"Asia and the Emerging Global Financial System"

Professor Lawrence H. Summers
Former U.S. Secretary of Treasury
Former President, Harvard University

Asia Society Hong Kong Center Annual Dinner
September 19, 2006

It wasn’t so long ago that I was introduced by a guy who said, “Larry, do you know what it takes to succeed as an economist?”, and I said, “No.” And he said, “an economist is someone who’s pretty good with figures but does not quite have the personality to be an accountant.” That was in Moscow and no one got the joke. Everybody would get the joke in Hong Kong and that’s got to say something about what’s happening in this part of the world.

It’s good to be here with so many old friends and it is good to be here for the Annual Dinner of the Asia Society, which is the kind of organization that I believe is profoundly important in the kind of connections, not just government to government, but citizen to citizen, businessperson to businessperson, cultural organization to cultural organization, that are going to be made, that are critical, if transformations underway in the world are to be well-managed. So I am deeply honored by the invitation to speak here.

I come here from Singapore where I attended, for the first time in half a dozen years, the annual IMF/World Bank meetings, and the nature of the discussions at the meetings were quite different than any that I remembered.

Unlike many of the meetings that I remembered, Asia was at the centre of the conversation. Unlike the discussions that I remembered, where Asia was at the centre of the conversation, like those held in 1997 and those held in 1998, the topic was not how we could assure that there was a flow of capital from the industrial world to Asia. It was not about how we could contain a crisis in Asia, it was very much about the flow of capital from the emerging markets of Asia, to the industrial world. It was not about the challenge that Asia posed, but about the opportunity that it represented. It was about Asia as a source of savings as well as a locale for investment.

Tonight, what I’d like to do is reflect on Asia’s rise with China at the centre of the story. Initially, in a broader historical perspective and then, in the medium term to focus in particular, on the global financial challenge that are posed and posed especially, by the magnitude of current global imbalances.

Begin with this: economic developments in Asia, in the past generation and especially in China, are without precedent in human history and are of profound historical importance.

They called it the Industrial Revolution because after 2000 years, when growth proceeded at rates where it was barely noticeable and all of a sudden, something that was then remarkable took place and it became the case that over a human lifespan of that period, 40 or 45 years, a person could expect to see living standards increase by as much as 50 or 75 per cent. So they called that the “Industrial Revolution”. Subsequently, in the most rapid phase of economic growth in the United States, in the late 19th century, growth proceeded at a rate where a person could expect, over a human lifespan, to see living standards increase perhaps by as much as four fold. And the world had never seen anything like that.

At a growth rate of 6 to 7 per cent in per capita terms, which is below the growth rate that China has enjoyed in recent years, which is modestly below the growth rates that the newly industrialized economies have enjoyed, living standards will increase by a factor of about 100 in a 75-year human lifespan. A third of humanity is now living in societies where living standards, in a single human lifespan, rise by a factor of 100. Nothing like that has ever happened before.

I would dare to suggest that when the history of this period is written 300 years from now, the end of the Cold War will not, be the primary story. September 11 th, Iraq and all that surrounds them, will not be the first story. Rather, the first story will be the rise of Asia and all that it meant for people in Asia and all that it meant for the world system.

Now to be sure, as the prospectuses have it, past performance is no guarantee of future returns. And yet - and there can be no certainties - and yet I think it bears quite considerable emphasis that as the IMF’s recent outlook suggests, the level of income today in China is roughly comparable to the level of income in 1967 in the newly industrialized economics when their take-off is said to have begun. And it is roughly comparable to the level of income in Japan in 1955 when its level of income began to rise.

And so while growth has been going on for a long time at a rapid rate, it would be a serious mistake to suppose that with income standards at about 15 per cent of American living standards, that there was not very substantial room for continued rapid growth. And in India, where living standards are approximately half of Chinese living standards, there is even more room for rapid growth.

And so I would say to you that this phenomenon that you all are part of, that the whole world is part of, really does rank, in the last millennium, only with the Renaissance and the Industrial Revolution in terms of its ultimate historical significance.

