"Dear China," said Roger Myerson, a Nobel Laureate in Economics from the University of Chicago, to an audience of Chinese business executives and government officials recently, "you have loaned us money against IOU's written in dollars, and we Americans can print the dollars, so you might be a little nervous."
You might do better, he told the audience, if you liquidated some of your American investments and spent the money to buy "more goods and services in this country rather than saving for the future in dollars."
Ominous words indeed. Myerson, who was a speaker at a recent executive forum in Shanghai hosted by the W. P. Carey School of Business, considers attempts to solve the current financial crisis with fiscal measures misguided.
Banks are the principal channel for the "vast flows of wealth from the population at large of investors to those limited numbers of entrepreneurs who are going to invest that wealth," Myerson noted. Banks, therefore, should play a central role in reviving the economy.
"If you use fiscal stimulus to substitute for a lack of investment otherwise, you're using a different channel, a political channel," he said, warning that "when official stimulus is planned politically to get around the banking system being too slow, banks are going to fail." But if the banks fail, the channel through which investment flows disappears, and that, in Myerson's view, is the economic version of shooting yourself in the foot.
Poor regulation to blame
Myerson, a game theorist who has written extensively on decision making in complex political, economic, and military situations, maintains that poor regulation is responsible for much of the current financial crisis. Fiscal stimulus may alleviate some of its symptoms, but it won't solve the underlying problem.
"Our crisis in America began when we discovered that banks were using loopholes in the rules to take much bigger gambles than were warranted, gambles that didn't pay off," he said. "I would have thought that the first priority should have been more in the direction of finding ways to fix the regulatory system, leaving alone what was working."
Myerson cited as evidence China's recently released positive economic growth figures, which suggest that the Chinese government's nearly $600 billion stimulus package has successfully buffered the Chinese economy from a major downturn on a scale comparable to the U.S. situation. "The problem in China is essentially fiscal, the decline of aggregate demand, and the government stepping in with some extra spending to fill in the gap makes a lot of sense," he said. By contrast, the problem in the U.S. was not a lack of demand but the breakage of the channels through which that demand could be satisfied.
Restoring confidence in America's financial sector
According to Myerson, the real challenge in the United States is not creating jobs or increasing the money supply; rather, it's a matter of restoring the private sector's faith in a badly bruised banking system. And as he points out, it's a challenge with substantial historical precedents that tend to hinge on some sort of a regulatory framework.
Myerson considers the story of J.P. Morgan (the elder) particularly illustrative. The United States of the late eighteenth century was a land rife with investment opportunities, much like China today, and many European pockets were ajingle with capital.
The problem was that European investors couldn't distinguish the real opportunities from the scams and thus invested reluctantly. In exchange for equity shares, Morgan and his men would certify American companies' creditworthiness to European investors with whom they always dealt honestly, thereby facilitating the flow of capital from Europe to the United States -- and becoming tremendously wealthy and powerful in the process. In this example, Morgan and his men served both as the channel for the investment and as the regulatory framework, reducing risks and inspiring confidence by wielding considerable influence over both companies and their investors.
But Morgan acted as a regulator in a much more direct way during the financial crisis of 1907, when the failure of certain banks provoked unease about the security of banks among the general population. After carefully scrutinizing the balance sheets of all the banks, Morgan created a consortium of solvent banks that preserved the banking industry. It was this move, incidentally, that finally prompted Congress to establish the Federal Reserve System.
In both cases, it was Morgan's reputation that allowed him to maintain investor confidence while assuring compliance with rules that he felt were in everyone's best interest. Congress deemed that too much power for one private citizen to exercise, and created a central bank to take it over. The current financial crisis, says Myerson, arose because the government let much of that power fall back into the hands of financiers whose understanding of everyone's best interest was heavy on risk and light on responsibility.
The result? A massive loss of reputation that crippled the banking industry.
According to Myerson, the government should be focusing on the restoration of that reputation. "A well structured regulatory reform that makes people think that America's financial system is as secure as it was deemed to be before this crisis would lead to a speedier economic recovery in the United States," he says, but "if we leave the system as it is, we leave people with lingering doubts about whether the financial system is healthy, then the recession will be very long."
Myerson is an expert in mechanism design theory -- an economic discipline that studies and designs systems which allow multiple selfish parties to achieve mutually beneficial outcomes without regard for each other's goals. He believes that clear rules and standards set by a separate and independent government agency would go a long way towards managing risk and restoring global confidence in the American financial sector that would in turn lead to rapid economic improvement.
Water flowing uphill
According to Myerson, the current financial crisis may also have the unexpected benefit of addressing an unsustainable imbalance between the developed world and the fast-developing economies of Asia -- a situation he likens to water flowing uphill.
"International flows of capital, in theory, should go from countries where capital is rich and plentiful, to countries where capital is more scarce and investment opportunities are more plentiful," he says. "In fact in the world in the past decade or two capital has tended to flow the wrong way, from countries that are poor in capital like China to the United States."
That seemingly limitless influx of capital has led to certain unhealthy assumptions, especially in the United States, where, according to Myerson, "the flow of Chinese wealth may have encouraged the American Congress and politicians to think that spending without taxing was no problem, and in the long run, that's not true." It also may have contributed to the hubris that proved the undoing of much of the financial sector.
"Banks lent too much in a property boom and now they, along with the taxpayers, are going to pay the penalty. It is still true that there are a number of accomplices and contributing factors, but the primitive forces are really revealed as symptoms and weaknesses in those institutions," says Jeffrey Coles, chairman of the finance department at the W. P. Carey School of Business.
Reversing the flow, however, will require more than failing American banks; it will require China and other developing economies to provide investors with assurances that have traditionally been the purview of advanced Western economies, assurances that rest on corporate governance and careful regulation that the U.S. lacks.
If Myerson is correct, then restoring the U.S. economy is not a matter of encouraging spending, but of regulating the banks and reestablishing their reputations. If the Chinese do indeed start shunning American and buying Chinese, it will be because they have created investment channels that leak less and hold more.
- The bank failures that caused the current financial crisis were largely the result of insufficient regulation that allowed banks to make irresponsibly risky choices.
- The major obstacle to the U.S.'s recovery from the current financial crisis is the focus on fiscal measures that circumvent the principal financial channels through which investment flows into the economy.
- The world's confidence in the U.S. as a safe place to invest has resulted in the influx of capital from countries rich in investment opportunities but relatively poor in capital -- a situation that has been likened to water flowing uphill. Reestablishing that confidence should be the U.S.'s highest priority.
- Clear rules and standards set by an independent government agency would go a long way towards managing risk and restoring global confidence in the American financial sector.