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July 10, 2012 8:35 pm
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We still have that sinking feeling
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By Martin Wolf
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Ingram Pinn illustration




It is nearly five years since financial turmoil broke upon an unsuspecting world, in August 2007. So how are crisis-stricken high income countries doing? Badly, is the only answer.




Of the six largest high income economies (plus the eurozone), only those of the US and Germany are above previous peaks. Since the US was the epicentre of the early shocks, its recovery has been relatively good. Yet none of these countries can be happy with its performance. While US gross domestic product has been more buoyant than that of these other countries, its unemployment rate more than doubled, from 4.7 per cent in July 2007 to 10 per cent in October 2009. Since then its unemployment has fallen only a little. But the US has still had a better performance than the eurozone, whose economy is stagnant and whose latest rate of unemployment is 11.1 per cent, against 8.2 per cent in the US.
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Click to enlarge

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Economies stagnate, while policy is aggressive. The highest short-term interest rate offered by any of the central banks of the big high-income economies is the 0.75 per cent offered by the European Central Bank. Balance sheets of central banks have also doubled in the big high-income countries, relative to GDP, since 2007. Japan, the US and UK continue to run very large fiscal deficits for peacetime. Yet despite huge fiscal deficits, long-term interest rates on Japanese, US and UK government bonds are very low, at 0.8, 1.5 and 1.6 per cent, respectively.



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David Levy, of the Jerome Levy Forecasting Center, labels this conjuncture of sluggish economies with huge policy stimuli a “contained depression”. The explanation is clear: a number of important economies are struggling with excessive leverage, particularly in their household and financial sectors. In the US, for example, total private sector debt rose from 112 per cent of GDP in 1976 to a peak of 296 per cent in 2008 (see chart). This ratio had fallen back to 250 per cent by the end of the first quarter of 2012, which is where it was in 2003. In 2007, US gross private borrowing was 29 per cent of GDP. In 2009, 2010 and 2011, however, it was negative.




Above all, private sectors are running large surpluses of income over spending. In the US, the financial balance of the private sector turned from a deficit of 2.4 per cent of GDP in the third quarter of 2007 to a surplus of 8.2 per cent in the second quarter of 2009. This massive shift would surely have caused a huge depression if the government had been unwilling to run offsetting fiscal deficits. That is how the depression was contained.




The US is the most important of the crisis-hit economies. But it is not the only one to have experienced large private sector retrenchment: so has the UK. In fact, the International Monetary Fund forecasts that the private sectors of all the large high-income countries will be in either balance or surplus this year (see chart). It follows that these countries must be running large current account surpluses or large fiscal deficits. Germany is doing the former. Others are running fiscal deficits. Since these big countries are unlikely to be able to run large current account surpluses together (with whom?), they have to run fiscal deficits once their private sectors run huge surpluses. These surpluses, in turn, are partly explained by the desire to de-leverage, partly by unwillingness to borrow and partly by the inability or unwillingness of the financial sector to lend. All this, then, is the painful hangover after the great credit binge.


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So the big story continues to be one of private sector de-leveraging, tempered by easy monetary policy and offset by the leveraging of the government’s balance sheet. The willingness of the authorities to do both of these things, despite foolish criticism, prevented us from experiencing a second great depression and continues to do so. The idea seems fantastic that these large fiscal deficits are crowding out private spending when interest rates are so low in countries blessed by not being in the eurozone.



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Yet some official observers are distressed by these policies. In its latest annual report, the Bank for International Settlements apparently argues for monetary and fiscal tightening in high income countries. Yet it presents no comprehensible analysis of the consequences. It remarks, for example, that “fiscal multipliers in a balance sheet recession may be lower than in normal recessions. In particular, in a balance sheet recession, overly indebted agentsthese days, households typically – are likely to allocate a higher fraction of each additional unit of income to reducing their debt rather than increasing discretionary spending”. That is indeed possible. The conclusion is that fiscal deficits, readily financed in important countries, need to be still bigger because they must both facilitate de-leveraging and sustain demand. The other plausible way to accelerate de-leveraging is mass bankruptcy, also known as a depression. Does the BIS want that?


