The Western Peril

Recently I've been reading the Mises Daily email.

The Mises Daily expresses the view called Austrian economics. (I subscribed to the Daily to learn a bit about that branch of the subject.) The Austrian school is highly concerned about the possibility of inflation. The school objects to government interference in the economy, favoring Laissez-faire. And, judging by the Daily, they're an opinionated bunch. That's what I've picked up so far.

But then the 7-21-09 post by Thomas J. DiLorenzo caught my eye:

I recently received in the mail the 2008 Annual Report of the Federal Reserve Bank of Minneapolis. The title of the report is "The Current Economic Crisis: What Should We Learn from the Great Depressions of the 20th Century?"

Now that's my kind of report: reputable source, fascinating topic. So I took a gander at the Fed report. The thing that most struck me was... Well, here's how it opens:

The current financial crisis has prompted these questions: Could the world economy enter a great depression like that of the 1930s? If so, what can governments do to avoid it?

Really??? Now they're gonna think about the possibility of economic depression? Now that it's upon us? Now that all sorts of bizarre policies to skirt depression are being put to the test? What have they been doing for the past 30 years? The fact of the matter is, in observations like this I find an explanation for how things went so terribly wrong: Incompetence, dogma, and ego. But I wander.

The Mises post expresses displeasure with the Fed report: "No mention at all is made of central-bank monetary policy as possibly introducing economic instability...."

Having ignored the role of central banks in generating boom-and-bust cycles, the "lesson" the Minneapolis Fed economists claim to have learned from their study of past depressions is that the "cure" is even more central bank inflation. "[G]overnments need to focus on providing liquidity," they solemnly intone. Following Alan Greenspan, they blame the current depression in the United States on a new version of "the yellow peril": impoverished Asians who have a penchant for saving a large percentage of their income. "Over the past decade, lending by China and other countries in East Asia … has kept world interest rates low." This is what fueled the real-estate boom, they say, ignoring altogether the role of Fed policy, as well as the policy of every arm of the federal government that is involved in housing (from HUD to Congress to the Fed itself) to force mortgage lenders to make bad loans to unqualified borrowers to achieve its goal of "making housing more affordable." (In reality, worldwide savings rates during the 2001–2008 period were actually lower than they were during the previous 15-year period.)

I'm not quoting this for its criticism of government. The quote is important I think because it exposes a topic about which too little has been said: The idea that the Western boom was fueled by the lending of Eastern nations -- the new "yellow peril," DiLorenzo calls it (I assume that wording is his. I think it unlikely Alan Greenspan used the phrase.)

DiLorenzo's observation of the low savings rate in this decade presents an interesting objection to the "yellow peril" view. If global saving is less in the current decade than it was between 1985 and 2000, the notion of excessive Asian saving as a driving force behind recent events does come into question.

On the other hand, it's common knowledge that our Government borrowing has been largely funded by Chinese lending; we worry about that. So it's easy to believe that Eastern lending fueled the Western boom.

I should point out that my post here contains no facts whatsoever. I'm gathering opinion and widespread belief. I'm feeling my way around the edges of a concept.

At present, I have only one other source of information on the "yellow peril" view. That is a review of Martin Wolf's book Fixing Global Finance. (The review is by John Mason.) I've only seen Wolf a few times on TV, but he strikes me as an exceptional mind. (Perhaps because he so often agrees with me.)

In any event, I recognized Wolf's name in the book review and made note of the article, and remembered it now when I needed it (after six months). Here is a relevant excerpt from Mr. Mason's review:

It's also a worthwhile read because of the story Wolf weaves to explain the development of the imbalances in world markets that resulted in the current financial and economic crisis. The author puts forth the “savings glut” theory to describe how the world evolved through the early 2000s. It is important to understand this theory because it is the one that was developed by and acted upon by the current Federal Reserve Chairman, Ben Bernanke. The theory absolves the Federal Reserve actions of the past eight years of blame for the current financial difficulties.

First, note that the "savings glut" theory describes the same trend as DiLorenzo's "new yellow peril:"

The basic idea is this: Emerging economies, like China... began to establish macroeconomic policies along with exchange rate management techniques aimed at fueling export-led balance of trade surpluses.... Savings soared in these countries and the governments started accumulating enormous international reserves. “Two-thirds of all the foreign-currency reserves accumulated since the beginning were piled up within less than seven and a half years of the new millennium.” That is, between December 1999 and March 2007.

Next, note the dates. According to Mason, the new macroeconomic policies observed by the savings-glut theory began emerging during or after 1998 and "evolved through the early 2000s." And the bulk of (Asian) foreign-currency reserves accumulated since those policies were put in place.

Now, if savings and foreign-currency reserves travel in tandem in these emerging economies (as Mason implies) then most of their saving occurred in the current decade. If that is true, then DiLorenzo's observation is irrelevant or false. If DiLorenzo is right and relevant, then Martin Wolf is wrong.

I am disappointed. My technique for learning is to find two sources on a topic and compare them. I figure if the two fit together and make sense, then I understand the topic. In this case, either I misunderstand, or at least one of the sources is junk. It's time to move on.

John Mason (the book reviewer) writes:

I tend to lean more to what Wolf calls the “money glut” theory of the world’s financial imbalances. In this theory, these world imbalances came about from a central bank that underwrote negative real rates of interest and served as a “bubble machine” that helped distort asset markets. Within the context of the bubble, “the credit expansion was associated with what was, in retrospect, unsound lending of a particularly innovative kind...."

Money-glut yes, savings-glut no. My gut reaction is to agree with Mr. Mason on this point. Mr. DiLorenzo seems to feel the same way. So you have on the one hand the weight of Mason and DiLorenzo and me... and on the other Bernanke and Greenspan! For what that's worth.

I checked out Mason's blog to see if he's in the Austrian school. (The view he shares with DiLorenzo has a wider base if they're not of the same school.) Mason looks not to be Austrian. A search of his blog for the word "Austrian" turns up no result.

Our Federal Reserve System establishes a Reserve Requirement for member bank funds. This determines how much each bank must keep in reserve. Since 1990 or so the Reserve Requirement on money in checking has been 10% and on money in savings has been zero. There is more money in savings than in checking in the U.S., so the zero rate predominates. In addition, the thing works like an electrical circuit: Check-money has a resistance of 10 ohms and savings have a resistance of zero, a short-circuit. All the electrons that cannot pass thru the 10-ohm circuit can easily pass thru the short.

Our effective Reserve Requirement is zero.

What does this mean? Well, you divide one dollar by the Reserve Requirement (RR) and that tells you how much money can be created from one dollar under our system of fractional reserve banking. If the RR is 25%, one dollar can become (1/0.25) or $4. If the RR is 10%, one dollar can become (1/0.10) or $10. If it is 1%, one dollar can become a hundred. As the RR approaches zero, the amount of money that can be created from one dollar approaches infinity.

Our effective Reserve Requirement is zero, and the amount of money banks can create from the existing money supply is effectively unlimited. For this reason I agree with Mason and DiLorenzo that our economic problems have been created not by a savings-glut in Asia but by a money-glut here at home.

One final point: The U.S. is not responsible for the economic policy of Asia. We are only responsible for our own policy. If the Asians do something that messes us up (I'm not saying that they have), we are responsible for tweaking our own policy to improve our position in the world. For us to blame the Chinese, for Greenspan and Bernanke to blame the Chinese, is to avoid our own responsibility to ourselves.