The Chinese Economy: Yesterday, Today, and Tomorrow

Wing Thye Woo '76 discusses China's impressive past growth, the present acrimony over its exchange rate policy, and the key challenges to maintaining its high growth in the future. Woo is a professor of economics at the University of California at Davis, a senior fellow at the Brookings Institution in Washington D.C., and the director of the East Asia Program within the Earth Institute at Columbia University. An expert on the East Asian economies, particularly China, Indonesia and Malaysia, he has advised the U.S. Treasury Department, the IMF, World Bank, and the United Nations.

Audio Transcript

Wing Thye Woo '76:            Good evening. Nothing makes a Swarthmore graduate happier than have the chance to come back and lord over the next generation, and I am very delighted to be standing in this reflected glory of my teachers, and especially in front of a captive audience that has been brought in for this occasion.

Well, as we know that the emergence of China has been an event that has been greeted with quite a bit of concern. I've heard Larry Summers talking about it three times and all three times, he brought up the case that all emerging powerful nations in the 20th century have brought about unprecedented conflict. Think of German ... Germany, Japan and the Soviet Union. So fear, possibly seems to be the emotion, which evoke. But, I think we have more grounds for optimism than that ... than what is suggested.

The reason is the strongest country to emerge in the 20th century and prevail was the United States of America, and I would say that US was a force ... most stabilizing force in the world at least until the Iraq adventure of six years ago. So we should, I think that there are grounds to be optimistic about if you engage China correctly, and I think that would be possibly the biggest cha ... bilateral ... most important bilateral relationship for the next administration, because I think we are standing on the precipice of a possible trade war. And, let me talk about that when we come on to the tomorrow.

Well, let us ... let me talk about issues I would talk ab ... try to cover tonight. The first ... the yesterday, I wanna to tell you about a debate that has occupied China watches about why China has been so successful growing ten percent a year for the last 30 years. Then, we'll talk about the growing tensions over China's trade surpluses and then, the last topic would be, How likely would China be able to keep up the high rate of growth that we are seeing for the last 30 years.

Well, on topic number one, we ... there ... there are two phases to the debate on explaining China, because China was not the only country that moved away from central planning. The ... China started moving away from central planning in 1978 but on January 1st 1990 Poland left the Soviet Block under the La Bolanza Leadership and it embarked the marketization of its economy, and what we do know is for the next three years GDP, which is total output fell roughly 12 to 20% depending on how one measures it.

Then, Russia - it is reformed on January 2nd 1992 that was follow by a collapse in output of around 15% over the next three years. This is very much opposite to China, which grew basically ten percent every year on the average from 1978 onwards.

So, the first explanation that came along was China's method of reform was responsible. China's reform. Why? They did it slowly unlike the Poles. What did the Poles do on January 1st 1990? The poles removed all price controls in one fell swoop. They cut the budget deficit to zero in one fell swoop. They lifted all trade taxes and allowed the black market to floats ... no, to allow the exchange rate to float to the black market level immediately and the fourth is they announced they would privatize each and priv ... each and everyone of the state owned enterprises.

And so, this was seen as a rapid comprehensive reform and whereas China, What did it do? It first started off with agriculture by telling the farmers "If they grow any more than what they were told to do under the state quota, they could sell the excess in the world market." And so, in other words there were two prices for agricultural goods. One is the state price and the other, which was for the mark birth quota products that is the free market price. And, China also allowed free trade in certain port cities, and China also then extended four years later extended the two track pricing system to industrial firms. No talk about privatization. No talk about removal of price controls. They kept existing controls, but they just allowed additional pricing mechanism to come into play.

So, given the collapse that occurred in the Eastern Europe and the former Soviet Union, many people thought that it was the rapid pace of reform that caused the collapse. It's like, in the words of a China watcher, Barry Norkin "The Eastern European way is that waking up a patient by shaking him violently till his bones dropped off." So in other words, the reforms itself was the shock, because too much at once. Whereas, the ... the Chinese method was a slow level of a gentle massage to wake up the patient from deep slumber.

