Interview with Randy Wray, Regarding the Next Crisis (Part 2)

Randy Wray (RW): As early as 1996, I was writing on the EU, and stating that this is a system designed to fail. The system will fail. The fundamental problem is that the countries are not sovereign and that they have adopted foreign currencies. The ECB always has the ability to create euros, but it is prohibited from buying the government debt of each individual country, and so you couldn’t use the normal procedure used in any sovereign country where the central bank either directly buys sovereign debt or it has an arrangement, like we do in the United States, where the Treasury first sells the debt to a private bank and then the Fed buys it from a private bank. So it is just a little more round about, but it has exactly the same impact of creating dollar reserves as well as deposits in the Treasury’s account that it can use for fiscal policy.

The ECB was prohibited to this, so you always had a constraint on the individual countries that they can only get euros by borrowing or exporting, but you cannot all be exporters. So some countries will be the exporters and some are the importers, and in net, this does not create euros. You could borrow euros from another country—for example from the net exporting countries, so that relieves the constraint a bit by not being completely constrained to exports. But that just means that if you are a net importer, you are going to be increasing your debts, external debts, to other European countries and eventually you are going to have to adjust your trade, or you are going to get shut-off, downgraded. It couldn’t last.

Then, the crisis hits, and the ECB starts providing loans in euros and creates new ways to finance individual country’s foreign debt–trying to prevent default or even worse downgrades of the debt, which the market wouldn’t buy either.

Is there a way out? Sure. And it is not hard at all to come up with solutions that are economically viable. One would be that you just allow the ECB to provide funding for individual countries, and they could do it directly. The ECB can start buying government debt, or they can do it indirectly by proving loans of reserves to central banks or private banks so that they can buy the debt.
Another is that you do it through fiscal policy, and that would be to increase the size of the budget of the European Parliament. Right now they have a budget of less than 1 percent of GDP for Europe versus our Congress that has over 20 percent of U.S. GDP to play with. And in the US they redistribute it among the states, so we have fiscal transfers to the poor states. If the European Parliament had a budget of 15 percent of GDP it probably would be enough to solve all the financial problems in Europe. With 15 percent of GDP they can target Greece, Portugal, Ireland, and so on by providing fiscal transfers to them. That would solve the problem.
Either one of those. But politically I don’t think either of these is possible, that is the problem.

RW: Correct, you would have to change the constitution to do it through the ECB, so that is the problem. I don’t think it is a secret: the ECB is completely run by Germany. And Germany would never allow the ECB to do this, and for the other one there is an even less political possibility because probably every country in Europe would be against it. Why? Because they still want to be independent, they want to have independent fiscal policy. It is not likely that they are going to give that much power to the European Parliament, so that is the problem.

RW: Yes, and from the beginning we always had more power in Washington than you have given. And it took the Civil War, but it also took the Great Depression—during which the Federal government budget grew from 3% of GDP toward the current 20% (of course it hit 50% in WWII).

RW: No there is no future with such high unemployment. And it probably will get worse. If Spain were the only country that had problems then there would be some hope. But Spain isn’t the only one, so there are only a few strong economies in Europe. The strongest, Germany, relies on exporting, so it is a mercantilist country, and mercantilist countries impoverish other countries. But failure of the other countries will kill Germany too, so it is self-defeating even for Germany. The problem is that Spain can compete only by becoming much poorer than it is. So this would work, but the problem is that you have many other countries that will pursue the same strategy. They are going to become poor at least as fast as Spain does, so that won’t work.

RW: That is true! And they always have to watch out. Let’s say that their workers are the most productive and the best trained, but at some relative wage German manufacturers would rather be located in Spain. So if you get Spanish wages low enough, German wages have to come down. So that is why it won’t work. And the Germans are willing to use austerity in Germany if they have to in order to keep their trade advantage, so there is no possible solution.

RW: I think they are in a much different situation because Germany is a rich country already highly developed. China was a very poor country and still has relative poverty for the majority of the population compared to European living standards. I wouldn’t say that what China is doing is illegitimate at all; they are following a normal development path. The normal development path is that for a while you export, and there are some reasons why they do that.

One is that if they don’t have to produce products that compete in world markets, they don’t have any competitive reason to produce good products. So they learn how to produce good products by competingthey have to export high quality commodities produced to world standards. Also, a lot of Chinese exports are very low value added. Much of the high value production is done outside China, and then sent to China. It is pretty misleading to say that Chinese are taking away manufacturing jobs as for the most part it is not true. They are adding a little bit at the end of the production process and learning something about producing high quality goods, so that they can produce some for their domestic population. Maybe not all, but most countries follow that same development path.

