清华-布鲁金斯公共政策研究中心BROOKINGS-TSINGHUA CENTER FOR PUBLIC POLICY

Managing Global Financial Instability

What should the U.S., China and Japan do before the next G20 meeting?

A brainstorming note

Initial draft, December 4, 2009Second draft, December 19, 2009

Current Draft, Feb 20, 2009

Geng XiaoDirector, Brookings-Tsinghua Center for Public Policy, Beijing

gxiao@tsinghua.edu.cn

Senior Fellow, Brookings Institution, Washington D.C.gxiao@brookings.edu

The U.S., China and Japan should lead the discussion at the G20 about a global strategy for managing both global financial instability and the recovery from the “once in a century” great “triangular debt” crisis the world currently faces. Before the April 2009 meeting, all three countries should try to agree on a simple but concrete plan that can then be presented to the council’s 17 other members. A U.S.-China-Japan agreement, if completed before the next G20 meeting, will provide a solid foundation for the much larger group of G20 nations to agree on an economic plan that is useful, substantive and implementable. What should such an agreement entail? Here are a few thoughts for discussion:

1. Establish a Trilateral Emergency Currency Peg Between the dollar, RMB and yen.

The U.S., China and Japan should attempt to reach an agreement on an emergency trilateral currency peg between the dollar, RMB, and yen at the current level of exchange rate for as long as it is necessary to stop the coming global recession and deflation.

This agreement will be crucial in stopping the temptation of competitive devaluation which will emerge naturally from domestic pressures as the economic crisis worsens.

This emergency currency peg will effectively bring the three largest trading economies in the world back to a fixed exchange rate regime not at all dissimilar from the post-war Bretton Woods international monetary system.

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With the U.S., China and Japan acting as global leaders, the world can eliminate a large part of the man-made and unnecessary exchange rate risks and politics, at least for the next few years, a period during which most countries will be focused on combating both recession and deflation.

Given the large amount of foreign exchange reserves China and Japan have now, the peg of RMB and yen to the dollar is entirely feasible on technical and economics grounds; that is, if the U.S. is willing to support it. The only barriers to the peg are conceptual and political, both of which can be overcome by strong American leadership.

2. Create a Group of Allied Global Central Banks including Fed, PBOC, and BOJ.

Once we have official commitments on a stable exchange rate between the dollar, RMB and yen, the U.S. should try to help China and Japan establish the RMB and yen as international reserve currencies. The Fed, PBOC and BOJ should then establish currency swaps and a pool of reserve funds, large and credible enough to act as the world’s lenders of last resort. The Fed, PBOC, and BOJ should then form a group of allied global central banks for coordinated leadership in global macroeconomic, regulatory, monitoring and crisis-managing policies and actions.

3. Recapitalize Key and Viable Global Corporations with Global Sovereign Funds.

Once the group of allied global central banks is established they should work with their respective governments to come up with a coordinated plan for immediate and systematic rescue and recapitalization of key global financial and non-financial corporations. This plan should feature a mixture of liquidity provision and partial nationalization/recapitalization schemes through sovereign funds.

Either the governments of the U.S., China, and Japan or their sovereign investment arms can work together to become passive minority shareholders for those global financial and non-financial corporations that are integral, viable and troubled . This non-conventional use of sovereign trusts for restoring public confidence in the markets could be critical in stabilizing asset prices and the associated deflationary pressure.

The classic example of successful government intervention during a financial crisis was the Hong Kong government’s intervention during the 1997-1998 Asian Financial Crisis. In an attempt to avoid an economic cataclysm, the government bought 10% of all the blue-chip companies listed on the Hong Kong Stock Exchange at an index level of around 6,000 and then sold the shares a few years later at an index level of around 12,000.

4. Create a Managed Global “Wage & CPI” Growth/Inflation for Managing Global Financial Instability and Global Economic Recovery after the Current Great Debts Crisis.

The group of allied global central banks should set up a strategy to engineer a worldwide, managed, smooth, and single-digit “wage & CPI” growth/inflation for as long as it is necessary to pull the global economy out of the current Great “Triangular Debt” Crisis.