Changes of this magnitude do not happen without profound consequences. And how those consequences are managed in every sphere by the countries involved and by the other countries that are influential in the world system, principally my country, will, I believe, define the history of this next century.

It is one of the lesser, but not insignificant, aspects of the period following September 11th that these matters, which would otherwise be top of mind for US policymakers and for Americans more generally, have not, in my view, received the careful attention that they deserve.

As we reflect in the international community on all that will be meant by Asia’s rise, we need, I believe, to recognize, as is insufficiently recognized in much of the Western discussion, that just as we shape our destiny, Asia’s destiny will be shaped in Asia.

With 700 million people still in extreme poverty, with growth at these rates transforming almost every aspect of societal life, from increased urbanization to changed patterns of regional equality and inequality, to changes in traditional patterns of social mobility. With the inevitable consequences and political pressures and political strains that come with the emancipation represented by standards of living that double every decade or less, it is inevitable that the pre-occupation of governments in Asia will be with what all of this means for their citizens and for their societies rather than primarily, what it means for the international community.

The United States and Europe and the rest of the world, have an enormous stake in how this progress takes place, on how China, India and the other countries in Asia define their greatness during their renaissance.

I would suggest, as a general principle that applies well in all areas, that policymakers from the West would do well to speak with their Asian colleagues in the interrogative rather than the imperative form because there is an enormous amount that we have to understand if we are going to constructively engage.

Now there are many spheres in which Asia’s growth will have profound global consequences. It will have enormous consequences for the balance of power for the global security order. It will have profound consequences for the global energy market and profound consequences for the global environment.

I will leave these topics aside. I want to focus on what it will mean for the global economy and in particular the challenge of maintaining sustainable growth and integration.

To be sure, growth with integration is no guarantee of stability. Western Europe, between 1905 and 1914, had plenty of growth and plenty of economic integration. But, if integration is no guarantee of stability, I would suggest to you that disintegration and the failure of sustained and integrated growth virtually guarantees insecurity and instability.

Let me speak frankly. I am deeply concerned about the medium term sustainability of the current global economic patterns connecting the emerging markets of Asia and the United States. While, as I shall suggest, these patterns are both beneficial and functional on both sides of the Pacific in the short run, that very short run constructive aspect has a tendency to blind policymakers to the medium-term challenge of sustainability that they represent.

What am I talking about? I am talking about the following: the United States is now running a current account deficit of between 6 and 7 per cent of GNP with the magnitude of that current account deficit increasing rather than decreasing. According to the IMF’s projection, the US current account deficit will approach $1 trillion next year.

What does it mean to say that the United States is running a current account deficit? It means a number of things that economics courses teach are essentially identical. It means that we’re importing a trillion dollars more than we’re exporting. It means that we’re spending a trillion dollars more than we’re earning. It means that we’re investing a trillion dollars more than we’re saving.

There is no economic theory that suggests - [mobile phone rings] - that tune is sort of vaguely reassuring in the midst of all of this. There is no economic theory that suggests that borrowing a trillion dollars at an increasing rate is a permanently sustainable strategy.

Now to be sure, there is always the argument that is made - and it’s a standard one that every Treasury Secretary or Finance Minister of a country with a substantial current account deficit has always made - that can be put this way: wouldn’t you rather live in a country that capital was trying to get into than a country that capital was trying to get out of? And so isn’t it terrific that a trillion dollars of capital wants to get in to the United States?

Maybe. And certainly the much smaller current account deficits that we had in the 1990s could be linked very clearly to increased capital formation and increased physical investment in American plant and equipment.

The data speak unambiguously to the current account deficit that the United States is now running. It is financing consumption. Savings has collapsed in the last five years, spurred primarily by increased budget deficits and despite the widening current account deficit, investment has declined rather than increased.

Indeed if one looks at the path of foreign direct investment or one looks at investments in equity, the United States is a net exporter of long-term capital rather than a net importer of long-term capital.

