In our modern age more than ever the world appears smaller. The actions of others are no

longer isolated and have an impact on others. The interactions between the United States and Asian

countries (particularly China) are evidently important to the current world crisis. The current economic

crisis is directly intertwined with the market interactions of China and the United States. Although each

party did not intend for this crash, the failure of each side to make the difficult decisions and

willingness to continue the status quo besides its forewarned dangers subsequently led to the current

economic crisis.

China has recently grown and developed into a major player in the global market. However, for

the most part of the twentieth century China was an underdeveloped country that had to learn what was

necessary to bring itself into the running with the other main participants of the world economy.

Fortunately, there were many other countries before China that had already gone under development

from which China could learn from. One of the models for China’s development was its neighbor

Russia. Russia was a lesson of error without the trial for China; both China and Russia had their

foundation in Communism but to compete in the world market both would eventually stray into

capitalism. However, each country utilized a different approach.

China learned from its communist comrade what not to do during a transition from an economy

under control of a totalitarian regime to a more open market. In the late 80’s to early 90’s the USSR

was on the verge of collapse. The drop in oil prices and lack of foreign exchange reserve to buy grain

forced the Russians to turn away from communism. The democratization of Russia consequently

weakened the central government and with the guidance of American economists, the country began to

privatize its market. It was believed that in order for Russia to compete, it needed to privatize quickly.

This sense of urgency was due to the fear of Communist resurgence, the lack of organization of those

against privatization and most importantly the fear of Russia trailing back into the state of a third world

country.(Cohen and Schwartz, 5) However, the privatization was not enough to carry the market. There

needed to be a public administration that would act as a retaining wall: a functioning democracy.(Cohen

and Schwartz, 6) Privatizing ownership was not enough. Big companies and markets both require

external structures of law, finance, and regulation. The state, while the economy is in development,

must control imports and oversee the flow of capital while controlling substantial portions of major

industrial assets.(Cohen and Schwartz, 8) China learned from Russia and maintained strict control over

their market and society and then subsequently opened up the system to a free market more gradually.

An advantage that China enjoyed was not only learning the benefit of learning from Russia’s mistakes

but also the opportunity to reform with a functioning government that was far from a disintegrating

hollow shell of a once powerful institution. Soon, China “with the right policies, have huge scope to

grow rapidly by importing capital, ideas and techniques from developed economies and using rich

countries’ markets as a springboard for growth. As a latecomer, China does not need to reinvent the

wheel, but rely to open its economy to ideas from the rich world.” (The Economist, 6)

Before the reforms of its earlier more constrained regime to its later more open market,

“Chinese trade took place within the context of a planned economy and therefore nearly all trade was

subject to very exacting quantitative guidelines.”(Branstetter and Lardy, 4) Neither exports nor imports

were sensitive to exchange rates or relative prices and China did not capitalize on its comparative

advantage.(Branstetter and Lardy, 4) Instead of exploiting its available resources like good

infrastructure and an educated work force before the reform, the focus remained upon capital-intensive

goods including refined petroleum products. (The Economist, The Great Leap Forward) (Branstetter

and Lardy) Interventions by the government stagnated China’s economy and it is apparent that as

Chinese policy grew lax the economy capitalized and grew.

Over the 1980 through the 1990’s, China experimented with different ways of opening up the

market but the initial trials were complicated. “As the authorities phased out the direct quantitative

planning of imports and exports, they began to rely more heavily on a complicated welter of alternative

trade policies, including conventional tools such as tariffs and quotas, and less conventional

instruments, limiting trading rights and tougher commodity inspection requirements.” (CITE)

Although foreign trade was restricted throughout China’s reform it still occurred and would prove to be

a successful for China. As time progressed, constraints such as tariffs became less popular. “A

substantial portion of this decline reflects the enormous expansion of foreign direct investment, the

increasing importance of exporting processing, and the exemption of selected industries and

organizations form import tariffs altogether.”(Branstetter and Lardy, 6) Other actions China took

towards reform was lowering tariffs; indeed, “china’s average tariffs have fallen from 41% in 1992 to

