|Man Without Qualities
Sunday, June 26, 2005
Glenn Hubbard writes at length in the Wall Street Journal about his belief that a big reason American interest rates are low is that Asians are investing in the United States because the weakness of Asian financial systems suppresses Asian ability to absorb and use their own savings. This article has a lot to recommend it, but I have a few observations:
The Man Without Qualities has some experience dealing with wealthy, third-world foreigners investing big sums in the United States. But Professor Hubbard (who is a very bright man) makes one wonder if he has had such experience. One striking aspect of such third-world investors is often their comparative insensitivity to expected rate of return from their United States investments. In this respect wealthy third world investors in America are often far different than, say, British, French or Australian investors. Third world investors - such as middle eastern oil interests and Chinese exporters - are different because third world investors are often mostly buying political security with the American investments - not because of any perceived differential in return or a weakness in their domestic financial systems. Contrary to what Mr. Hubbard suggests, the Chinese economy - for example - is growing fast enough, has sufficient capital needs and promises high enough returns to absorb every bit of Chinese savings. Indeed, China is absorbing vast quantities of foreign investment right now - which could in theory be displaced by Chinese domestic investment. Wealthy Chinese people won't do that because they want a good part of their assets separated from Chinese political risk. Professor Hubbard's suggestion that the scale of Chinese overseas investment is somehow largely a mere side effect of Chinese government policy seems naive. Yes, Chinese government economic policy is consistent with Chinese investment actions - but Chinese government economic policy is broadly consistent with the needs, desires and actions of wealthy Chinese people.
By way of example: Many a billionaire family keeps essentially every asset in the United States (consider billionaire American real estate or technology investors, for example). But no wealthy Chinese family would keep all of its assets in that country. It is curious that some economists - such as Paul Krugman - focus excessively on American political risks (the possibility that the United States might deliberately inflate it currency to address its debts, for example, seems to prey on his gnomishly handsome mind), but pay essentially no attention to the vastly more significant Chinese and developing third world political risk as a reason for the American trade deficit.
In my opinion, political risk matters a lot more than most commentators have been allowing, at least before the risk condenses into something obvious and immediate. Consider the effect of the recent dollop of political risk on the euro, a risk essentially ignored until a few weeks before the French referendum - although the structural issues now identified as the causes of the French rejection have long been present. In fact, it is possible that many wealthy third world investors would be willing to accept negative returns on their American investments for a very long time. Which, of course, would mean that American interest rates could stay low or even become negative during that period - even if (especially if) the United States runs a gigantic trade deficit and the dollar "should," by some schools of rational economics applied absent adequate political risk considerations, fall radically.
Normally, nominal interest rates cannot be negative. But that normal argument rests on the assumption that negative nominal interest rates would cause investors to substitute currency for interest-bearing assets, and that the demand for currency would be perfectly elastic at zero nominal interest rates. However, in the presence of transaction costs, investors might be prepared to hold cash even at negative interest rates. For example, Swiss nominal money market rates briefly fell below zero in 1979. Suppose political risk for wealthy people in Asia rose and such people decided (for whatever reasons) to hold a good deal of currency. What currency could they hold and where would they hold it? Obviously, currency could not be held domestically in the third world country - that's what the political risk is all about. So it has to go overseas in some form. That means the overseas jurisdiction is providing a service - political insurance, if you will - for which wealthy, third world people will pay for if necessary. That "payment" could, in my view, take the form of negative nominal interest rates (and equity returns) for as long as the political risk lasts at a sufficiently high level.
How long could that be? That is difficult to predict, but one might start by considering how long it would take to fix the sources of the potential Chinese (for example) political instability, even assuming anyone wanted to do so and was in a position to do so. It is no secret that a huge economic class disparity has opened up in China, and with it the potential for truly gigantic political repercussions. While there is much free market activity in China, there is also a huge amount of cronyism and corruption connected with the recent and rather concentrated growth of wealth in that country. Development seems to be taking place without much regard to economic externalities, including pollution. There is no democratic political system. Indeed, the country is still nominally Communist - and the legacy of the hard Communist era is not fully past or repudiated in all quarters. There is no deep, stable or reliable property rights system or broadly meritocratic educational system. The courts are unreliable. Nor does China possess any deep, liquid, transparent national securities system or a sensible bankruptcy code. In general, China seems to lack a great many of the features that relieve political stress in other countries. But each of these factors appears to be, if anything, worsening yearly - although the main countervailing factor, Chinese prosperity, is increasing (although a significant positive factor, memories of the insanities of the hard Communist era, are receding). How much weight each of these factors should be given in China, and how much weight wealthy Chinese people actually put on any of them in evaluating Chinese political risk to their fortunes, is hard to tell. But one need only spend some time east of Los Angeles in the San Gabriel Valley, for example, where billions of dollars of Chinese money is being deployed - and thousands of young Chinese children of wealthy Chinese families are being Americanized - to get some feeling that the Chinese, at least, are willing to pay quite a lot for what may be America's most important export service: political and property security. What would the Constitutional framers think of that?
Japan, of course, is another story. Professor Hubbard's list of Asian countries with "weak" financial systems includes Japan. The political and development gaps between Japan and China may give some idea of how long the Asian low-interest rate effect may last. Japan is far in advance of China on all fronts, both political and economic (although it is my belief that the Chinese are "more natural" capitalists, and that may make a big difference eventually). It will likely take China quite a while to "catch up." But, as Professor Hubbard notes, Japan is still locked into a system that subsidizes American interest rates and prosperity. That may suggest that China will be doing the same for a very, very long time - much longer than most current commentators are now suggesting. Japan still has a thin bond market and impacted, politicized banking system. Japanese is a very clever, rich, democratic country, whose leaders (I absolutely guaranty) fully understand the nature of their domestic financial system, how it is "weak," and how it could be changed. Indeed, even if they did not originally have that understanding, they have it now as the result of many years of American hectoring. Why don't the Japanese "strengthen" their financial system? That's a difficult question - but the fact that the Japanese system remains so "weak" suggests that China may have a tough time "strengthening" it's system any time soon.
UPDATE: A perceptive reader e-mails:
The comments you make about China are, for somewhat different reasons equally applicable to Latin America, which is why Miami is often referred to as "the financial capital of Latin America". The amount of Latiin American AUMs (assets under management), almost all of which are dollar denominated and all of which are held outside of Latin America, managed by Miami based private bankers/broker-dealers must be several hundred billion dollars. And of course a lot of the really big Latin American money goes to New York, not Miami
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