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We know that big financial crises cast long shadows, particularly in countries whose underlying rate of growth is modest, which makes de-leveraging slow. Policy must both sustain demand and facilitate de-leveraging. This means aggressive monetary and fiscal policies, working in combination, along with interventions aimed at recapitalising banks and accelerating restructuring of private debt. The Obama administration attempted all this.



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But it was not ambitious enough. It was also thwarted by Republican intransigence. Yet, provided the US avoids going over its “fiscal clifflater this year, a moderate private sector-led recovery should proceed. Once that is securely in place, serious fiscal consolidation could begin. Austerity should follow a strong recovery, not proceed it.



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Unfortunately, the troubled big economies do not consist of the US alone. The crisis has also caused a deep rift inside the eurozone, the world’s second largest economy. The latter’s inability to craft a response guarantees turmoil. The people shaping policy worry more about moral hazard than about panic. This makes a wave of sovereign and banking crises, culminating in exchange controls and disintegration of the eurozone, all too conceivable.


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Far too much policy making and advice neither recognises the post-crisis challenges nor crafts effective answers. The heart of the matter is accelerating de-leveraging, while promoting recovery. By that standard, the policies now in place are, alas, very far from good enough.



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Copyright The Financial Times Limited 2012.

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OPINION
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Updated July 9, 2012, 8:20 p.m. ET
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What's Wrong With the Federal Reserve?
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Business investment is held back by uncertainty about taxes and regulation. Printing dollars won't help.
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By ALLAN H. MELTZER

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       Ben S. Bernanke speaks during a Joint Economic Committee hearing in Washington, D.C.




By allowing its monetary policy to be influenced by elected politicians and market speculators, the Federal Reserve is putting its independence at risk. It is also neglecting basic economics, which was a great strength of its current chairman, Ben Bernanke.



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Consider the response to last week's employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.





To his credit, Mr. Bernanke did not immediately agree. But he failed utterly to state the obvious: The country's sluggish growth and stubbornly high unemployment rate was not caused by, nor could it be cured by, monetary policy. Market interest rates on all maturities of government bonds are the lowest since the founding of the republic. Banks have $1.5 trillion in cash on their balance sheet in excess of their legally required reservesfar more than enough to meet any unsatisfied demand for loans that bankers regard as prudent.



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Consider also how, in the summer of 2010, the Fed allowed itself to be spooked by cries about a double-dip recession and deflation. It added $600 billion to banks' reserves by buying up federal Treasurys and mortgage-backed securities. Today, $500 billion of those reserves remain on bank balance sheets, and most of the rest of the dollars are held by foreign central banks. Not much help to the U.S. economy. By early autumn 2010, it had become clear that fears of a double-dip recession and deflation were just short-term hysteria.




One of the Fed's big mistakes is excessive attention to the short term, over which it has little influence. As I researched the central bank for my "History of the Federal Reserve," I was dismayed to find hardly any discussions in the minutes of its policy arm, the Federal Open Market Committee, about what members expect to happen a year from now as a result of whatever actions it is taking today.




True, the staff provides forecasts about the future, but these are made before policy action is decided. Former Fed Chairmen Paul Volcker and Alan Greenspan told the staff several times that its inflation forecasts based on the Phillips Curve—which theorizes a trade-off between inflation and employment levels—were not useful. But the Phillips Curve is still central to the inflation forecasts that Messrs. Volcker and Greenspan found useless.



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The problem with the short term is that data reported today are subject to revision, or reflect only transitory changes. The better economic data last winter are one of many examples. Would the reported improvement in the economy persist? We didn't learn the answer until weaker data reported this spring. Is the slowdown persistent or temporary? We can only guess.



Executing monetary-policy changes in response to transitory data is a mistake. The late Nobel laureate economist Milton Friedman taught that monetary policy operates with long lags. Actions today have their main effects much later. By then the data often support a very different story.



The other big problem at the Fed is staying mum about the real cause of the high current unemployment rate—fiscal policy.