6% after it joined the WTO in December 2001, giving it the lowest tariff protection of any developing

country.”(The Economist, 6) “Many non-tariff barriers have also been dismantled. Moreover, China has

welcomed foreign direct investment, which has bolstered growth by increasing the stock of fixed capital

and providing new technology and management know how. Joint ventures with foreign firms produce

27% of China’s industrial output.”(The Economist, 6)

Foreign trade expanded and its growth was alleviated with “changes in foreign exchange and

tax policy. Prior to reform, the regime maintained an overvalued exchange rate in order to subsidize the

import of capital goods that could be produced domestically. Overvaluation led to excess demand for

foreign exchange, necessitating an extensive system of rigid exchange controls.” (Branstetter and

Lardy, 9) This was the opposite of the current situation where there are huge sums of foreign exchange,

specifically U.S. dollars within China’s possession. This shift is attributed to the reevaluation of the

RMB (Yuan, Chinese Currency) where it lost about “70 percent of its value against the dollar in real

terms over the period of 1980 and 1995, substantially enhancing the international competitiveness of

China-based export operations”(Branstetter and Lardy, 9)

China’s focus on products to be exported during reforms also shifted. Branstetter and Lardy

points out that: “a decade and a half ago China’s leading exports were crude oil, refined petroleum

products and apparel. In a seemingly complete transformation China has emerged in recent years as a

major producer and exporter of electronic and information technology products, such as consumer

electronics, office equipment and computers, and communications equipment.” (Branstetter and Lardy,

37) Although their exports are products of high technology, China is only able to do so because “it

imports most high value-added parts and components” that go into its goods.(Branstetter and Lardy 38)

China’s development into electronic and information technology is “consistent with its underlying

comparative advantage”, which is “relatively low-wage assembly service.”(Branstetter and Lardy, 38)

China is not “leapfrogging ahead technologically, because these exports are not primarily driven by the

expanding “knowledge stock” or innovative capabilities of domestic firms.”(Branstetter and Lardy, 40)

At the root of China’s development are foreign owned companies who classify their technology to

ensure competitiveness, and the “foreign firms in the electronics and information technology space in

China are almost entirely wholly-owned companies rather than joint ventures.”(Branstetter and Lardy,

40)

The partnership between the countries and the companies are mutually beneficial. However,

this type of growth creates an imbalance where countries exclusively produce for export. With the

reforms towards a more open market, China’s foreign trade exploded from $21 billion in 1978 to $1.1

trillion in 2005, “when China became the world’s third largest trading economy.”(Branstetter and

Lardy, 3) By 2006 China’s GDP measured in purchasing-power parity would account for 13% of the

worlds output, second only to America’s. It grew to be largest recipient of foreign direct investment,

and placed as the third-biggest exporter behind America and Germany.(The Economist, 4)

China is not alone in adopting this model for growth it has applied throughout Asian countries

like Korea, Thailand and others where “export flows are generated, in most developing Asia by flows of

inbound Direct Foreign Investment.” (Cohen, China Asia Meltdown) The developments of the Asian

countries were built for export. This creates the framework for a trade imbalance where the Asian

countries are producing for export to the U.S. who has many companies within Asia with Direct

Foreign Investment. This system would effectively transform the U.S. “from the world’s biggest

creditor nation in the early ‘eighties to the world’s biggest debtor.”(Cohen, China Asia Meltdown)

Over time with “years of inward foreign investment, then speculative capital inflows and, more

recently, a swelling trade surplus” in conjunction with Asia’s ‘savings glut’ China accumulated a huge

sum of U.S. dollars. China has accumulated up to one trillion dollars in 2006, and they are struggling to

manage the money since “if it is not well managed, any erosion of value will be source of shame for

whoever is responsible for it.”(McGregor, London Times) The ‘savings glut’ is the response of Asian

countries to the Asian financial crisis of 1997-98 where countries “began protecting themselves by

amassing huge war chests of foreign assets.” (Krugman, Revenge of the Glut) The volatile nature of

savings is explained as “huge sums of money would normally change the dynamics of the Chinese

economy by driving up the power of the reminibi. To offset the effects of the foreign money, “the

central bank bought virtually all the incoming foreign currency and managed the money on its own

balance sheet.”(McGregor, London Times)

