We're All State Capitalists Now

The debate about whether America or China will ultimately triumph is a red herring that distracts us from the real contest of our time.
FEBRUARY 9, 2012

If there is one issue on which the rival candidates for the U.S. presidency agree, it's that America's global leadership will endure. Mitt Romney insists  it is not a "post-American century," while Barack Obama declared  in his State of the Union address that "anyone who tells you otherwise, anyone who tells you that America is in decline or that our influence has waned, doesn't know what they're talking about."

They must enjoy this kind of chest-beating in Beijing.

That a resurgent China poses a challenge to American power -- especially in the Asia-Pacific region -- has been clear for some time to those who know what they're talking about. The real question is whether the United States has a credible response.

Should it apply some version of the "containment theory" that the late George Kennan recommended for dealing with the Soviet challenge after 1945? Or something more subtle, like the "co-evolution" suggested by former Secretary of State Henry Kissinger?

Leave aside the military and diplomatic calculus and consider only the economic challenge China poses to the United States. This is not just a matter of scale, though it is no small matter that, according to the IMF, China's GDP will overtake that of the United States within four years on the basis of purchasing power parity. Nor is it only about the pace of China's growth, though any Asian exporter forced to choose between China and America would be inclined to choose the former; their trade with China is growing far more rapidly than trade with the United States.

No, according to some commentators, the contest between the two Asian superpowers is also fundamentally a contest between economic models: market capitalism vs. state capitalism. Speaking at the World Economic Forum in Davos this January, David Rubenstein of the Carlyle Group expressed    a widely held view that the Chinese model of state capitalism is pulling ahead of the U.S. market model.

"We've got to work through these problems," Rubenstein said. "If we don't do [so], in three or four years the game will be over for the type of capitalism that many of us have lived through and thought was the best type." I think this view is dead wrong. But it's interesting to see why so many influential people now subscribe to it.

Market capitalism has certainly had a rough five years. Remember the Washington Consensus? That was the to-do list of 10 economic policies designed to Americanize emerging markets back in the 1990s. The U.S. government and international financial institutions urged countries to impose fiscal discipline and reduce or eliminate budget deficits, broaden the tax base and lower tax rates, allow the market to set interest and exchange rates, and liberalize trade and capital flows. When Asian economies were hit by the 1997-1998 financial crisis, American critics were quick to bemoan the defects of "crony capitalism" in the region, and they appeared to have economic history on their side.

Yet today, in the aftermath of the biggest U.S. financial crisis since the Great Depression, the world looks very different. Not only did the 2008-2009 meltdown of financial markets seem to expose the fundamental fragility of the capitalist system, but China's apparent ability to withstand the reverberations of Wall Street's implosion also suggested the possibility of a new "Beijing Consensus" based on central planning and state control of volatile market forces.

In his book The End of the Free Market, the Eurasia Group's Ian Bremmer argues that authoritarian governments all over the world have "invented something new: state capitalism":

In this system, governments use various kinds of state-owned companies to manage the exploitation of resources that they consider the state's crown jewels and to create and maintain large numbers of jobs. They use select privately owned companies to dominate certain economic sectors. They use so-called sovereign wealth funds to invest their extra cash in ways that maximize the state's profits. In all three cases, the state is using markets to create wealth that can be directed as political officials see fit. And in all three cases, the ultimate motive is not economic (maximizing growth) but political (maximizing the state's power and the leadership's chances of survival). This is a form of capitalism but one in which the state acts as the dominant economic player and uses markets primarily for political gain.

For Bremmer, state capitalism poses a grave "threat" not only to the free market model, but also to democracy in the developing world.

Although applicable to states all over the globe, at root this is an argument about China. Bremmer himself writes that "China holds the key." But is it in fact correct to ascribe China's success to the state rather than the market? The answer depends on where you go in China. In Shanghai or Chongqing, for example, the central government does indeed loom very large. In Wenzhou, by comparison, the economy is as vigorously entrepreneurial and market-driven as anywhere I have ever been.