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Today's economic problems are serious, but the Fed can't do much about them if these problems are not monetary. Very expansive monetary policies did help during the crisis of 2008-09, but they're not what is needed now. To get out of our bad economic situation, we need coherent long-term fiscal policy, especially entitlement reform.




With mortgage rates lower than ever and housing showing very sluggish recovery, what can be gained by dropping the mortgage rate another small fraction? Business investment is held back by uncertainty. No one can reliably calculate tax rates, health-care costs, and the regulatory burden until after the election, if then. How can corporate officers calculate expected return when they cannot know these future costs? How is more monetary stimulus today supposed to help?




From about 1985 to 2003, the Fed achieved relatively stable growth, short, mild recessions, and low inflation by more or less following the Taylor Rule, which specifies (to simplify) what interest rate the Fed should establish in response to the expected inflation rate and the unemployment rate. Rule-based monetary policy brought us a far better economic outcome than discretionary ups and downs. The Fed should commit to that rule and follow it.



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The policies that are really needed are on the fiscal side. Instead of more short-term stimulus, we need a government that puts us on a path toward a balanced budget over time, mainly by reducing spending. Instead of denigrating and then ignoring House Budget Chairman Paul Ryan's courageous effort at entitlement reform, the administration should put a program on the table to control our deficits.



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Evidence is growing that many think higher inflation is in our future. One sign is the premium that investors pay to hold index-linked Treasury bonds that protect against inflation. Another is the shift by asset owners from holding money to holding equities and real assets, or claims to real assets. What many call "bubbles" cannot occur without this shift occurring.




One of the many costs of the Fed's excessive attention to the near-term is that it will wait until after the inflation is upon us before it does anything to stop it. The Fed's view is that by raising interest rates enough, it can stop any inflation. True, but not entirely relevant. Will the politicians, the public, business and labor accept the necessary level of interest rates? Much history says: "Don't count on it." Better to adopt something like the Taylor Rule and begin gradually reducing the banking system's excess reserves now.




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Mr. Meltzer, a professor of political economy at Carnegie Mellon University's Tepper School, is a visiting fellow at the Hoover Institution. He is author of "A History of the Federal Reserve" (University of Chicago Press, 2003 and 2009) and "Why Capitalism?" (Oxford University Press, 2012).




Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved



Inequality Inhibiting Growth?
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Raghuram Rajan
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10 July 2012
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CHICAGOTo understand how to achieve a sustained recovery from the Great Recession, we need to understand its causes. And identifying causes means starting with the evidence.



Two facts stand out. First, overall demand for goods and services is much weaker, both in Europe and the United States, than it was in the go-go years before the recession. Second, most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms. In Europe, concerns about domestic income inequality, though more muted, are compounded by angst about inequality between countries, as Germany roars ahead while the southern periphery stalls.



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Persuasive explanations of the crisis point to linkages between today’s tepid demand and rising income inequality. Progressive economists argue that the weakening of unions in the US, together with tax policies favoring the rich, slowed middle-class income growth, while traditional transfer programs were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption.


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Rising house prices gave people the illusion that increasing wealth backed their borrowing. But, now that house prices have collapsed and credit is unavailable to underwater households, demand has plummeted. The key to recovery, then, is to tax the rich, increase transfers, and restore worker incomes by enhancing union bargaining power and raising minimum wages.


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This emphasis on anti-worker, pro-rich policies as the recession’s primary cause fits less well with events in Europe. Countries like Germany that reformed labor laws to create more flexibility for employers, and did not raise wages rapidly, seem to be in better economic shape than countries like France and Spain, where labor was better protected.


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So consider an alternative explanation: Starting in the early 1970’s, advanced economies found it increasingly difficult to grow. Countries like the US and the United Kingdom eventually responded by deregulating their economies.


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Greater competition and the adoption of new technologies increased the demand for, and incomes of, highly skilled, talented, and educated workers doing non-routine jobs like consulting. More routine, once well-paying, jobs done by the unskilled or the moderately educated were automated or outsourced. So income inequality emerged, not primarily because of policies favoring the rich, but because the liberalized economy favored those equipped to take advantage of it.