A reason for the isolation of the foreign money was that its impact on the market would raise

the exchange rate, thus coastal export industries would suffer, due to relatively higher costs for the

foreign buyers, and the “loss of any jobs there [coastal export industries] would be felt just as keenly in

poorer inland provinces, which rely on remittances from migrant workers employed on the

coast.”(McGregor, London Times) Officials also feared that “Japan’s lengthy recession had its roots in

large revaluation of the yen forced on it by the US in the mid -1980s.”(McGregor, London Times) This

practice of artificially manipulating the exchange rates is practiced throughout Asian countries “to limit

appreciation of their currencies in order sustain growth-oriented trade surpluses.”(Branstetter and

Lardy, 41)

The Chinese government has artificially kept the value of the yuan low by pegging the currency

to the dollar; this method “boosted the competitiveness of its industries abroad, earning the countries

hundreds of billions of dollars in foreign exchange. But it has also held down consumption at home by

keeping the price of imports high for consumers.”(Too Much Money) With the yuan pegged to the

dollar China “has been forced to import America’s easy monetary conditions. Its higher interest rates

have attracted large inflows of capital that have inflated domestic liquidity, encouraging excessive

investment and bank lending in some sectors which could lead to a bust.”(The Economist, 4)

Branstetter and Lardy notes that for China that to “continue to keep the currency pegged at 8.28 yuan to

the dollar, in the face of significant surpluses on both the current and capital accounts as well as

unrecorded capital inflows, China’s authorities since 2001 have had to purchase massive amounts of

foreign exchange and reserves have risen accordingly.” (Branstetter and Lardy, 42) This mass purchase

of US Treasury Bonds in conjunction with low interest rates would cultivate and “prolong America’s

unhealthy consumer spending and borrowing”(The Economist, 14)

China is urged to reconsider its methods, in undervaluing the yuan and storing wealth through US

Treasury bonds. In Washington, politicians argue that the “Chinese intervention in foreign exchange

markets has kept its currency artificially low, making it harder for the US to export and thus reduce its

trade deficit.”(McGregor, Financial Times, September 25, 2006) While the massive exports of China is

a cause to the trade deficit, critics against the revaluation of the yuan point out that it would do “little to

reduce America’s trade deficit.” (The Economist, 16) A study at Stanford University shows that “only

20 cents in every dollar of Chinese exports to America reflect value added by domestic Chinese

production, so even a 20% rise in the yuan against the dollar would increase the price of Chinese

exports to America by only 4%.” (The Economist 16)

China reaps the benefits of an undervalued currency because it makes them more competitive

against in the arena of exports but “by far the strongest argument for a revaluation” is for China’s own

interest since the dollar peg in a way forced China to adopt “America’s super-lax monetary policy.”

Consequently the “large capital inflows and rising foreign-exchange reserves have caused rapid growth

in the money supply and bank lending as well as rising inflation. Excessive credit has fuelled

overinvestment and property bubble, increasing the risk of yet more bad loans. The central bank cannot

easily raise interest rates to cool down its economy, because that would attract more foreign money.”

(The Economist 17)

“If the reminibi continued to be undervalued for 3 to 5 years there would be a substantial

adverse effects on China’s trading partners and China’s central bank would constitute to be very

constrained in using interest rates as macroeconomic policy tool.