Good story telling, but it's at odds with the facts, because Poland certainly did what is known as the shock therapy, rapid movement across the board. But, there were many countries that moved much slower and there were countries that were completely paralyzed and did not do anything. Like, the first speech given in the newly independent Ukraine by Kravchuk. His speech to parliament was "What did we do that we were given independence?" "What did we do to deserve to be punished in such a way?" So, Ukraine did nothing and upward fell.

So, what we see in Eastern Europe is regardless of the speed of reform upward fell by very similar amount. And, in Vietnam provides a very good counter example. In March ... in ... Red Beret striker begun in 1985 when Gorbachev told all the [00:08:15]? to start reforming. They did reform. What inspired the 1985 reform of Gorbachev? When Gorbachev came to power, he was no idiot. He was not gonna start something that wasm't, he send a team to China, and he came back with the Chinese recipe, and he did all of that from 85 to ... to until 1990. None of them worked.

And, similarly, it didn't work in Vietnam. The only thing that happened in Vietnam was that Vietnam's inflation rate started rising and they had ... and the rice production kept falling. On March 1989, Vietnam did the following:-

Remove all price controls.

Floated the exchange rate to the black market level.

Cut off all subsidies to state enterprises and allowed private agricultural activities.

The growth rate of Vietnam went from five percent in 1988 to eight percent in 1989 in a matter of six ... March to December. In a matter of nine months, Vietnam turned from being the world's biggest importer of rice to a net price ... net rice export, and Vietnam continued to grow at nine percent a year until the Asian financial crisis in 1997.

So what we see is that Vietnam had wrapped its comprehensive reforms, and it grew. It was not partial, and what we see in Eastern Europe regardless of whether it was partial or complete, output fell.  So the difference is really not how fast the reform, but the difference is really between the East Asian Communist States and the Eastern European Communist States. Why was? ... So, the precision of ... it was the speed of reform that was responsible for it was not tenable.  What was the main reason? The main reason for the difference in output is the following:-

The outcome I told you about in Vietnam was repeated in Laos, because Laos is for all purposes a colony of Vietnam. So, when Vietnam did its policy, it told Laos to do it and they did not do a lousy job at it. Did ... they did it, and the same salubrious results happened. Eastern Europe was already an industrialized ... with all industrialized, urbanized economies, and what was the percent of population employed in the agriculture sector in the Soviet Union? Around ten or fifteen percent. What is the proportion that were employed in agricultural sector in China in 1978? Eighty two percent. Vietnam ninety percent, Laos only five percent.

So, once the private sector was unleashed in all these countries, the private sector needed workers. The workers in the case of Vietnam, Laos and Vietnam - they moved from the countryside into the new industrial firms. So, the all industrial firms could be kept intact and they kept producing, so there's no collapsing upward. Whereas, in the other Eastern European countries, the agricultural sector was very small by the 1990's so, where would the labor come from for the new industries? From the existing state industries. So, when they cut off the subsidies to the state industries, that was the way in which workers could flow from one to the other.

And, this is the primary reason for differences in outcome in these countries. In other words, for the case of Eastern Europe and the former Soviet Union, economic reform meant economic restructuring. Whereas for China, Vietnam and Laos, economic reform unleashed economic development, which is the movement of labor into the industrial sector, which is a lot less painful process than moving people from one industry to another industry.

So, that was the first part of the debate. The second part of the debate was when people decided to give the slow reform another twist, and that twist is goes as the following:-

The reform was slow because the government was engaging in economic experimentation to find the optimal reform strategy. After doing experiments in a number of places, and you pick the best and then you adopt the best strategy throughout the country. And, experimentation takes time and that is why and the Chinese found the best. The Chinese not only found the best, they also found non-capitalist alternatives. Specifically, there is no need to privatize land. All you've got to do is to tell the peasants you can have use of the land for 15 years.

