A Chinese lesson on how not to crash an economy

When the global financial crisis unleashed its destructive power across the world, China’s export industry dipped into red territory, with negative growth for several quarters between 2008 and 2010. Its breakneck double-digit growth rate slowed to 6.6 per cent during the first quarter of 2009. The situation was reversed when Beijing implemented a massive four trillion yuan stimulus package that not only saved China but also Australia.

Since the 2008 financial crisis, China has been responsible for 40 per cent of global growth, despite the fact the country only accounts for 15 per cent of the world’s population and less than 20 per cent of its income. The country not only pulled off a perfect Keynesian experiment, but also offered a few instructive lessons about financial crises (How China’s Keynesian experiment paid off, March 19).

Graham Allison and Lawrence Summers of Harvard University arranged for the translation of a document prepared by Liu He, one of China’s most influential economic advisers to Chinese president Xi Jinping, on the lessons of two global financial crises in 1929 and 2008.

Liu is the head of the Office of the Central Leading Group on Financial and Economic Affairs, comparable to the American National Economic Council that advises the president on economic policy and the deputy chair of the National Development and Reform Commission, the economic planning agency. He is also a graduate of Harvard University.

Liu and his team examined two global financial crises in 2010 during the worst aftermath of the subprime mortgage crisis. They drew 10 lessons after comparing the great crash of 1929 and the global financial crisis of 2008. China Spectator will look at some of their most interesting findings.

Lesson 1: Both crises happened after a major technology revolution, laissez-faire policies and growing income disparity.

Chinese policymakers found both great crashes were preceded by significant technological revolutions. In the case of the 1929 crisis, it was the electrical technology and for the 2008 meltdown, it was the IT boom. They believe these two crises followed the classical pattern of "technological innovation begets economic boom, which in turn causes depression".

They believe that policymakers need to be prepared for the next technology revolution, not only for its positives but also for its shocks and changes. Apart from technological innovations, a common characteristic linking two crises is the generally laissez-faire policy before the spectacular meltdowns.

In the years before 1929, US President Calvin Coolidge supported a hands-off policy in running the economy. Similarly, both the Clinton and Bush administrations inherited the free-market ideology of Margaret Thatcher and Ronald Reagan. The Glass-Steagall Act, which separated investment banking from commercial banking, was abolished.

Liu and his team also find that another feature shared by the two economic disasters is “yawning income gaps”. Incomes of the richest 1 per cent in the US accounted for 23.9 per cent of total income in 1928, while in 2007 the share was 23.3 per cent.

Lesson 2: The effects of irresponsible social and welfare policies, speculative investment and loose monetary policy.

Liu and his team of Chinese researchers are critical of over-generous American and European social welfare policies. “Populist promises have changed people’s expectations of welfare, increased their reliance on government, and unwound their commitment to individual struggle, leading to an extremely corrosive effect,” says the report.

Speculative mania also besieged the US before the outbreak of two crises, and loose monetary and credit policy further inflated the ballooning bubble. “Prior to the two crises, the handiest tool had been easier monetary and credit policy,” Liu says.

Lesson 3: Ineffectual policy response under triple assaults of populism, nationalism and economic problems that morphed into political ones.

Liu and his team of policymakers warn against the danger of implementing crisis response policy under pressure to appease panicked voters. They cited examples of European countries that were torn between polarising political forces and the consequent policy paralysis in dealing with the debt crisis. 

“Policymakers lacked experience and had to deal with populism, insular nationalism and economic problems with heavy political implications. Politicians were hijacked by short-term public opinions and mired in political gridlocks, afraid of breaking ideological constraints,” he argues. 

Lesson 4: Beware of broader contagion of the financial crisis and the re-making of the global economic order post-crisis.

This is a particularly interesting point from Liu and his team. They argue the financial crisis will not be resolved conclusively until it runs its full course, which could take the economy on an unusual cycle. “Both crises would commence from an economic crash, deepening from the bursting of bubbles to soaring unemployment, from economic stress to social conflicts, and extending from economic and social sectors to political or even military fields,” they warn.

They highlighted an extreme case of the rise of Adolf Hitler in the aftermath of an economically devastated Germany. Chinese policymakers warn that the world must be on guard against any major political and military risks arising out of the ongoing crisis.

Financial crises are also harbingers of change in the global geopolitical and economic order. Henry Kissinger predicted that a new world power emerges every 100 years. His assertion is largely correct when you look at the last two crises.

The US became the undisputed world leader after the Great Depression of the 1920s and '30s. Similarly, the global centre of economic gravity is shifting to the Asia Pacific after the economic crisis of 2009. This point is especially clear to spectators in Australia.

Given China’s increasing importance in the world, it is imperative that we understand how Chinese policymakers view international economic issues. The bibliography to Liu’s report suggests that Chinese policymakers had consulted the broadest range of Western gurus both living and dead that include Kissinger, Keynes, Reinhart and Rogoff, Bernanke, and Friedman. Western analysts should do the same.