Although there are many reasons for China to revaluate their currency and let the yuan

appreciate relative to the dollar, China’s banking system is still unstable to “China to open its capital

account and let its currency float.”(The Economist, 17) Letting the currency float would “risk massive

capital flight and a banking crisis.”(The Economist 17) For China “a convertible currency with a

floating exchange rate is a risky option” since Chinese households hold more than 13 trillion yuan, and

there are very few Chinese savers who “had an opportunity to diversify the currency composition of

their financial savings.”(Branstetter and Lardy, 43) “Eliminating capital controls could lead to a

substantial move into foreign-currency dominated financial assets, most likely held outside of Chinese

banks.”(Branstetter and Lardy, 43) Therefore the Chinese government does not relax “capital controls

on household savings” until they have “fully addressed the solvency problems of the major state-owned

banks.”(Branstetter and Lardy, 43)

Proposed solutions in handling the US dollars instead concentrating and pegging to the US currency

is to peg the yuan to a “basket of several currencies, including the yen and the euro. (The Economist,

17) China’s exchange rate would be increased by 15% and its permitted trading band widened modestly

to allow more flexibility” (The Economist, 17) Later on, China “could move on to liberalize capital

flows and adopt a floating exchange rate.” (The Economist, 17) Another point about the yuan is that

China’s exact currency value is that it is uncertainty. It is argued for the introduction of “greater

exchange-rate flexibility for China as soon as possible rather than trying to settle on a particular

exchange rate.”(The Economist, 17) The flexibility of China’s exchange rate is said to be important

because it is said to “help to buffer the economy against shocks. But greater flexibility should not be

confused with a fully opening up the capital account, which can not be safely be done yet.”(The

Economist, 17)

The government realizes that the dependence on foreign currency (mainly the dollar) through

export is a problem, which is why in “March and August 2004 the relevant regulators announced that

the national social security fund and domestic insurance companies could invest in offshore markets.

They are contemplating approving a qualified domestic institutional investor (QDII) program that

would allow individual Chinese investors to invest in securities traded on foreign markets. Each of

these measures tends to increase the demand for or reduce the supply of foreign exchange, thus

lessening the build-up of official foreign exchange reserves.”(Branstetter and Lardy, 43)

The effect of the global imbalance has taken its toll, ignited by the housing bubble. The U.S is today

struggling in how to start the economy and revive deteriorating banks. The United States is faced with

many challenges in the crisis brought about by the housing bubble. But solving the problems caused by

the housing bubble does little to solve the underlying problem of the global imbalance.

Various leading economists and the current Fed Chairman Ben Bernanke agree that the current crisis

is traced directly to China. As mentioned before, China’s growth strategy has forced it to invest heavily

on U.S. Treasury Bonds, effectively creating a “global savings glut.” Bernanke claims that “this glut

artificially reduced global interest rates and created the perverse incentives for an unsustainable build

up of debt in the United States.” The low interest rates supports consumer spending while the cycle of

money in essence, China buys “dollar assets to ensure that Americans can afford to keep buying its

exports.” (The Economist 14) Although it may be true that China and other Asian countries amassed a

huge amount of savings, they are not solely responsible for the current crisis: one must remember that

for there to be a lender there must be debtor.

Instead of blaming foreign entities, other critics argue that it was the Federal agencies’ cheap

monetary policies in the late 1990’s and early 2000’s that was “responsible for fueling debt-driven

consumer boom, and sucking in record volumes of imports… Funding all this requires issuing huge

volumes of debt, much of it securitized against dubious mortgage and consumer debts, and sold to

foreigners when domestic savings proved inadequate.” Or as The Economist puts it gently, “some

central banks, slow to grasp the effect of these structural changes on inflation and monetary policy,

have been running overly loose policies that have fuelled unsustainable booms in America and some

other economies.”(The Economist, 6) “America’s lax monetary policy has spilled over beyond its

borders. Low American interest rates have encouraged capital to flood into emerging economies. For

those countries that try to peg their currencies against the dollar, notably China and the rest of Asia, this

has caused a large build-up up in foreign-exchange reserves and excessive domestic liquidity. When

central banks buy dollars to hold down their currencies, they amplify the Fed’s loose monetary policy.