So, that is what that is called the experimentalist school, and the other thing they would say. "There is no need for private ownership in general. In fact, instead of having national level state ownership, you should have localized socialism. Let the local community own the property", and the case that is always brought up is, what there is known as town village enterprises. These are small medium enterprises at the village owned by the local village collectively.

No one ... the profits of the firm are dispersed to the community at large and managed by the village leadership. And, there have been many positive accounts of these town village enterprises. One of the ... one's I like to quote is by Martin Wiseman unsit usungshun? [00:15:15] They said "Why is state ... Why is local community ownership possible?" It is because the Chinese have a great sense of brotherhood, and when this great sense of brotherhood there is really no need to be very explicit about "What belongs to me, What belongs to you? So we could share."

What is wrong with that particular theory about TVE's is the fact that there are lots of village enterprises in Taiwan but not a single one of them is owned at the village level. Perhaps the Taiwanese are not Chinese, as the Taiwanese have been claiming for a long time. Or, perhaps the Kwamintung committed the ultimate crime of the culturalizing the Taiwanese such that they no longer had the sense of brotherhood we stand mentality.

The reason is actually quote simple. The reason is private enterprise was illegal, and since private enterprise was illegal, the only way you could form an enterprise outside of the state system was to call it collectively owned. And, when private property was legalized, all the TVE's disappeared and it will emerge as privately owned enterprises. So, it was nothing to do with specific economic circumstances. It was political circumstances that caused the riots / rise [00:16:53] of the township village enterprises, and I could go on and on about the rationalization that has gone on. Like for example, the people have talked about "Land has not been privatized."

In fact, farmers are allowed to transfer the use of their land to each other. In [inaudible 00:17:21] the land use rights are transferrable, but yet, the land use rights market hardly exists in China. Since around 1984 it's transferable, and if you go in search of people who would lease someone ... who would take over someone else's lease, you can hardly find such activities.

One explanation by China Watchers is that the Chinese peasants really love their land. They cannot bear to part with it. Another explanation is that it is common practice for local officials to re-distribute the land occasionally to take into account of changes in the size in the family. And if the local party comun ... committee could always re-distribute the land, why should you ever take over someone's lease? because it could just disappear. So given that lack of security on contractual arrangements, how could there have been a market?

So again, yes, very little to do with cultural reasons for why the land transfer market did not exist, and in fact, if you look at what were the next steps that occurred?  The land lease has now been extended for 35 years and that was done around 1992, and in discussion now, is extending the land lease to 70 years.

So, what we do see therefore is a convergence to what I call a normal private market economy, and I think this is the key to the success of China's reform. It is the convergence to a normal market economy, rather than the discovery of alternatives to the private market economy. And ... So what would be the implications of my explanation? It is that we would expect to see further movements of China towards a privately owned market economy specifically we can see that most of the state enterprises have been privatized and the state banks have all, except for one, have been floated on the stock exchange with substantial amounts sold to foreigners. And so what there has been called experimentation, is actually adoption and adaptation of standard economic mechanisms.

You can certainly see this by China's joining the WTO, because the WTO is an organization that is set up to promote trade among private market economies. So the WTO actually specifies what all your economic institutions have to look like. If your economic institutions do not look like those in modern market economies, you would be classified as a non-market economy, and you would not get the benefits of WTO membership.

The fact that China embarked on trying to get WTO membership in 1986 shows to you what the top leadership was thinking about. They knew that convergence through a market economy was what that would ensure the success of their ... of their reform. And, this of course, is after China has caught up to the frontier. I think that is the time when we might be able to see indigenous institutional innovations coming forward. That could possibly be of ... that the rest of the world could ... might well adopt, but up until this point I would say there has not been any Chinese ... China miracle in the fact that he has found economic mechanism that is an alternative to what ... that is new to economic theory, standard economic theory.