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The managed “wage & CPI” growth/inflation will encourage current consumption and investment, boost future prices of property and financial assets, and lighten the burden of the gigantic public and private debts, at least for the principal component, if not for the interest component of the debts.

No matter how large the current public and private debts become, as long as they are a fixed amount, they will become bearable after one or a few decades if the world can maintain a stable inflation rate between 5% and 10%.

5. Implement Coordinated Macroeconomic Policies for Households and Firms to Operate Productively under the Future Global Environment of Steady “Wage & CPI” Growth/Inflation (e.g. maintain positive real interest rate).

The group of aligned global central banks and their governments should announce their minimum targets of “wage & CPI” growth/inflation together with concrete measures to protect households and corporations so that they can operate productively under the future global environment of “wage & CPI” growth/inflation.

For example, salaries and wages, employee welfare benefits and deposit rates should be indexed to CPI to ensure reasonable stability as regards household real income and to minimize any distortion to the real price of capital (e.g. the real interest rate should be zero or positive).

Without the timely upward adjustment of the nominal interest rate to offset the inflation rate, the aforementioned inflationary policy will lead to a negative real interest rate, which, sooner or later, will create new asset bubbles. Therefore, at the start, the “wage & CPI” growth/inflation policy should incorporate safeguards so as to minimize the volatility of future business cycles.

6. Implement Coordinated Tax Reduction and Public Spending Schemes to Jump Start the Global Economic Recovery.

Since the group of allied global central banks will not be able to generate “wage & CPI” growth/inflation if the unemployment rates of their respective economies remain high, the governments of these countries should jump-start the economic recovery and employment engine by implementing large fiscal stimulation packages as soon as possible. Such packages could include drastic tax cuts and public spending, until “wage & CPI” growth/inflation reaches 5% to 10%.

In order to boost nominal incomes, which are the basis for sustainable and managed “wage & CPI” growth/inflation, the governments of the U.S., China and Japan should not only invest in infrastructure, education, health, and green energy, but also implement nominal income-enhancing policies such as temporary subsidies on individual payments to social welfare and retirement funds and temporary waivers or reductions in taxes,

Given the fact that running large fiscal deficits during times of crisis is widely accepted, the governments could in principle double nominal wages by matching whatever wages the private sector is paying to the workers. The governments could also put to work most of the

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unemployed workers by investing in major infrastructure projects that will benefit future generations.

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An addendum to the above brainstorming note: Questions and Answers

(1) What is special about the current global financial crisis?

The roots of the current global financial crisis can be traced back to inconsistent macro economic policies (cheap credit and distorted prices in capital and factor markets) and loop-holes in the regulation of complicated financial products (subprime loans and derivatives).

If a financial crisis happens in a country like Mexico, it can be stopped by getting a large enough check from the U.S. If it happens in Argentina, it can be resolved by declaring bankruptcy. In these cases, the debts will either disappear or be contained after the distribution of losses among creditors.

Unlike previous crises, the current one has unfolded in the world’s largest economies (the U.S., Europe, Japan). No outsiders can write a check to the U.S. to stop its debt crisis. Right now it is the Fed that is writing the check to the banks under its control. The U.S. government and many U.S. corporations also cannot possibly declare bankruptcy without creating a systematic risk for the global financial system. Thus, a lot of “triangular debts” will continue to stay on the books of the governments and private sector for the U.S., Europe, and Japan. The world will undoubtedly have to face gigantic “triangular debts” for a long time (ranging from three years in the case of Asian financial crisis to more than two decades in the case of Japan’s debt crisis). That is why we have a Great “Triangular Debt” Crisis.

(2) What is special about the U.S., China and Japan in dealing with the crisis?

China and Japan are the largest creditors to the U.S.

The U.S. is the largest economy in the world and has the only global central bank that produces a creditable reserve currency (the dollar).

The imbalance in international payments and reserves between the three can be turned into strong global leadership in the new international financial architecture if all parties can form a strategic partnership and alliance quickly to safeguard China and Japan’s investment in the U.S. as well as the U.S.’s leadership role in the realm of global finance.