All this means that arguably the Fed has not only caused the Americas to save too little but also the

Chinese to invest too much.” (19)

The global imbalance is the underlying problem but what set off the crisis was the rampant debt

accumulation fuelling the housing bubble. The surge of money coming from the China and various

other countries, combined with the desire for steady growth, interest rates were substantially low.

“Thanks to low interest rates the price of assets specially homes, has risen steeply, which made

households feel richer and encouraged them to spend.” (The Economist, 20) There was an overall

confidence in the market, and American households “addicted to asset appreciation” took advantage of

the housing bubble, and “thanks to surging house prices and partial recovery in share prices, the value

of the households’ total assets rose by a record $6 trillion last year, equivalent to 70% of personal

disposable income. Increases in property wealth also tend to have bigger effect on consumer spending

than increases in equity wealth. This is because more people own homes than share and it is easier to

convert capital gains on a home spending power without having to sell the asset, by taking out a bigger

mortgage.” (The Economist, 21) Deregulation has made borrowing much easier for households and

thus, “debt in relation to income has steadily risen, for at least half a century.”(The Economist, 20)

The American population has grown increasingly reliant on debt, likely due to the wage imbalance

that the average American experiences. From 1947 to 1973 the productivity within US doubled, and

median “income kept in place; it too doubled.”(Cohen, Income Distribution) But from 1973 to 2003

productivity increased 71% while “the income of median male American worker did not rise at

all.”(Cohen, Income Distribution) To correct for the relatively lower wages American families worked

more; now often both the mother and the father work.(Cohen, Income Distribution) When this was not

enough, Americans borrowed “and borrowed big. Household debt as a percentage of GDP roughly

tripled from 1960 to 2005, mortgage debt rose from 1/3rd GDP in 1990 to 80% in 2005, while home

equity falls from 2/3rd GDP to ½.(Cohen, Income Distribution) Borrowing was rampant but real wealth

and equity decreased.

The perceived wealth from the housing bubble allowed for Americans to feel wealthier. “In 2003

housing-equity withdrawal (the total increase in mortgage debt minus net household investment in

housing) rose 6% of personal disposable income in America.” (The Economist, 20) Analyst warned

against the rampant borrowing, while optimists point out that “85% of American home owners have

fixed-interest-mortgages, so they are not at risk.” (The Economist, 20) Unfortunately adjustable-rate

mortgages grew to account for half of all new mortgages in America, leaving households exposed at

exactly the wrong time. Despite low interest rates, households’ total debt-service as a proportion of

income is already close to a record high.”(The Economist, 22) The lax lending policies combined with

deregulation allowed for increased borrowing of loans for houses that were believed to be appreciating

in value, since the market was overrun with buyers who recently qualified for these loans. “The housing

stock has been turned into a gigantic cash machine.” However there is little genuine wealth being

produced since “in the long run, the only way to create genuine wealth is to consume less than your

income (ie, save), and invest in real income-creating assets.”(The Economist, 21) Through the housing

bubble however America and some other economies have been enjoying a very different sort of wealth

creation. Central banks are, in effect printing wealth by running lax monetary policies. Illusory paper

wealth is boosting consumption at the expense of saving. America’s net nation saving rate, the share of

income that America is putting aside for their future, has fallen to a record low.”(The Economist, 22)

Housing prices were only going up. Rising housing prices combined with cheap money available

coming from foreign economies like China through Treasury bonds made it easier to borrow money to

buy the expensive houses and thus continue the cycle that increases the value of houses. For this cycle

to work there must a supply of money to be borrowed, coming from foreign countries and borrowers

who wish to buy houses. To allow for more lending for the bank, the bank reduced standards on whom

they can lend money to. Soon people who cannot afford to pay the mortgages borrowed money to buy

houses. Eventually homeowners who borrowed huge amounts of money that they couldn’t pay back

defaulted and the house they bought with borrowed money would become the banks. This happened

throughout and consistently thus flooding the market with houses, thus driving the value of houses

down. Now the banks are left with worthless houses and huge debt borrowed to lend as mortgages.