And ... so, China has been doing well and what is the price of part of this success? It is that China is no longer a small economy and so naturally, there are significant spillovers from its actions. And one of the thing that we do see is the mounting trade tensions that have appeared especially in the last two years. During ... in July this year ... June this year, there was a bill in the senate to impose 20 ... 70% tariff on all Chinese goods, because it was felt that China's trade surpluses was creating a hardship on US labor. And both Barak Obama and Hilary in their pres ... demo ... in their pursuits of the democratic party elections both said they would sign such a bill if it were brought to them.

And, on December 26th this year ... last year, the New York Times carry on the front page the story that China's imbalances allowed China to accumulate a lot of reserves and because China puts all of its US dollar owning's into US Treasury bills that kept the long-term interest rate down, and because of the housing bubble, we are in the deep doodle we are in today.

So China is the culprit for the loss of one percent of Swarthmore's endowment, and if the imbalances was the reason ... were indeed the reason for the ... for the bubble and it's aftermath, then what's the logical policy implication? We should stop all these imbalances, and what is one way to stop all these imbalances?. One way is we control on tariffs, import banks, licenses, and we're [inaudible 00:24:44] administrative measures to block it. So, that would ensure there would be zero imbalances.

And, another way is to ask the Chinese to make their goods more expensive and one way of making it more expensive is to have the Chinese currency appreciate against the dollar. And at the forefront of the ... for the precision that the Chinese should be forced to appreciate the roman b?[00:25:14] is the Institute for International Economics. In their opinion, China needs to appreciate 40%. So far, in the last two years China has appreciated by 20%. So there's another 20% to go.

Well, what do we think? I think that the trade imbalances constitute an important problem, but not for the reasons that I've given so far. And I think that the recommended cure that that has been suggested, is the wrong one. It's wrong because it represents the triumphs of hope over experience. China is not the first country that the United States has ever pressed to appreciate this currency. The US did that to Japan in 1985. The Japanese ran large, but nowhere as large as what the Chinese are running now.

Surpluses - trade surpluses against the United States, and under US pressure, the Japanese appreciated their currency. I know there are lots of numbers. Look at the numbers of 251. There was 250 Yen to a Dollar in 1984, and by 1988 it was 125 Yen to a Dollar. Basically, the Yen appreciated by 50%. And, let's look at the United States. If, you look at the trade imbalance of the United States, depending on how you measure it. Let's look at column B.

You would find that the imbalances of the United States ran from 2.95% of GDP to 2.38% of GDP. So, 50% change of the accuracy of ... of currency and you see a change in the second ... in the first decimal point.  And, this small change is true even for the other way that I measure it, and if you look at the Japanese, the change is bigger.

 If you look at the bilateral balance, in other words, not the overall trade balance but just the imbalance between US and Japan in their bilateral trade, you would find big changes. So you find big changes in the bilateral, but very small change in the overall US precision. Why? The reason is this world consists of more than two countries. When Japanese goods became more expensive, we bought more from other countries. The Japanese capital flowed it up from Tokyo into South East Asia. They built factories all over South East Asia to service the US market.

So what happened with the import of Japanese, we bought from South East Asia, and what happens to overall defi ... imbalance stay the same. We bought less from Japan, that is true as you can see from 3.6 to 1.8, but we certainly made up for it by buying more from other countries. And the Japanese imbalance did not change significantly because they exported less to the US, but they exported a lot of capital equipment to South East Asia so South East Asia could produce the goods for the US market. So the US ... so the Japanese imbalance did not change significantly. Well change more than the US but not a lot more.

Similarly, you look at the impact of the 20% of appreciation of roman P [inaudible 00:29:11] on the US imbalance - unchanged. Why? We have bought more from elsewhere. Most of the exports from China are made by US firms that invested in China, and the US firms have been in the last two years been moving to Vietnam, Mexico and Indonesia, and they have been exporting to the US from there. So, the exchange rate cannot be an effective answer - the bilateral exchange rate. What we would need is the entire East Asia to appreciate against the United States. That we might see something significance. So, after getting China to appreciate, we have to go after each and every one of the other East Asian countries and get them to appreciate too. So that is the wrong solution. I think there are better solutions and I hope that during discussion, we will get to talk about it.

