The Next China: An Interview with Stephen Roach

Conducted by Nick Rugoff and Joseph Mensah

A highly influential authority on the global financial system, Stephen Roach has been at Morgan Stanley since 1982, most recently as the Hong Kong-based chairman of Morgan Stanley Asia and previously as chief and senior economist. He is currently a Senior Lecturer & Senior Fellow of the Jackson Institute at Yale University. His work has appeared in academic journals, congressional testimony and on the op-ed pages of the Financial Times, The New York Times, The Washington Post and The Wall Street Journal. China Business News named his latest book, The Next Asia, the 2009 Book of the Year.

The Politic: You attended a widely publicized event with Chinese Premier Wen Jiabao last week. What is your biggest takeaway from that meeting?

SR: The thing that struck me the most came from Henry Kissinger, who hosted the meeting. If there is one man in the United States who really defined America’s initial engagement with modern China, it was Kissinger with his secret missions to China in 1971 that paved the way for Nixon’s famous trip to China in 1972. Kissinger observed at this meeting that there is a certain irony in the way the U.S. – China relationship has evolved over the past 40 years. When the relationship began back in 1971, the U.S. had a very hostile relationship with China, but quickly learned how to work with China. Today, the U.S. has a much friendlier relationship, but is actually having a harder time learning to work with China. That juxtaposition is a pretty telling observation of how difficult it is for the United States to figure out what role China plays in its own growth and raises a lot of questions. Is China a partner or a competitor? Is it interested in strategic engagement? Is there a threat? What does China stand for? I think Kissinger’s observations would be pretty close to the top of my list insofar as what I took away from the meeting with Premier Wen Jiabao.

The Politic: In July you gave a 45% chance of a double-dip in the U.S. by year’s end. Do you still feel this way?

SR: The year is almost over, so I may have to lower my prediction to 39.8% (laughter). I think the odds of a U.S. double-dip occurring this year have receded well below 40%, but I’m not prepared to say that the U.S. is in the clear. The point I made when I wrote the now infamous “double dip” piece at the start of 2010 is that we are in an anemic recovery environment where we don’t have the normal cushion provided by a standard vigorous recovery that allows us to withstand the blows from a shock.

Shocks come along. For example, we’ve recently seen a European sovereign debt crisis. Was that enough to cause a relapse in the world? So far, no, but it certainly could under certain conditions. This double-dip debate will be around for a while. The U.S. recovery is going to be weak for quite sometime. In that context, if we avoid a double-dip this time, there’s no guarantee that we’ll avoid it when the next shock occurs.

The Politic: You’ve argued that the recent heated rhetoric over the yuan is more political than practical. Why do you believe this is the case?

SR: America has a jobs problem. We have a 9.6% unemployment rate that would be even higher than that if you threw in people who have given up looking for work. Even for those working, wages have been stagnant in inflation adjusted terms for over a decade. American middle class workers are understandably ticked off and they’re holding their politicians accountable. Politicians either do not have answers, or the answers they do have not resonated with hard-pressed American workers. So instead, politicians have sadly chosen to blame someone else – China.

The argument that politicians make to American middle-class workers is that your problem is trade – that we have a big trade deficit, and that the biggest piece of that deficit is with China. China “manipulates its currency,” goes the argument, and if we get them to strengthen their currency, things will be better. That’s the Washington argument, and its reinforced by a lot of economists with pretty fancy pedigrees, including a Nobel Prize in the case of Paul Krugman, who underscores the fact that currency manipulation is strangling American workers.

As I recently wrote in The New York Times, I happen to think that that’s completely wrong. If you look at the U.S., we don’t have a bilateral trade problem with China – we have a multilateral trade deficit with ninety countries. The reason we have that is because we don’t save. So, as we are unwilling to boost savings given our large budget deficit and low household savings rate, we’re going to have a multilateral trade deficit with a large number of our trading partners for years to come. If we close down trade with China, the Chinese piece will just go somewhere else. This is an example of bad economics driving bad politics.