The costs of negotiation among the three are probably the lowest among any three countries in the world given the complementarities of their economies and the nature of their political and historical legacies. The impact on the world will be greatest if the three can reach an agreement quickly.

(3) Why should the U.S., China and Japan help each other and lead the global recovery?

The U.S. has difficulties in dealing with its crisis alone and needs help from China and Japan in providing short-term as well as long-term funding to its coming gigantic debts.

Japan had some bad experiences in dealing with the debt crisis over last two decades and could become a burden for the world if Japan could not stabilize its currency and its domestic debt explosion.

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China has the greatest potential for sustained growth and can provide much needed confidence to the global recovery in addition to providing funding of short-term liquidities to other economies in crisis and of long-term U.S. government debts through both its large foreign exchange reserves and its RMB lending if RMB becomes an international reserve currency.

(4) Why should the U.S., China and Japan agree to a peg between the dollar, RMB and yen given the large global current account imbalances for all three countries?

The real world experiences of Japan, China and the U.S. seem to refute the conventional wisdom that nominal exchange rate adjustments can correct the international payment imbalances. The inability of these three countries to correct the extant imbalances between them is likely due to a fatal mistake in identifying the real causes of the imbalances.

The real causes of China’s large current account surplus are:

First, a weak social safety net which encourages private savings and discourage current consumption;

Second, distorted factor markets where inputs for manufacturing exports, including capital, land, water, oil, gas, coal, electricity, minerals, grain, etc are all subsidized through price control and poor property rights;

Third, the dominance of SOEs in the monopoly sectors creates excessive savings due to a lack of efficient investment of their profits.

To reduce their respective current account surpluses, China should focus on continued market-oriented reform and Japan should focus on the reform and opening of its services sectors, where subsidies and other protective measures exist.

Adjustments in nominal exchange rates will have only short-term transitory effects on the balance of trade but will create huge distortions, high uncertainty and massive re-distributions since no firms and households can predict accurately the changes in exchange rates. For a concrete example of this, compare life in Europe before and after the euro for both households and business.

Hence, if possible, we should eliminate the unnecessary economic uncertainties and risks coming from the volatility of exchange rates and do away with the protectionist risks and costs associated with exchange rate politics.

To achieve adjustments in real exchange rate and balance in current accounts, it is better to rely on wage & CPI inflation (under a stable nominal exchange rate) than on nominal exchange rate adjustments.

Hence, China and Japan should aim to achieve a higher wage & CPI inflation than the U.S. under a dollar-RMB-yen peg. China, Japan, and the U.S. should also aim to maintain a similar level of real interest rates.

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(5) Why should the U.S., China and Japan work together to engineer a worldwide managed wage and CPI growth/inflation for the next decade?

The U.S. and Japan need wage & CPI growth/inflation to digest their huge debts and to maintain asset prices for property and equity.

China needs wage & CPI growth/inflation to encourage consumption and discourage excessive savings. In addition, wage and CPI growth/inflation will ensure the continued nominal appreciation of the value of property and financial assets. China’s wage & CPI growth/inflation should be higher than those in the U.S. and Japan so as to allow China’s nominal wages to gradually catch up with those in U.S. and Japan.

(6) Why should the U.S. and Japan help China to make the RMB an international reserve currency?

This is the only way to leverage the strength of China when dealing with the current financial crisis. China’s foreign exchange reserves of about two trillion dollars are too small when compared with the size of the gigantic debts in the U.S. and Europe (tens of trillion dollars).

But if RMB becomes an international reserve currency, China can extend much more RMB credit to troubled economies. Given the capacity constraint of using its own savings, it is also in China’s interest to act as a lender of last resort to help other economies and create a stable international economic order for its trade and investment in overseas markets.

Given the momentum of China’s growth and reform movement and the sheer scale of its economy, the RMB will become an international reserve currency sooner or later. The internationalization of RMB will certainly facilitate the opening of China’s financial markets, which will provide opportunities for the recovery of the American and Japanese financial sectors.

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