True, China's economy continues to be managed on the basis of a five-year plan, an authoritarian tradition that goes all the way back to Josef Stalin. As I write, however, the Chinese authorities are grappling with a problem that owes more to market forces than to the plan: the aftermath of an urban real estate bubble caused by the massive 2009-2010 credit expansion. Among China experts, the hot topic of the moment is the new shadow banking system in cities such as Wenzhou, which last year enabled developers and investors to carry on building and selling apartment blocks even as the People's Bank of China sought to restrict lending by raising rates and bank reserve requirements.

Talk to some eminent Chinese economists, and you could be forgiven for concluding that the ultimate aim of policy is to get rid of state capitalism altogether. "We need to privatize all the state-owned enterprises," one leading economist told me over dinner in Beijing a year ago. "We even need to privatize the Great Hall of the People." He also claimed to have said this to President Hu Jintao. "Hu couldn't tell if I was serious or if I was joking," he told me proudly.

Ultimately, it is an unhelpful oversimplification to divide the world into "market capitalist" and "state capitalist" camps. The reality is that most countries are arranged along a spectrum where both the intent and the extent of state intervention in the economy vary. Only extreme libertarians argue that the state has no role whatsoever to play in the economy.

As a devotee of Adam Smith, I accept without qualification his argument in The Wealth of Nations that the benefits of free trade and the division of labor will be enjoyed only in countries with rational laws and institutions. I also agree with Silicon Valley visionary Peter Thiel that, under the right circumstances (e.g., in time of war), governments are capable of forcing the direction and pace of technological change: Think the Manhattan Project.

But the question today is not whether the state or the market should be in charge. The real question is which countries' laws and institutions are best, not only at achieving rapid economic growth but also, equally importantly, at distributing the fruits of growth in a way that citizens deem to be just.

Let us begin by asking a simple question that can be answered with empirical data: Where in the world is the role of the state greatest in economic life, and where is it smallest? The answer lies in data the IMF publishes on "general government total expenditure" as a percentage of GDP. At one extreme are countries like East Timor and Iraq, where government expenditure exceeds GDP; at the other end are countries like Bangladesh, Guatemala, and Myanmar, where it is an absurdly low share of total output.

Beyond these outliers we have China, whose spending represents 23 percent of GDP, down from around 28 percent three decades ago. By this measure, China ranks 147th out of 183 countries for which data are available. Germany ranks 24th, with government spending accounting for 48 percent of GDP. The United States, meanwhile, is 44th with 44 percent of GDP. By this measure, state capitalism is a European, not an Asian, phenomenon: Austria, Belgium, Denmark, Finland, France, Greece, Hungary, Italy, the Netherlands, Portugal, and Sweden all have higher government spending relative to GDP than Germany. The Danish figure is 58 percent, more than twice that of the Chinese.

The results are similar if one focuses on government consumption -- the share of GDP accounted for by government purchases of goods and services, as opposed to transfers or investment. Again, ignoring the outliers, it is Europe whose states play the biggest role in the economy as buyers: Denmark (27 percent) is far ahead of Germany (18 percent), while the United States is at 17 percent. China? 13 percent. For Hong Kong, the figure is 8 percent. For Macao, 7 percent.

Where China does lead the West is in the enormous share of gross fixed capital formation (jargon for investment in hard assets) accounted for by the public sector. According to World Bank data, this amounted to 21 percent of China's GDP in 2008, among the highest figures in the world, reflecting the still-leading role that government plays in infrastructure investment. The equivalent figures for developed Western countries are vanishingly small; in the West the state is a spendthrift, not an investor, borrowing money to pay for goods and services. On the other hand, the public sector's share of Chinese investment has been falling steeply during the past 10 years. Here too the Chinese trend is away from state capitalism.

Of course, none of these quantitative measures of the state's role tells us how well government is actually working. For that we must turn to very different kinds of data. Every year the World Economic Forum (WEF) publishes a Global Competitiveness Index, which assesses countries from all kinds of different angles, including the economic efficiency of their public-sector institutions. Since the current methodology was adopted in 2004, the United States' average competitiveness score has fallen from 5.82 to 5.43, one of the steepest declines among developed economies. China's score, meanwhile, has leapt from 4.29 to 4.90.