The Politic: You’ve cited a lack of national savings as a major problem for the United States. What strategies do you suggest in order to boost domestic savings?

SR: In 2008, our national savings went negative for the first time ever. By national savings I mean the savings of individuals, businesses and the government sector, adjusted for depreciation. Last year the net national savings rate was -2.3% of US national income, which is the biggest shortfall of saving for a leading economic power in the modern history of the world. There are two things we have to do to boost saving. First and foremost is the budget deficit. We’re running trillion dollar budget deficits as far as the eye can see. The crisis certainly raised these deficits, but there’s really no hope that we’re going to get out of this quagmire just because the crisis is over.

We need a credible exit strategy from outsize government budget deficits. Additionally, we need incentives for individuals to boost savings. The US personal savings rate for households went down to about 1% during the height of the property bubble because people got convinced that home price appreciation was a new and permanent source of savings. That’s wrong. Savings are now adjusting, but they’re still below the long-term average. Whether its expanded IRA or 401(k) plans, there are a variety of savings schemes that could be expanded.

The Politic: What measures can the US take to increase the prudence of the consumer?

SR: I think the biggest mistake we made was a lack of regulatory oversight and undisciplined monetary policy. We have passed a variety of new measures via the Dodd-Frank bill that will hopefully make the regulatory environment more understandable and more consumer friendly by cutting down lending abuse and mistakes that consumers made such as taking on obligations they couldn’t afford. However, we still have not addressed the monetary policy problems that have allowed the Fed to condone asset bubbles and run a much easier monetary policy over the last fifteen years than should’ve been the case. Until we do that, I’m afraid consumers could still be exposed to another bubble, and make very irrational decisions on savings and spending on the basis of not believing that it’s a bubble.

The Politic: You’ve advocated that the Fed should take action to prevent asset bubbles from occurring. How can the Fed determine when an asset bubble is actually occurring? If it can, what policy instruments should it use to burst it?

SR: To answer the first question, the Fed has used explanation as a copout. They always say how it’s impossible to tell if there is an asset bubble. I am afraid that is just ludicrous. We all knew there was an equity bubble in the late 1990s in dot-com and technology stocks that had huge spillover effects to the rest of the asset class. We all knew there was a property bubble with home prices rising at a record rate. We knew there was a credit bubble as credit spreads – the relationship of the price of credit to other financial instruments – were tighter than they’ve ever been. That made no sense. It is a total cop-out to say it’s impossible to tell if there are bubbles.

Moreover, there are some concrete measures the Fed can look at to help them identify bubbles. First, the Fed can consider the rate of appreciation of assets. When you have a sustained period where asset price increases are accelerating, in other words, house price increases are going from 5% to 6% to 7%, you know you’re on a trajectory where the second derivative, the rate of change in the inflation rate, is being driven more by speculation than by intrinsic fundamentals driving the asset class. Second, I think you need to look at the related growth in leverage. Forget about house price inflation; if mortgage finance is growing in an outsize rate, then you know that there are a lot of spillovers into the credit dimension of the asset class. Third, you need to look at the distortions on the real side of the economy that are affected by asset plays. In the case of the US, we had consumption growing faster than income for twelve years. We had homebuilding activity at a record share of GDP even though the rate of growth of the population had stabilized long ago.

At its peak, close to 77% of the US economy were sectors such as consumption and homebuilding activity that had risen five percentage points above the average that prevailed in the final quarter of the twentieth century. When you have distortions in the real economy, you know something is screwy. What should the Fed have done about it? It should have run a tighter monetary policy, and been much more aggressive in using some of the administrative measures they have at their control, such as increasing loan-to-value ratios. They didn’t do it. They did the contrary. Greenspan repeatedly extolled the virtues of subprime lending as providing home ownership through creative new technologies to a class of American income distribution that never before could experience the joys of home ownership. Well, many former subprime homeowners not enjoying the lasting and bitter aftertaste.