I think part of the mounting trade tensions is reflected in the fact that there's a backlash against globalization. In 2008, the Pew Foundation released a study, which asked people in 48 countries "What would ... what do they think about international trade?" In 2003, 78% of the US population thinks that international trade is a good idea and good for US.

                                    In 2007, it's still a majority, but it's down from 78 to 59%, and you would see that out of 40 ... 48 countries ... 37 of them reported a decline in support for free trade and quite ... and most of them have a decline of more than five percentage points. What is important to note here is that, the most powerful countries in the world the G7, six of them have experienced a loss in support for free trade by about more than five percentage points.

So, it is not just the US that is having a re-think about free trade. It's occurring in all the developing ... developed countries. Why is that so? One way to understand the ... this change in attitude, one could be What is globalization? What is the single biggest event in globalization in the 20 years? The single biggest change I would say occurred in the 1990 to 1992 period. That is the time when the number of people participating in the international division of labor doubled.

If you add the population of the Eastern Europe and the former Soviet Union, China and India. China really joined the world only in 1992. Largely because after the collapse of the Soviet Union rock, China could see that there was really no alternative but to go full fletch down the road to capitalism.

And India, which has been watching the steady growth of China, when it saw the Chinese navy in the Indian Ocean checking in the Burmese port knew that to be poor was a security threat to itself. So, it took advantage of a balance of payment crisis to liberalize and privatize. What is the balance of payment crisis? The standard things is change your exchange rate, cut back on government expenditure, reduce the money supply, but India went way beyond that, allowed foreign direct investments and so forth. So India joined the international division of labor. That doubles the number of workers producing for the world economy.

If you take any standard economics model HECSU or Lin?[00:33:51] or just use common sense. What happens if the number of workers double? The outcome is, wages must fall because supply has greatly ... has expanded tremendously. And, what would be the process by which wages in the rich countries would fall? Cheap imports come in, create unemployment. The unemployment in turn drive down wages, right? So is it this structural adjustment that I just talk about, the cause of backlash against globalization? Good story, but unfortunately the facts don't support that.

If you look at ... when the US trade imbalance started rising rapidly after the ... from during the Bush years - 2001 to 2007, US trade imbalance been climbing. During this seven years, the average unemployment rate is lower than the average unemployment rate of the previous seven years - 1994 to 2001, and this in turn is lower than 1987 to 1994.  So, the unemployment rate has been secularly declining. Does it mean that people are staying employed by accepting lower wages?

The evidence on blue collar wages is that we have hear quite a bit from Robert Wright about the declining real wage of the American worker. That number is true when you measure wages incorrectly. What is the right measure of labor compensation? Take-home pay, plus your fringe benefits i.e. pension benefits and medical benefits. If you look at total compensation, you will find that labor compensation of workers grows faster in 2001 to 2007 when the US trade surplus very quickly compare with the previous seven years. And, what is unfortunate is that because of the high price of medical care, most of the wage increases went towards covering medical insurance.

So, if we can control the ... if we can do something about the cost of healthcare, that would certainly translate into additional disposal take-home income for the worker. But, the important thing to realize, how ... how is it that firms are able to pay more given the increasing penetration of foreign goods? How is it that workers are able to find jobs paying the same or higher pay? And Why are they still unhappy if they are still able to find jobs and at higher pay? Are we just a nation of whiners? Of course, in a Swarthmore audience, ja, but I think the main thing to s ... I think that the key is to realize that employers have been paying more. How could ... how could a capitalist be willing to pay more unless the worker is more productive?