The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans. Thus, while differing on the root causes of inequality (at least in the US), the progressive and alternative narratives agree about its consequences.



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The alternative narrative has more to say. Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment. And, while inequality did not increase as much as in the US, job prospects were terrible for the young and unemployed, who were left out of the protected system.


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The advent of the euro was a seeming boon, because it reduced borrowing costs and allowed countries to create jobs through debt-financed spending. The crisis ended that spending, whether by national governments (Greece), local governments (Spain), the construction sector (Ireland and Spain), or the financial sector (Ireland). Unfortunately, past spending pushed up wages, without a commensurate increase in productivity, leaving the heavy spenders indebted and uncompetitive.




The important exception to this pattern is Germany, which was accustomed to low borrowing costs even before it entered the eurozone. Germany had to contend with historically high unemployment, stemming from reunification with a sick East Germany. In the euro’s initial years, Germany had no option but to reduce worker protections, limit wage increases, and reduce pensions as it tried to increase employment. Germany’s labor costs fell relative to the rest of the eurozone, and its exports and GDP growth exploded.




The alternative view suggests different remedies. The US should focus on helping to tailor the education and skills of the people being left behind to the available jobs. This will not be easy or quick, but it beats having corrosively high levels of inequality of opportunity, as well as a large segment of the population dependent on transfers. Rather than paying for any necessary spending by raising tax rates on the rich sky high, which would hurt entrepreneurship, more thoughtful across-the-board tax reform is needed.


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For the uncompetitive parts of the eurozone, structural reforms can no longer be postponed. But, given the large adjustment needs, it is not politically feasible to do everything, including painful fiscal tightening, immediately.



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Less austerity, while not a sustainable growth strategy, may ease the pain of adjustment. That, in a nutshell, is the fundamental eurozone dilemma: the periphery needs financing as it adjusts, while Germany, pointing to the post-euro experience, says that it cannot trust countries to reform once they get the money.



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The Germans have been insisting on institutional changemore centralized eurozone control over periphery banks and government budgets in exchange for expanded access to financing for the periphery. Yet institutional change, despite the euphoria that greeted the latest EU summit, will take time, for it requires careful structuring and broader public support.




Europe may be better off with stop-gap measures. If confidence in Italy or Spain deteriorates again, the eurozone may have to resort to the traditional bridge between weak credibility and low-cost financing: a temporary International Monetary Fund-style monitored reform program.




Such programs cannot dispense with the need for government resolve, as Greece’s travails demonstrate. And governments hate the implied loss of sovereignty and face. But determined governments, like those of Brazil and India, have negotiated programs in the past that set them on the path to sustained growth.




As a reformed Europe starts growing, parts of it may experience US-style inequality. But growth can provide the resources to address that. Far worse for Europe would be to avoid serious reform and lapse into egalitarian and genteel decline. Japan, not the US, is the example to avoid.






Raghuram Rajan is a professor of finance at the University of Chicago’s Booth School of Business. He previously served as the International Monetary Fund’s youngest-ever chief economist, and was Chairman of India’s Committee on Financial Sector Reforms. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

miércoles, julio 11, 2012

WHY CHINA CAN´T ADJUST / PROJECT SYNDICATE ( A MUST READ )

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Minxin Pei
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05 July 2012
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CLAREMONT, CALIFORNIAChina’s current economic slowdown has no shortage of causes: Europe’s financial turmoil, sputtering recovery in the United States, and weak domestic investment growth, to name the most commonly cited factors. Since exports and investment account, respectively, for 30% and 40% of China’s GDP growth, its economy is particularly vulnerable to weakening external demand and accumulation of non-performing loans caused by excessive and wasteful spending on fixed assets.


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But China’s vulnerability to these factors, as serious as they are, is symptomatic of deeper institutional problems. Until these underlying constraints are addressed, talk of a new consumption-based growth model for China, reflected in the government’s recently approved 12th Five-Year Plan, can be no more than lip service.



