the consequences.  All true.

From the other side of the table, the debt hawks respond that the Greeks incurring that debt, and certainly the sovereign Greek government, also were mature adults (the most aggressive critics of Greece might ask to word that statement carefully).  They insist that they cannot run a monetary union with a perceived ability of one of the members to exercise a continuing and unlimited draw on the resources of its neighbors.  Also all true.

So we have a negotiating standoff.  For those of you who have studied economics beyond a basic level, the analysis yields a contract curve.  We can identify a locus of solutions that are in some sense optimal, but where every alternative solution point makes one side better off and the other side correspondingly worse off.  The solution chosen depends on how hard a bargain each side is willing and able to strike.  And to this moment, that drama continues.

Meanwhile, halfway around the world, the globe’s financial markets are being dealt another shock.  China’s stock market appears to be in free fall.  As I write this, the Shanghai market, from its June high to its close yesterday (Wednesday, July 8), is down almost one third (it has recovered somewhat today).  In very round numbers, this decline in wealth was about five times the size of Greece’s annual GDP, or about three times the entire Greek public debt.

What is going on in China?  Our colleagues from The Conference Board have provided an excellent background in their study entitled The Long Soft Fall in Chinese Growth.  China began its “market economy” phase running like a sprinter, with rapid growth driven by large volumes of rather non-market-oriented investment of that nation’s vast underutilized resources, steered by government-owned enterprises and government officials, and fueled by government-controlled credit.

But now, at the current stage of the economic marathon, that sprinter’s start appears to have been somewhat unwise.  China no longer can rely on inexact government-determined allocation of an apparently infinite pool of underutilized resources.  It must transition toward a more-market-oriented growth, with less piling up of unoccupied apartment blocks and commercial buildings (among other command-driven investments).  That transition inevitably involves a slowing of growth, because responding to a dynamic and multifaceted global market inevitably takes longer than just throwing up another building.  But such a transition is necessary if China is to continue to approach the world’s economic state of the art.  (Also slowing China’s output growth is a demographic shift that limits the growth of its labor force.)

But on the other hand, China’s government is constrained by a strong popular demand for growth of living standards.  Failure of government to deliver could result in social and political unrest.  Hence, China’s government will be tempted to go back to the bad old ways of influencing markets by fiat – including, in the instance of the stock market decline, using government-controlled pension funds to buy shares and prop up the market.  Yet another specific example of a necessary long-term economic reform would be privatizing China’s numerous and very large state-owned enterprises (SOEs).  And yet another example of backsliding on necessary long-term economic reform in the interest of shoring up the stock market short-term would be postponing such privatization, to keep those shares off the market to reduce the supply of shares for sale and increase share prices broadly.  The temptation of the Chinese authorities to take the easy way out today and thereby postpone – with interest – the tough decisions until tomorrow is an interesting echo of the choices that have confronted the government in Greece.

What does all of this matter for us in the United States?  Possibly, a lot of the pain from Greece already has been felt.  Investors have been on vivid notice of the error of the earliest perceptions that the creation of the Euro put Greek debt on a par with German debt (and the debt of all other EMU members).  Those who now hold Greek debt should have known that they were undertaking serious risks, and they should have allocated the rest of their portfolios accordingly.  The danger of cascading failures should Greece default therefore should be limited, though it cannot be ignored.

Meanwhile China’s market crash is obviously much larger.  It will impinge on the sales of firms that sell to China.  Of course, the hit is mostly on wealth rather than income, and the impact on income and spending of wealth shocks typically is only a small fraction of the wealth shock itself, and it arrives with a lag.

For now, the U.S. economy looks solid.  We are fresh off of another good – not robust, but good – employment situation report.  Our stock market appears to have taken its medicine from the recent news from China and Greece, with the digestive process accelerated by a major computer glitch.

What this should highlight for us (in my opinion) is the importance of keeping our own policy on the straight and narrow.  We cannot look to other nations for economic leadership.  No other economy can be an engine of growth.  But the United States is crippled as well.  Our Federal Reserve has been trapped in an extreme posture by failures elsewhere in our economic policy process.  Our fiscal posture, too, is unsustainable.  For our nation’s sake and the sake of the world economy, we need leaders to establish a plan to address those problems, and thereby to give the entire world an economic foundation on which it can build for growth.  We should be worried more about the lack of that stability than we are about a few hundred points on the Dow Jones Industrial Average.

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