There's no monopoly ... no mono [inaudible 00:37:48] that we see. So, what is it that has caused worker productivity to go up? It is because we live in an age of accelerated technological innovation, at least for the last 14 years. The pace of technological innovations - just look at the ICT revolution, as men, people are more productive. That's why they are being paid more at the blue collar level. But, What is the evil twin of accelerated technological progress? All of us are for progress, but What is the evil twin? The evil twin is an accelerated rate of obsolescence of skills.

What you know having graduated from Swarthmore for so long, I am out of date, but that's okay because I'm gonna retire soon. But, the important thing is that people have to change jobs much more frequently.  They're "Oh, I gotta ... got too much in love the sound of my voice." What this was is ... that is not how I learned my economics of course. It was much better, but I am not a good reflection of my teachers.

This is what wages is like on the take-home level. This is what wages is like for the blue collar workers after you add in the pension and the wage and ... and the health benefits. So you could see from 2001 to 2005 ... 6 is when it really picks up at the time when the US faces even more competition from abroad.

And ... what is? ... so I started thinking how could I find evidence that people are unhappy because they have to switch jobs more frequently? Well, I was just simply delighted when I found in this the falling set of statistics. Let's take my H group, the pyramid shape, the triangle shape, the 45 to 54 year old group. This group. This group of people in 1983 - the median worker would have been at his job for 12.3 years. The median worker in the age group in 2005 would have been there 8.1 year.

So, and when we look at it, that the turning of jobs is the greatest at the older level. It is not the young and the restless, it is the old and the restless. Is it because they're more restless? This the 40 year old itch come in to play, or the job has disappeared. They just gotta look for a new one. They gotta retune themselves in some way, and the young are certainly not restless, but they are certainly as you could see ... not more restless. They are restless because they only stay in a job two to three years before quitting. But, the thing is they are pretty steady. They have not gotten more restless. But, the age ... is not the people have gotten more that there's been a preference change. I think that just show the rapid entry and exit of firms.

And, the United States has the lowest social insurance coverage of the G7. The amount of unemployment insurance you get as a percent of your previous pay is the lowest of G7. And, the duration of the unemployment insurance is the lowest of the G7. We are a tough, competitive society so we don't want to pamper our unemployed, and more than that, it is particularly painful in that our health insurance is supplied by our firms.

So, during your period of unemployment it is more painful to be in the US than if you were in England, because if you are in England, the healthcare is supplied by the state or in most everyone of the G7. So you could see that the US is not set-up. Our social insurance system is not set-up to shelter people from churning of jobs, and therefore, this is the part that I think we can fix domestically. So all this talk about the U ... the Chinese immis ... immiserizing the United States true risk growth, I think has been overstated, but what ... we could reduce some of the pains if we fixed our social insurance system. Yes sir.

Speaker 2:            [inaudible 00:43:03]If we go back to the power point where you show the ... the wages increase.

Wing Thye Woo '76:            Yes.

Speaker 2:            Yes, but you see I've just [inaudible 00:43:11] but I'm really sure and I'm not expert in what I'm about to say but you see that the wages rises rapidly right after 1997 ...

Wing Thye Woo '76:            Ja.

Speaker 2:            ... and I remember 1997 is the year when a group of investment bankers invented this thing called a privately false swap. So that ... so 1997 is the time when America starting borrowing a lot of money and then the bubble starting to get like a lot bigger. So, is it possible actually the increase in salary is just like a reflection of the bubble, and actually America now is very much in debt so actually the wages mean ... yes you get more wages but you get even bigger debt. So, actually they are worse off?

Wing Thye Woo '76:            Ah, but that ... that has been advanced is that ... that's a good news, and a bad news to what you just say. The bad news is that it's the Chinese that's given us this financial opit that's causing the bubble. The good news is, look at the wage of the white collar workers. The white collar workers really took off a lot more and faster than the blue collar workers. So the bubble ... so there's trickling down right? The good news is trickling down exists.