I suspect you know what’s coming next: what is the source of this finance? The source of this finance is, for the most part, not the decisions of individual private investors deciding where it is most profitable for them to locate their capital. US current account deficits are largely mirrored by increases in reserve assets that reflect choices of governments around the world with the most important of those governments being the government of China and more generally, the governments of East Asia.

That capital is being acquired out of an entirely appropriate - indeed when I was at the Treasury I advised it - desire to accumulate reserves so as to prevent financial instability and to insure against any possible recurrence of the Asian Financial Crisis of the late 1990s.

The level of reserves in China which now approach a trillion dollars, in the developing world generally which now approach 2½ trillion dollars, are far beyond any measure of what is needed to ensure stability. Indeed they represent approximately five times the level of all debts coming due within the next year. Rather, the accumulation of reserves comes not out of a strategy of accumulating reserves, but as a by-product of a strategy of maintaining exchange rates at very competitive levels that support export led growth.

This alignment is very functional in the short run. Americans get to spend more than they earn, and to finance that spending, at very low rates - 4 to 5 per cent in nominal terms. After correcting for inflation, 1 to 2 per cent in real terms. The suppliers of capital to the United States are not earning a very high return on their lending - the same 1 or 2 per cent at best. But they are supporting a level of export demand that provides a very strong impetus to growth. And so growth in the capital supplying countries, who might be said to be engaged in a kind of vendor finance for their exporters, the ability to keep spending in the United States, is a short-term, very healthy dynamic.

But I would suggest to you that in the medium term, it is unsustainable for three reasons, any one of which is sufficient to bring it to an end at some point.

First, it can’t be the case that any country can be allowed to increase the magnitude of its debts at an indefinite rate forever. And so borrowing by the United States on this scale is not something that will be indefinitely permitted, nor at a certain point, even if the markets were prepared to do it, will the set of assets that the United States is prepared to sell to foreigners who want to accumulate claims on the United States diminish. Already well over half of the participation at US debt auctions comes from abroad, principally from emerging Asia.

So at the first level, the borrowing is unsustainable. At the second level, the lending is unsustainable because what is it that is driving the lending? It is, you’ll recall, the fixing of the exchange rate and the associated accumulation of reserves.

In economic lingo, the difficulty is that those capital inflows cannot be sterilized forever. In regular language, if you keep printing money to buy dollars, eventually you’re going to have more and more inflation - first in asset markets and then in product markets. The longer you hold the exchange rate down and the further you hold it from its natural level, the more capital will flow in hoping to be there the day that the exchange rate adjusts. The more you try to raise interest rates in an effort to cool down the economy amidst that inflation, the more capital flows in because the interest rate rises. The more open the financial system becomes, either as a consequence of financial reforms or as a consequence of the general greater integration with the global economy, the more these problems are presented.

Japan ’s experience in the 1980s is highly suggestive in this regard. It was a rapidly growing economy. It was an exchange rate oriented economy. It attempted, in the late 1980s, to prevent excessive Yen appreciation through monetary policy. The results were enormous asset price inflation - the bubble of the late 1980s that eventually led to the very difficult period of the 1990s.

So you can’t forever borrow at these magnitudes and you can’t forever lend at these magnitudes. Those are matters of arithmetic. They are matters of hard economics.

The third reason why this pattern is, I believe, unsustainable in the long run, is not a matter of economics or arithmetic, it is a matter of politics. And that is that the concomitant, indeed the very motivation for this whole alignment, is the very substantial increase in US imports relative to US exports or conversely, in the exports of the emerging countries, relative to the imports of the emerging countries. That is terrific for the people who get to produce and it is terrific for the people who get to consume. It is not so good for the people who compete with the people who get to produce. And experience, again and again around the world, suggests that when trade deficits become substantial and sustained, there is very substantial protectionist pressure that results.

It was there in the 1980s when Toyotas were being bashed on the steps of the US capital and it gives me no pleasure to say that protectionist pressures are very substantially increasing, right now, in the United States and Europe. When those protectionist pressures will lead to the taking of precipitous action is not a judgment that I can make. Already, the commitment to free trade and to global integration in the United States and Europe has been substantially attenuated as workers contemplate the implications, for them, of a huge increase in the effective global labor force as Asia rises and technology permits increased integration. There is no surer way to increase protectionist pressures than to increase the magnitude of trade imbalances.