At some point, China does have to switch over. I have been to China talking to Chinese, and I think they universally recognize that. They are rapidly increasing consumption domestically, and they will move to much higher domestic consumption and much lower investment and exports as a percent of total GDP. And they are doing it: living standards are rising extremely fast in China and you can’t do that without having consumption.

The second reason why they did it is that they saw what happened in the other Asian countries. If you don’t have huge dollar reserves, you get attacked. So they wanted to accumulate a lot of dollar reserves to make sure that they can control their currency. That brings in the US charge that they are currency manipulators, and again, I think that is extremely unfair. Most countries, almost all countries, pegged their currencies until Bretton Woods fell apart, so how can you blame a country for pegging their currency when you did it too? Within Europe, all of the nations in the EMU have pegged currencies. And many Asian countries peg their currencies to the dollar, so what China is doing is not unusual at all. It is very common even today and it was almost universal a few decades ago. Why are they doing it? Because this is consistent with trying to develop your export market as you develop. To secure stable development you try to maintain the value of your currency.

China is not likely to open up its capital markets, as they saw what happened to Asian and Latin American countries with open capital markets. As a result, they are probably not going to do it. And the financial crisis only confirmed what they believed, so they are thankful that they didn’t allow this to go on. So the pegged exchange rate is reasonably easy for them to maintain, and it is going to be very hard for anyone to attack them. They’ve got capital controls and they have huge dollar reserves. They won’t use their dollar reserves for a long time. They probably will become net importers in a reasonably short amount of time as they increase domestic consumption, so they need the dollar reserves for a while.

RW: I think the concept of efficiency is overused and almost always wrong. I don’t think that out in the real world where you have unemployed or underemployed resources, the notion of efficiency applies. I think that is irrelevant. It only matters once you reach full employment of all resources—then it is legitimate to worry about using them more efficiently.

Regarding the banks, on conventional accounting, they are massively insolvent. Does it make any difference? No, it makes absolutely no difference. They are completely stable, there will be no financial crisis in China. Why? Because banks will be backed up by the government. The government uses the banks as a fiscal tool, it has nothing to do with normal banking. It is a fiscal tool so that the Chinese government doesn’t have a budget deficit. So what the banks do—and they are mostly government banks–is to make loans that they know are going to be bad, but it doesn’t matter, because it is spending, it is not really lending. The finance is mostly public infrastructure and universities, so it is achieving a public purpose I wouldargue that is efficient. All you have to do is go to China and look at the trains, at the universities which are like cities. That is where the bad loans are, the bad loans are paying to build magnificent universities. So what?

They could have just allocated the funds and built a university. We should look at this as fiscal spending. The debt will be written off, and the buildings will remain.

Now, there is a legacy of bad loans to the state-owned enterprises, which were uncompetitive so when China opened up there was no way that these state-owned enterprises were going to compete with modern manufacturing. They’ve got all of those loans on the books, but many of those were closed, and gradually all of these are going to be closed down, and you are going to be stuck with bad loans. But again, that is not a problem– the government is going to bail the banks out.

There could be one danger, and that is the real estate boom. They have a huge real estate boom, maybe it is a bubble. The equity is pretty high so it is not like they are borrowing 100 percent, they are borrowing 60 percent. The homeowners have a lot of equity and for the most part they are living in the homes. The prices are probably going to come down but they can drop a lot before the people get in trouble. The Chinese in those situations in cities have secure financial positions as they have relative high income and very low costs. A college professor in a major city in China lives much better than a college professor in a major city in the United States; their standard of living is much higher. It is hard to believe, but it is true. They make $400 a month but they have few expenses, and $400 goes a long way in China.

RW: It is very much worse. The worst corruption in the world is on Wall Street. People talk about the corruption in Latin America or Africa or China, but it is nothing compared to what is going on. The biggest scandal in human history without any question at all; the whole thing is fraud, everything they do is fraud.

Yes there is corruption in China, and the further you get away from Beijing the worse it is, but the corruption, at least what I hear when I talk to Chinese, comes from the fact that the government owns the land and local governments sell the land to get the revenue. That is a major source of finance for local governments, from the sale of land to developers. Whenever developers play a big role, there is always corruption. That is true in the United States too–the whole savings and loans crisis was caused by developers and the link between developers and politicians. Because then you favor a particular developer, so they have massive corruption whenever developers and politicians get together.

But what is the purpose of it? It is to get the land developed, largely homes, and then to provide financing to the local government (from the sale of the land), and so they are favoring individual developers who become massively rich, but comparing that to Goldman Sachs, the consequences of the corruption is completely different. Think about it: the fraud perpetrated by Wall Street is kicking millions of Americans out of their homes, destroying financial wealth, jobs, families, and neighborhoods. The relatively minor corruption in China is generating economic development, building homes and putting people into them.