Visions of the financial crisis and solutions

Edward Luce provides a good description of the different views on the financial crisis.

The Purgative view that believes that the excesses of the past now have to be purged from the financial system. This would be the Republican view that debt has to be reduced and that government excesses have to be eliminated.

The Restorative view believes that Keynesian policies need to be employed to return us to the pre-crisis environment. This would be the current Administration's view.  If deficit financing and government spending is used correctly, the economy can be placed back on trend.

The New Foundations view states that the economy is flawed and needs to be adjusted through new policies which look at intensive development through skills, technology, infrastructure and new polices that adapt to the new global environment.The economy is broken and needs an overhaul.

Some of these views intersect, but they lay-out alternative approaches to dealing with the crisis and the economy in general. There is  no consensus on what path the future should take.

Encumbered and unencumbered assets

Are central banks making banks riskier? They are willing to lend to banks in exchange for collateral. The collateral employed by banks for these loans is of the highest quality. These assets are now encumbered and cannot be used for other purposes. If there is a need for cash, these encumbered assets cannot be sold to raise funds. Hence, it is possible that banks will have less funds available in a crisis and they could be capital constrained. Additionally, if all the high quality assets are taken by the central bank, then there will be less available as collateral for private investors. There are strings attached to these central bank lending programs.  

Trade games - there are no rules

Clyde Prestowitz in the Financial Times provide a good description of the current trade environment and it is not pretty. The trade game has no rules or the rules change with the players. There is the WTO game and then there is the silent mercantilism trade game. The WTO game is what is generally discussed in the press, by academics and in polite company. 

The real trade game is the silent mercantilism of all countries as they attempt to gain advantage with trade. It can be through manipulation of currencies which seems like what many emerging markets engage in, or it an be through direct subsidies and regulation that enhance trade advantages and restrict competition at home. Academic will not discuss this rough game because this will mean that the premise of free trade will be fractured. Policy experts and diplomats would like to believe that world organizations like the WTO work so they will pretend that the system can handle any trade problems. In reality, every country is a silent mercantilist and it is just a matter of how much the rules are bent. The is an anarchy n trade that will be more out in the open if there is no increase in global growth.

China and development economics

China is moving through what many would believe to be a classic development cycle. There is extensive and intensive development  behavior as the economy grows and adapts. Extensive development relies on increases in labor and capital to increase growth. Labor has been cheap in China so it has been easy to use this input to increase economic welfare. The same applies to capital as it used to build plant and equipment as well as infrastructure. Extensive development is not easy because labor and capital have to be usefully employed but the Chinese government has been able to move labor to the coast and build a export driven economy.

Intensive development comes from improvement in skills ad technology as the driver of growth. Intensive development is necessary when labor costs increase to the level of other trading competitors. This will require a change in behavior by both labor and the government. There has to be greater allowance for entrepreneurial development and less from entrenched state enterprise. It can easily be argued that many developed countries need further intensive development to beat those countries that have excess capital or labor.

The transition period is when countries may enter a middle-income trap. It is this turning point between extensive and intensive development which has to managed carefully. The Chinese government is aware of the turning point because it is well know in development economics after the Noble prize winner Arthur Lewis. However, awareness does not mean that it can be executed properly. The transition is what will be the key feature of 2012 growth.