Now one could argue or cavil with each of these three points, the question of how long borrowing can take place, the question of how long lending can take place without macroeconomic consequences, and the question of how long the configuration can be maintained without a prophecy destroying protectionist backlash. But I would suggest to you the odds that all three of those risks can be maintained for five to ten years are very, very small indeed. To be sure, there is no reason for precipitous alarm. The investors who are holding the treasury bills are not the kind of private investors who can panic. They are large actors who will find it very expensive to panic and very damaging to their own economies to panic.

At the same time, the medium term situation is not sustainable. Nor are there any self-correcting trends in place. The deficit is increasing. The rate of reserve accumulation is increasing. Protectionist pressures are rising. If the situation is not managed, and if it manages itself at some point, either because lenders are unwilling to lend or because borrowers are unwilling to borrow or because speculators decide on a massive scale to speculate against the sustainability of the configuration, the consequences are likely to be very severe.

At the same time, you are likely to see very substantial financial pressure on the US economy as the dollar falls and the supply of credit dries up. And you are likely to see very substantial pressure towards recession in the United States. You also would have the need for painful adjustment in the countries that have been relying on US demand as a source of demand for their exports. Substantial economic disruption in the international system at a time of such tectonic changes obviously carries with it enormous risks.

What then should be done? I would suggest five steps.

First, these are serious issues that need to be addressed but this is not an emergency that requires panic. There is a kind of co-dependency built in from the simultaneous desire to borrow and to lend.

Second, this is the international financial challenge of the next decade and so the fora for international discussion need to assure close working relationships that build trust between the major capital supplying and the major borrowing countries.

The G7, which contains two North American countries, four European countries and Japan and does not include a representative of emerging Asia or a representative of the oil exporting countries, is hardly a suitable group for discussion of these issues. The G20 that was instituted some years ago is a very valuable forum, but a meeting of 20 countries, each of which is represented by a Finance Minister and a Central Bank Governor, is a meeting of 40 people and serious work is not done in meetings of 40 people. And so the design of a process where the management of these issues can be discussed, in a serious way, that builds trust, needs to be established before, rather than after, the crisis.

Third, United States needs to recognize, clearly and explicitly, and act on the recognition that the US trade deficit is made in Washington. It is not made in Tokyo or Beijing or London or Paris. As long as the US net national savings rate - that is the rate at which households save plus corporations retain earnings, less the amount the Government borrows - as long as that number is as it currently is - close to zero, there is no way that the United States can invest to provide for growth without very substantial reliance on foreign borrowing. Any solution to global imbalances must start with a US commitment to increased national savings, starting with actions to reduce the budget deficit and extending to actions to improve household savings. Without such actions, durable solutions that increase the sustainability of the global expansion are not possible.

Next, US increases in savings that reduce the American need to borrow from abroad, without complementary policy action, risk global recession. Why? An increase in US savings reduces the level of US demand, an increase in US savings reduces the level of US interest rates tending to make the dollar less attractive, tending to lead to a Dollar decline, tending to make US goods cheaper and foreign goods more expensive, switching demand from the rest of the world towards the United States.

An increase in US savings without other policy action is a prescription for a slowdown globally. Indeed, when the concern is expressed in debates about this moment, about the consequences of a falling US housing market for the global economy, it is exactly that concern that is paramount. And so, if US savings are to be increased, as they must, there must be complementary measures to increase global demand.

There are many potential sources for such measures. It is not easy though to make the argument that either Europe or Japan has room to substantially increase consumption, relative to their incomes. If anything, the pressures with societies that are ageing very substantially operate in the other direction. There is perhaps some scope for increased investment, particularly if appropriate deregulatory actions are taken. But the consequences of those deregulatory measures for the global supply/demand balance are not clear. The largest scope for increasing demand lies within the countries of Asia.