Now, for me, I ... I would say that 97 was the beginning of a j ... of let me see. The bubble story goes as following, because that was the high tech. Bubble. What year did the high tech bubble end, 2001, right? 2001 or 2002? So in terms of this being the, you know what, I've gotta guess, but we can both find out the answer. How much of that borrowing do you think is done by the lower classes? Was this of how much of borrowing is done by bankers leveraging to buy stocks?

Speaker 2:            I think ... I think [inaudible 00:45:37] now has a two trillion Dollars American holding[inaudible 00:45:38] so I guess America borrowed two trillion from [inaudible 00:45:43] over the years.

Wing Thye Woo '76:            Okay. Let's talk about what started the bubble.

Speaker 2:            Leverage?

Wing Thye Woo '76:            I think that ... that ... that the following:-

Did the Chinese give us the bubble? Well one thing for sure is what do ...what happens when that is this ... when the labor force of the world double? So the flood of goods was tremendous, new goods coming in. So that's the supply side Shift, because all these people are shifting from agriculture to industrial goods. So there's an increase in productivity overall, because we know that in China the productivity of agricul ... of industrial workers is at least eight times that of an agricultural worker. So there is a natural big shift.

What happens when there's this flood of goods appearing in the world? It tends to drive price down, right? Think of the world supply of goods increasing, and what is the operational criteria of the Federal Reserve under Alan Greenspan - keeping CPI constant. And Alan Greenspan in his book before the ... before his latest book, he say that "He was hailed as the world's best central banker", and he say "I was a good central banker because I recognized the  productivity increases in the world, which was threatening a deflation, and I prevented it by allowing money supply to increase faster than what peo ... than historical levels."

So the increase in demand permitted by the increase in credit prevented the deflation from happening. But, what Alan Greenspan did not say was that, a lot of the credit that was created went to buy stocks and bonds, and houses, and the prices of assets went up while CPI stayed pretty much the same, right? So, what is price stability? Should price stability be just prices of goods and services or should it be prices of all things in general? If you believe ... if Alan Greenspan could see that a lot of the borrowing, the credit that he created was going to the stock market. That was a big cry at that time that you should stop the bubble from occurring.

Dan Binaki in 1999, which is right after 1997 wrote a famous paper in Jack for a Jackson Hole conference the varies?[inaudible 00:48:34] of Kansas. Dan Binaki asked the following question, "If there is an asset bubble, should the Federal Reserve pull back on credit so that to stop the leveraging by the bankers so that they would cause the bubble to collapse?" Should you do it? Dan Binaki's answer in 1999 was "Stopping the bubble is more dangerous than allowing it to go on, but the most important thing is keep your eye on CPI. Keep your eye on CPI. Don't ... not look at asset prices, because the market will take care of it. The bubble will collapse, and the people who engage in this stupid speculation will be punished, and we will then end up with a normal world." That was the conclusion of the 98? [00:49:26] 1999.

So, number 1 - What we see was that this great expansion of credit. Independent of what ... whether the Chinese were lending us any money or not.

Number 2 - There was also an innovation that happened ... that happened. That is call the sub-prime market happens around that time. And what's the securitization of mortgages is very interesting.

Basically what happens is the reason why we had the bubble was .. was the large sh... the large flow of credit, because we were focused only on CPI and neglected the possibility that the credit was going to stock market.

Number 2 - We had a new financial instrument that allowed ... that encouraged the banks to lend without really checking people's financial situation. That's why you had these bonds were known as know as Ninja bonds. No income, no jobs, no assets, but here take a loan because we could just sell it on the market, but the rating agencies classify all of this AAA, and so there was a lot of it. None of this had anything to do with China. So we could have had we fix ourselves one anyone of these three, I think we might not have the bubble.

Let me quickly jump ahead. Let's talk about tomorrow a little bit. The clever thing in talking about tomorrow, not the smart thing is to always predict disaster. Because if it happens, you take credit for your superior foresight. If it doesn't happen, you take credits for having prevented it with your timely warning. So, this is why Frank Buxton is the Chicken Little of economics. That's ... the sky is always falling down for one reason or another. Hard landing for the US or implosion of the world trade system and so forth.