The Politic: What lessons should U.S. policymakers draw from Japan? Have they done so?

SR: The answer to the latter question is no. We are steeped in denial, believing that we’re smarter than the Japanese and have learned from their experiences, so their problems could never happen to us. The lesson that we should have drawn is that you do not allow asset bubbles to infect your real economy. In retrospect, the most serious mistake the Japanese made was to allow an equity and property bubble to distort business capital spending, which at its peak in Japan was close to 20% of Japanese GDP. In the U.S., the bubbles ended up affecting an amount nearly four times the size of our economy. We didn’t learn anything. The single most important lesson is that once you have allowed the bubble to infect the real side of your economy, the post-bubble aftershocks invariably last for a lot longer than you think.

The Politic: Is there a Chinese housing bubble?

SR: There was a bubble in high-end property in about twelve Chinese coastal cities. The government moved quickly last April and imposed administrative measures on loan-to-value ratios, especially for the multiple home purchases of speculators, and the bubble has burst. This is an example of Chinese authorities moving sooner rather than later and preempting rather than reacting to an asset bubble.

The Politic: And you’d like to see these types of policy actions occur in the U.S.?

SR: Yes. The idea that we could have zero interest rate, no down payment, and negative amortization mortgage loans in retrospect is scandalous. The regulators and central bank never said a word, so I would definitely like to see a more disciplined approach and better regulatory oversight of U.S. mortgage and consumer lending.

The Politic: You claimed you would have voted against the reappointment of Ben Bernanke as Fed Chairman.

SR: The day after Obama reappointed Bernanke in August 2009, I was on vacation. I was not too thrilled with the news, so excused myself from my family and went upstairs to write a piece that was published in the Financial Times the next day. I took a lot of flack for my rather public position. But I felt that Bernanke, like Greenspan, was too easy on asset bubbles and not willing to focus monetary policy on broader concerns related to financial stability.

We need central bankers in America who are good at avoiding crises, not at attempting to clean up the mess after a crisis. Bernanke’s view has always been that monetary policy should be used after the fact or post-crisis, rather than pre-crisis, and I think that’s wrong.

The Politic: You wrote an excellent piece on India earlier this year. What are some of the biggest challenges India is facing?

SR: The first challenge for India is getting the macro right. I think they’ve done a good job with the micro, in terms of having good companies, a strong workforce, market institutions, rule of law, and democracy. For a long period of time, they have suffered with relatively low savings, inadequate infrastructure, and very limited inflows of foreign direct investment. In recent years, all three of those macro characteristics have improved a lot, but they are still well below levels that we see in China. Savings rates have moved from below 20% of national income into the 30% range, but in China they are over 50%. Savings are a key metric because it’s very important for developing countries to generate much of their investment funding internally rather than to have to rely on external sources of capital.

The second challenge is that India has had a difficult time since the early 1990s at pushing ahead aggressively on economic and financial reforms. This was particularly bad from 2004 – 2009, when the Congress Party ruled in conjunction with the Communist Party. It was very difficult for them to run that country with Communists as partners, but even though the Communist Party has recently been defeated, the reformers are still not as aggressive about economic change as I’d like to see.

The Politic: You’re teaching a popular Yale course this year titled “The Next China.” For the 5,000+ students on campus who will not be able to take your class, what would you want them to know about the next China?

SR: The China that you see today, which is such a powerful story in the annals of economic development, is not the China you will see over the next thirty years. China needs to change for a variety of reasons. I agree with China’s own Premier, Wen Jiabao, who has said in no uncertain terms that the current growth model is not sustainable. The Next China will have to broaden out the base and focus on stimulating their own internal consumer markets, which would give them better balance, less frictions with the rest of the world, and more opportunity to focus on the quality of economic growth rather than the quantity of economic growth. China is not a static construct. While the last thirty years have been spectacular, as we say in the investment business, past performance is not necessarily indicative of future developments.

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