In China, private consumption is approximately 42 per cent of income and it is declining. With the rapid growth that China has achieved, there is very substantial room - and very substantial gains I would suggest - to enabling increased consumption. However, it’s very difficult for someone from the outside to prescribe.

One approach that’s been suggested is very substantial improvements in social insurance and pension arrangements. So individuals don’t have to save so much on a precautionary basis. Another is changing policies on state owned enterprises to promote the payment of dividends and so reduce corporate savings and, at the same time, reduce the pressure to reinvest free cash flow in relatively unproductive kinds of capital.

These may or may not be appropriate ways to think about moving to a strategy of consumption led growth. But the basic truth is that a large and growing region cannot enjoy export led growth at an increasing rate without a part of the world that’s going to enjoy import led growth at an increasing rate. And the United States cannot afford that. And so, one part of the desirable adjustment process is an orientation towards consumption led growth. The financial counterpart of that adjustment is moving over time, a process that has begun, towards increased exchange rate flexibility.

Now there’s much discussion of the question of the sequencing and the pacing of financial liberalization and exchange rate flexibility. I would suggest that the logic points very much towards exchange rate flexibility preceding financial liberalization precisely because, in the absence of such financial liberalization, the magnitude of capital flows is lower and the controllability of exchange rate fluctuations is, therefore, greater. And so increased exchange rate flexibility will permit the use of monetary policy to provide for economic stability, rather than commit monetary policy to the exchange rate objective, is the other part of a path that is likely to be desirable if these balances are going to be reduced over time.

What will the magnitude of the exchange rate adjustment be? It’s very difficult to know. You know it’s precisely because it’s very difficult to know that economists increasingly recognize and countries increasingly follow the advice that major large economies should have flexible exchange rates because if you have flexible exchange rates, you don’t have to know what the right exchange rate is. The market makes the choice.

I would suggest one relevant, overarching lesson of the financial history of the last half-century. There are literally dozens of examples of countries that maintained fixed exchange rates or quasi-fixed exchange rates for too long and then were forced to exit them in a disorderly way or found the consequences of their exit to be wrenching. I know of no example of a country that suffered substantially from the premature movement towards increased exchange rate flexibility. Don’t panic, provide fora for trusted discussions, move towards increased savings in the United States, a consumption led growth strategy in emerging Asia.

The fifth thing that I believe is necessary and that I believe represents the reason why gatherings like this are so important, is for the leadership in both countries, on both sides of the Pacific, to do two things that are very difficult in a political context.

The first is to look beyond the moment, to look to problems that are not the problems of today but will be the problems of tomorrow and to take steps that are painful. Increasing savings in the United States through reducing our budget deficit is painful. Starting to make the changes in an enormously complex structure in China that are necessary to move towards consumption led growth does involve consequences that are painful in the short run. And so it does take courage and it does take support to do the painful when it is most effective but not yet obligatory.

The other part of what is necessary on the part of leaders - and by leaders I don’t just mean government leaders, I mean those in all kinds of leadership positions in society - is to recognize that it is terribly important to recognize the need for mutuality and to not seek popularity by scapegoating the other side. For us in the United States, not to blame our trade deficit, which results fundamentally from our low level of savings, on the policies of other countries and for those on this side of the Pacific to recognize that they have a stake in the management of these imbalances as well.

In many ways it is this last question, the maintenance of a constructive spirit in addressing a problem before it is imminent and pressing, that is most difficult. It may be that others will believe that some aspects of the analysis I’ve presented here aren’t right but if the broad thrust, that there are questions of sustainability, questions of sustainability that are hidden by the very comfort of these patterns in the short run is right, then a constructive spirit of mutuality on both sides is of profound importance.

Let me finish where I started. What is taking place in Asia is the most important thing that’s going to happen in any of our lifetimes. It’s the thing that’s happening in our lifetimes, in anybody’s lifetime, that’s creating more human betterment, more human emancipation, more opportunity than anything that’s ever happened. We all have an obligation to do what we can to assure that with all the change, there is a commitment to maintaining as much stability as we possibly can and that’s why I’ve chosen tonight to sound this warning.

Thank you very much.