Anyway, that's always a good strategy and that is us about what's the likely future of China? I think it's fair to say that China has been like a speeding car and if a crash were to happen, you could think of it as coming from three things. One is hardware failure - that is a breakdown in economic mechanism for example, the banking sector collapsed at the way it has here. Fiscal mismanagement - so they're printing money like made, or a software failure, a car crash because we were fighting in the car. Social disorder, right? There's lots of corruption, incompetence, it's universal, not a US specialty or anywhere else, or it could be a power supply failure - the car just run out of gas or someone pulled the ignition key. Power failure would be environmental mismanagement or there could be external trade sanctions against China.

Of these three types of possible failures, What's the one that the communist party has the most confidence of handling? Hardware failure. They are very confident they could handle hardware failure. Why? Because you open your eyes and see what the rest of the world have done when it came to similar crisis, you do the same. Maybe you fire a few economic managers for incompetence and then you put in the new guy who will then copy, adopt and adapt what has been done elsewhere. So hardware failure is something that the party's quite confident that it could fix.

What is more likely to be difficult are the last two. Specifically ,let's talk about software failure. One thing you do know, is social disorder involving 150 people persons or more has jumped drastically. Is it because management has gotten better ... worse? It's no longer just democratic institutions in Europe and North America, but right [00:54:12] neighboring states. You see the democratic transition in Korea. You see the democratic transition in Taiwan and people see the performance of the government, they naturally want the same.

In China from 60% poverty rate, poverty rate is defined as one Dollar a day. The climb of 60% 78 down to 30% by 1987 and now at the ... by 1997 is around 10%. Growth rate has continued growing at 10% - GDP growth rate, but the poverty rate has stagnated. Basically, China has hit what we have seen in the US that doing more of the same does not reach. That's why the distribution of income has worsened so much in China. The bottom percent is not seeing an increase in the income. Certainly, a lot of unhappiness about that and how could one increase the accountability of the state?

I think the formula from the rest of the world is you gotta fix your software, and the software is a three well known components. You've gotta to have open elections, and elections to be fair, you've gotta have a free you've gotta have an independent judiciary; and my prediction is China actually talks about doing all of this. Whether they certainly talk the talk but whether they walk the walk, will be their big challenge.

And, of course it could be done peacefully as in Taiwan or non-peacefully as in Soharto, Indonesia. That, I think is something that could be fixed because you can look at the rest of the world. A brave leader could copy and do the same, but what he's hard to fix, is the environmental failure - the power supply failure. Largely because if you go two hours outside of Beijing, there's water rationing in most parts of Northern China. You would not know if you were in the major cities. You cannot grow without enough water. Why? There has been a climate change that has occurred, has shifted the rainfall from Northern China to Southern China. So, Southern China has unusual amount of floods. Northern China has, yes experienced [inaudible 00:56:59] and are  pumping more water out from the ground such that we know from satellite pictures from the National Security Agency, China is sinking five millimeter's a year. So, when they talk about having a sinking feeling, it's certainly not your imagination that is at work.

So, these are the big challenges and there are no easy solutions in that you cannot just look at the rest of the world and do the same. And, the climate change requires international collaboration on a scale that has not been seen before number 1, and what that needs to do is that China needs to take a more active role on the world in the following:-

China builds one coal power plant a week. Every two months that's the equivalent of the entire UK power supply system. So, but China has no incentive to invest in how to burn coal cleanly. Largely because that could be copied and be used elsewhere. It is therefore imperative that international cooperation be instigated such that China will be the sites of the experimental coal burning plans - clean coal burning where technology like car ... CCS - carbon capture and sequestration, and we ... the rest of the world will have to help finance that scientific effort, and this goes across the board.

Let me stop here and take questions. We can come back to your question on what caused the bubble later, but let's serve the other people.

Thank you.