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After all, China’s major trading partners, international financial institutions such as the World Bank and the International Monetary Fund, and senior Chinese officials themselves have long recognized the structural vulnerabilities caused by excessive investment and low household consumption. And, for nearly a decade, China has been urged to undertake reforms to redress these economic patterns, which have undermined the welfare of ordinary Chinese and strained the global trading system.


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The best-known feature of China’s macroeconomic imbalances is heavy dependence on exports for growth, which is typically attributed to weak domestic demand: as a middle-income country, China lacks the purchasing power to consume the goods that it produces. With nearly unlimited access to advanced-country markets, China can tap into global external demand and raise its GDP growth potential, as it has done for the past two decades.


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If this view is right, the solution is straightforward: China can correct its imbalances by increasing its citizens’ incomes (by cutting taxes, raising wages, or increasing social spending), so that they can consume more, thereby reducing the economy’s dependence on exports. Indeed, nearly all mainstream economists prescribe this approach for China.



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But there is another explanation for China’s excessive export dependence, one that has more to do with the country’s poor political and economic institutions. Specifically, export dependence partly reflects the high degree of difficulty of doing business in China. Official corruption, insecure property rights, stifling regulatory restraints, weak payment discipline, poor logistics and distribution, widespread counterfeiting, and vulnerability to other forms of intellectual-property theft: all of these obstacles increase transaction costs and make it difficult for entrepreneurs to thrive in domestic markets.


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By contrast, if China’s private firms sell to Western multinationals, such as Wal-Mart, Target, or Home Depot, they do not have to worry about getting paid. They can avoid all of the headaches that they would have encountered at home, because well-established economic institutions and business practices in their export markets protect their interests and greatly reduce transaction costs.


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The Chinese economy’s institutional weakness is reflected in international survey data. The World Bank publishes an annual review of “the ease of doing business” for 183 countries and sub-national units. In its June 2011 survey, China was ranked 91st, behind Mongolia, Albania, and Belarus. It is particularly difficult to start a business in China (151st), pay taxes (122nd), obtain construction permits (179th), and get electricity (115th).


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Faced with such a hostile environment, Chinese private entrepreneurs have been forced to engage in “institutional arbitrage” – taking advantage of efficient Western economic institutions to expand their business (most export-oriented businesses are owned by private entrepreneurs and foreign firms).


.Unfortunately, as China has already claimed a large share of the world’s merchandise exports (10.4% in 2010) and economic stagnation in the West is constraining external demand, this strategy can no longer work. But reorienting their businesses toward the Chinese domestic market requires far more than government policies that put more money in consumers' pockets.


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In order to enjoy the same low transaction costs that they have in exporting, China’s entrepreneurs need a much better business environment: an effective legal system, a sound regulatory framework, a government that protects their brands by fighting intellectual-property theft, dependable logistics and distribution networks, and a graft-resistant bureaucracy.

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China cannot create such an environment quickly. In essence, the Chinese government must transform a predatory state into a nurturing one, and treat private entrepreneurs as creators of wealth rather than targets of extraction. In nearly all other countries, such a transformation was accomplished by establishing the rule of law and/or moving from autocracy to democracy.



The impossibility of sustaining growth in the absence of the rule of law and political accountability presents the Chinese Communist Party with an existential dilemma. Ever since it crushed the pro-democracy movement in Tiananmen Square in 1989, the party has vowed not to surrender its political monopoly. The investment boom and the globalization dividend of the last two decades allowed the Party to have its cake and eat it maintaining its rule on the basis of economic prosperity, while failing to establish the institutions critical to sustaining such prosperity. Today, this is no longer possible.



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So in a sense, the Chinese bubble – as much an intellectual and political bubble as an economic one – has burst. As China’s economic deceleration exposes its structural vulnerabilities and flawed policies, the much-hyped notion of “Chinese exceptionalism” – that China can continue to grow without the rule of law and the other essential institutions that a modern market economy presupposes – is proving to be nothing but a delusion.




Minxin Pei is Professor of Government at Claremont McKenna College