Even more fascinating is the WEF's Executive Opinion Survey, which produces a significant amount of the data that goes into the Global Competitiveness Index. The table below selects 15 measures of government efficacy, focusing on aspects of the rule of law ranging from the protection of private property rights to the policing of corruption and the control of organized crime. These are appropriate things to measure because, regardless of whether a state is nominally a market economy or a state-led economy, the quality of its legal institutions will, in practice, have an impact on the ease with which business can be done.

Table: Measures of the rule of law from the WEF Executive Opinion Survey, 2011-2012

(Note: Most indicators derived from the Executive Opinion Survey are expressed as scores on a 1-7 scale, with 7 being the most desirable outcome.)

It is an astonishing yet scarcely acknowledged fact that on no fewer than 14 out of 15 issues relating to property rights and governance, the United States now fares markedly worse than Hong Kong. Even mainland China does better in two areas. Indeed, the United States makes the global top 20 in only one: investor protection, where it is tied for fifth. On every other count, its reputation is shockingly bad.

The implications are clear. If we are to understand the changing relationship between the state and the market in the world today, we must eschew crude generalizations about "state capitalism," a term that is really not much more valuable today than the Marxist-Leninist term "state monopoly capitalism" was back when Rudolf Hilferding coined it a century ago.

No one seriously denies that the state has a role to play in economic life. The question is what that role should be and how it can be performed in ways that simultaneously enhance economic efficiency and minimize the kind of rent-seeking behavior -- "corruption" in all its shapes and forms -- that tends to arise wherever the public and private sectors meet.

We are all state capitalists now -- and we have been for over a century, ever since the modern state began its steady growth in the late 19th century, when Adolph Wagner first formulated his law of rising state expenditures. But there are myriad forms of state capitalism, from the enlightened autocracy of Singapore to the dysfunctional tyranny of Zimbabwe, from the egalitarian nanny state of Denmark to the individualist's paradise that is Ron Paul's Texas.

The real contest of our time is not between a state-capitalist China and a market-capitalist America, with Europe somewhere in the middle. It is a contest that goes on within all three regions as we all struggle to strike the right balance between the economic institutions that generate wealth and the political institutions that regulate and redistribute it.

The character of this century -- whether it is "post-American," Chinese, or something none of us yet expects -- will be determined by which political system gets that balance right.

Is QE still working?

February 8, 2012 3:24 pm

by Gavyn Davies

The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.

Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.

Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right?

Most of the empirical evidence published since QE started in 2008 is on the side of optimism. Admittedly, a lot of it is published by the central banks themselves, who are scarcely the most independent source on this matter. But the weight of evidence is still impressive, and runs counter to those who believed from the start that QE would be a complete waste of time, if not worse.

First, there is little doubt that QE has significantly reduced the level of bond yields in the US and the UK, which is what it was primarily intended to do. The BIS reckons that the impact on the average bond yield across the curve has been fairly minor, amounting to about 25 basis points for each of the three doses of QE in the US, and to a total of only about 25 basis points for the much larger episode of QE in the UK in 2009/10. But two separate studies by the Bank of England (here and here) conclude that the impact of the UK action was about 100 basis points or more, and several other US studies suggest that the BIS estimates are on the low end of the range. The graph below shows how the yield curve has flattened markedly on both sides of the Atlantic since QE started:

The success of the central banks in reducing bond yields has come as a surprise to some economists, who believed that bonds and cash would be perfect substitutes when short rates hit zero. If that had been the case, then the central banks would not have been able to nudge bond yields downwards, no matter how much cash they had offered in exchange for them.

But in reality it turned out that bonds and cash were not perfect substitutes, so the central banks were able to raise bond prices (and cut yields). They needed to spend a considerable amount of extra cash to do this, but not the infinite amount which would be implied by perfect substitutability.

It is true that there is a lower limit to sustainable bond yields set by the Keynesian liquidity trap (explained in this earlier blog). Japanese experience suggests that this baseline is around 1.3 per cent, and the graph shows that the yields on maturities out to five years are already at or below these levels. So the central banks have now done all that they can do with QE in that part of the curve.