The aftermath of the housing bubble produced massive crisis debilitating the US banks. Although

optimists claim that the banking crisis is “one of liquidity and not solvency,”(Baker) there is evidence

of “a mountain of toxic assets, housing market declines, a sharp economic recession, rising

unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital—

strongly suggests that some American banks face a solvency problem and not merely a liquidity

one.”(Baker) Japan has experienced the exact same problem caused by its own housing bubble in 1990.

(Tabuchi) The US parallels Japans initial approach of having ultra-low interest rates, employing fiscal

stimulus, and cash infusions. (Tabuchi) Japan even tried “to tap private capital to buy some of the bad

assets form banks.”(Tabuchi) However all these proved to be futile and brought about years of

economic stagnation.(Tabuchi) What finally recovered Japans’ economy and the urged solution for the

US is nationalizing the banks. Proponents of nationalization insist that the government must intervene

and organize the banks, leaving healthy banks alone, reorganizing and recapitalizing needy banks. This

proposed solution would be capital intensive and needs much time to see the effects, however the

alternative is anxiously hope for the economy to fix itself.

The US is a democracy where its many states that may have differing concerns and priorities

and can at times cause paralysis within the central government. There is much debate in how to resolve

the current crisis and there is much impetus for the nationalization of banks. But there is much hesitance

in bringing about the necessary changes. There is reluctance due to “political anger” and “a wide range

of uncertainties-over the valuation of bad assets.” (Wolf, 257) However China, reigns as a totalitarian

government where the decree comes from the top and must be obeyed down. This allows for one clear

goal that can immediately and directly be followed. This has been seen in the reformations brought

about by the Chinese government, which were effectively unquestioned and successfully brought about

change.

China now, however, is wrought with problems that stem from its dependency on US for

growth. The Dependence on the US dollar for foreign reserve is now being intensely questioned more

than ever because of the US no longer appears impervious. There are growing fears over the dollar; it is

seen by some as “a huge pool of resources not being used that at home that will plunge in value if the

US dollar collapses.”(Getty) There are proposals to spend the money at home, or to diversify their

investments instead of storing the wealth within US dollars. Part of the problem is the dependence on

US dollar as foreign reserves for liquid asset. No other currency can hold up against it, “and if China

did not want to accumulate so many reserves, it would have to let its currency strengthen—exactly what

the government does not want at a time when exports are crumbling.”(Getty) This highlights China’s

problem of relying on exports as their main source of income, as we have seen in the US and the Great

Depression the dangers of mass production. A possible solution to resolve both parts of the problem of

reserves and dependence on exports is to spend the money at home, to improve the infrastructure and

cultivate other means of income. If China was to invest heavily on the infrastructure of the country they

may improve education and other social amenities thus relieving dependence on other countries,

importing unfinished goods and technology for export.

It is human nature to take available opportunities so that he is at an advantage. However within

conglomerates as huge as an entire countries market, there is greater impetus for the beneficial status

quo. It is difficult for one person to decree a decision that ultimately is the best decision disrupts the

prosperous status quo. It is human to err, but it is the responsibility of the governing institution to

account for, or accommodate these human flaws. It was the strong governing body that Russia needed

to ease it out of communism into a free market. It is the success of the governing body to allocate and

capitalize on resources to bring about the growth and development of China. However it is when the

government fails to make the difficult decisions, and settles for the beneficial status quo, that wrecks the

country?? It is when the intrinsic human flaws combine and compound within a governing body instead

of working to restrict it is when government fails. This is what ultimately brought upon the current

crisis. It was the greed of direct foreign investors that created the trade imbalance. It was the

ambivalence of the Chinese government to keep its influx of money through exports, by manipulating

exchange rates, and hording the U.S. dollars for savings. It was the greed of companies to depress the

wages of Americans. It was the ambivalent greed of the banks to blindly lend out money for mortgages.

It was the greed of America to get everything for nothing. All of these flaws converged to create this

crisis that will ultimately bite us in the ass, it is only the government who has the power to make these

changes and regulate the market, to prevent the accumulation and magnification of these flaws.