However, that still leaves the rest of the yield curve, especially the part between 10 and 30 years, where there is plenty of scope for a further decline in yields. And, of course, the central banks could choose to buy mortgage debt, corporate debt, or other private securities, where spreads could be substantially reduced by official purchases.

Admittedly, any of these options would imply that the central bank balance sheets are taking on even more risk. But that is the whole point of the strategy. As the private sector attempts to restore its overall risk levels to the levels held before QE, they bid up the prices of other risk assets, like equities. The Bank of England study quoted earlier suggests that the immediate impact on UK equity prices may have been as much as 20 per cent.

That leaves the question of how the strategy affects the rest of the economy. The empirical evidence on this (which is well summarised in this Banca d’Italia overview) is also supportive of the policy, so far. Key research papers suggest that real GDP in the UK may have been boosted by about 1.5 per cent, while that in the US may have risen by 0.6-3.0 per cent, compared to what otherwise would have occurred. Inflation also rose, by more than 1 per cent, but again that was the deliberate intention of the central bank, not the reverse.

While encouraging, this evidence does not prove that future injections of QE will have the same benign effects, either in scale or even in direction. Much of the evidence seems to indicate that the first bout of QE had the most significant impact on bond yields, with subsequent bouts having far less bang for the buck.

There are various reasons, including the increasing importance of the liquidity trap, and the waning impact of signalling effects about future central bank policy, that suggest this drop in efficacy may continue to be the case.

Nor should anyone feel entirely confident that the long term effects of QE on inflation are well understood. The historic correlations between the growth of central bank money and inflation in the long term are a cause for concern, as this earlier blog argued.

However, the growing consensus among central bankers is that their experiment with QE is still working. It was a shot in the dark, and a rather desperate one at that. But up to now it has had the desired effect, which is certainly a far better outcome than the alternative.



A Money Market Funds are in the Fight of Their Lives

February 9, 2012

By Shah Gilani, Capital Waves Strategist, Money Morning

Money market funds aren't exactly the safe-haven investments they're cracked up to be.

In September 2008, when Lehman Brothers failed, money market investors fled funds in droves, exposing investors and capital markets across the globe to huge systemic risks.

Now, to better safeguard investors and prevent the commercial paper market from shutting down in future crises, SEC chairwoman Mary Schapiro is proposing to re-make the money market mutual fund industry in the image of banks.

The SEC staff is recommending money market funds set aside capital reserves, as banks are required to do, and fund sponsors issue stock or debt to bolster their positions as a "source of strength," as bank holding companies are expected to do.

Also, the staff recommended restricting redemptions under certain circumstances and potentially requiring funds to collect upfront fees to further cushion themselves in times of trouble.

Industry leaders immediately attacked the plan as an assault on their business. They're threatening to sue the SEC.

The battle ahead isn't just about changing an industry.

It is about reshaping modern finance, the future power of regulators, and the real world implications of moral hazard.

Money Market Funds Explained

Money market funds are mutual funds. Investors who buy shares are pro-rata owners of the underlying investments that funds hold.

Money market mutual funds are restricted by SEC rules under the Investment Company Act of 1940 to purchasing only the highest-rated debt of issuing companies. They also invest in government securities and repurchase agreements.

The duration of the debt instruments they hold cannot exceed 13 months and the average weighted maturity of their portfolios has to be 60 days or less. Additionally, funds can't hold more than 5% of one issuer, except for governments or repurchase agreements.

The first U.S. money market mutual fund, The Reserve Fund, was established in 1971 to directly compete with banks for investor deposits. At that time "Regulation Q" prohibited commercial banks from paying interest on checking accounts.

Money market funds quickly drew in investors looking to earn interest on cash positions.

By September 2008, the size of the oldest money fund in the U.S., the Reserve Primary Fund, was $64.8 billion. Total industry assets were $3.8 trillion.

Anatomy of a Money Market Fund Panic

On Sept. 15, 2008 Lehman Brothers filed for bankruptcy and everything changed.

The Reserve Primary Fund, which held $785 million of Lehman's debt obligations, had to immediately write down the value of its Lehman holdings. The following day, Sept. 16, 2008, the fund "broke the buck" by declaring the par value of its shares had fallen to 97 cents.

"Breaking the buck" is a cardinal sin for money market funds. Whatever the mix of debts and maturities any fund holds, and no matter how little interest they pay, at an absolute minimum investors park their cash in these funds for safety. The measure of safety is every fund's ability to maintain at least a dollar per share par value.

When the buck was broken at one fund, money market investors at all "prime" funds panicked. Only one day later investor redemptions exceeded $169 billion.

While investors were panicking about the par value of their fund holdings, the Federal Reserve, the U.S. Treasury and world financial markets feared the collapse of U.S. money funds would take the global financial system over a cliff.

Since short-term government securities don't pay a lot of interest, portfolio managers juice up fund yields by buying commercial paper (short-term funding instruments issued by corporations and financial firms) with more attractive yields.

The crux of the crisis, which nobody saw coming, was that not only did banks and investment banks issue hundreds of billions of dollars in commercial paper, but their off-balance sheet "conduits" also known as SIVs (structured investment vehicles) were also issuing commercial paper to finance the purchase of hundreds of billions of dollars of mortgages and other asset-backed securities.

As investors pulled out of prime money market funds, commercial banks, investment banks, asset-backed holding vehicles and every top-rated corporation in the U.S. that relied almost daily on functioning commercial paper markets were all unable to finance themselves.

The panic in the money markets was driving America's corporate elite and the rest of American businesses to an abyss.

To stem the "run" on money market funds, the Federal Reserve announced the creation of the Commercial Paper Funding Facility (CPFF) on October 7, 2008. The CPFF effectively extended access to the Fed's discount window to issuers of commercial paper, including those not chartered as commercial banks, to act as their lender-of-last-resort.

In addition to directly lending to commercial paper issuers, the Fed introduced the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and the Money Market Investor Funding Facility.

According to the Fed, "All three facilities supported short-term funding markets and thereby increased the availability of credit through various mechanisms."

In other words the Fed saved investors and credit markets from an almost certain death.

But, not much changed in the commercial paper market. The same contagion and systemic issues that led to the money market crisis are still inherent in the system.

Making Money Market Funds in the Image of Banks

Behind the scenes, banks are now working to level the playing field.

Banks have restrictive capital reserve requirements; they have to pay FDIC insurance fees, and are subject to far greater scrutiny than funds.

They complain that money market funds don't have those restrictions and the full backing of the Fed affords funds an insurance backstop that they don't have to pay for, but benefit from because lower costs allows them to offer higher yields.

From the moral hazard perspective, critics point to the Fed's backstopping money market funds as a license for them to take more risks as they divert deposits from the more regulated banking system.

The SEC staff's proposals level the playing field between funds and banks by essentially requiring money market funds to re-make themselves more in the image of better regulated banks.

Although the recommendations are meant to lessen the likelihood of another taxpayer-funded bailout in the future, money market fund sponsors are up in arms that they are being disadvantaged by regulatory overreach.

Fund sponsors claim the future of the commercial paper market is at stake.

They say increased regulatory costs will raise financing charges for commercial paper issuers to the detriment of the entire economy and that their own businesses will be destroyed.

The battle ahead is bound to get ugly.

"Free market capitalists" (as "socialists" might call them) will make their usual case that if left alone, bruised fund sponsors and commercial paper issuers will adjust to the complex realities that nearly caused their collapse. And investors should be free to chase yield and face free market consequences for decisions they make based on their own due diligence. They will argue that moral hazard will disappear if individuals, businesses, and banks are allowed to fail.

Of course, the "socialists" (as "free market capitalists" might call them) who want the American financial system to be safe for everybody will point to how free market capitalists are the first ones to cry for bailouts when their greedy schemes overwhelm the economy's capacity to absorb their losses. And that bailouts, which are increasingly necessary because deregulation unleashed the wrong kind of animal spirits, are the root cause of moral hazard.

The battle for the soul of America's financial and economic future hangs in the balance.