Against the Consensus: Why conventional theories on the crisis are inadequate

Justin Lin interviewed by Viv Davies, 08 August 2013

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Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I am Viv Davies from The Center for Economic and Policy Research. Today's interview is with Justin Lin former chief economist of the World Bank and honorary dean of The National School of Development at Peking University. We met in London on the 27th of June 2013 to discuss Justin's new book Against the Consensus: Reflections on the Great Recession. Drawing on his rich experience Lin offers his thoughts on the causes of the crisis and argues that conventional theories provide inadequate solutions. Lin suggests that the financial crisis originated in global imbalances arising from the wealth effect of excess liquidity created by US financial deregulation and loose monetary policy. I began the interview by asking Justin to explain the basis of his book in some more detail.

Justin Lin: Well yes, because I became chief economist of the World Bank in 2008, three months before the eruption of the financial crisis. Certainly, at that job I needed to understand what are the causes of this crisis? A way out of this crisis. And the book is a reflection of my attempt for understanding and finding a way out. Because there was a confliction in the world. The global financial crisis was triggered by the global imbalances. It means that East Asian economies that they manipulate their policies to gain [inaudible 01:44] process and accumulate foreign reserves. And use that foreign reserve to purchase US treasury bill and re price the interest rate. Because interest rate is so low people were encouraged to speculate the housing asset real estate, causing the bubble in real estate. According to this hypothesis, when the bubble burst it turned into the global financial crisis.

In this hypothesis they attribute the policy manipulation in the East Asian economies for the causes of the global imbalances and also the causes of the global financial crisis. I examined this hypothesis. Certainly, this hypothesis looks logically consistent but it cannot really reconcile with the empirical evidence that I observed.

In this global imbalances hypothesis they attributed three reasons for this policy manipulation. One is the export promotion policy in east Asian economy. The second one was the intention to accumulate reserves as a way for some insurance. And the most popular one as you know was the Chinese government artificially re priced the Chinese exchange rate, underwater exchange rate.
But the empirical evidence cannot support all those hypothesis although it seems to be logically consistent. I tried to find a new hypothesis which can reconcile with all the empirical evidence that is available. I think the only hypothesis that can reconcile, is consistent with all the empirical evidence is well, the US has all the global reserve currencies and the policy mistakes in the US contributed to the low interest rate in the US. And so it encouraged the housing bubbles and because the housing prices increased dramatically people capitalized again and increased their consumption.

Also because the Afghanistan War, Iraqi War the US government had a physical deficit and so they over consumed. So the US had a large trade deficit and the East Asian economy especially China happened to provide those kind of goods to the US. The East Asian economies had larger trade surpluses. This kind of situation can sustain for a long time only because US dollars is a global reserve currency.

That is my first part of the book. Trying to understand the causes of this crisis. Because only when we know the causes of this crisis we can prevent similar things to happen in the futures.

Viv: What do you think is the best way out of the crisis for both high income economies and developing economies? Are the solutions the same?

Justin: I think they are different. I think that for the developing country, I think that almost all of them already recovered to their level of economic production before the crisis. The trouble now is blending in the high income countries including the Euro Zone, the US, and Japan. The current focus is on the Euro Zone, whether they can get rescued. When [inaudible 05:34] country, less sovereign debt is due. Now, we know that if we do not carry out the structure reform, then any kind of rescue is just like painkillers. A similar problem will come back again. But to carry out a structure reform, we know it's contractionary in the short run. It can slow down the growth, it can push the unemployment figures higher, and politically it's infeasible.

In the past there's one way out that was to devalue the currency in order to increase exports and create the space for the structural reform domestically. But we know southern European countries they don't have their independent currency.

The euro can devalue, but the trouble is that the euro zone, UD, and Japan are all high income countries. Their products are competing in global markets so any intention to devalue as a way to create a space for structural reform in euro zone will be at a cost to the US and Japan. We know that the US and Japan also have their own structural problems. They also need to carry out structural reform in order to regain their inner competitiveness, but they haven't carried it out yet.

Viv: What kind of structural reforms?

Justin: Structural reform in the context of the euro areas is to lower the wage rate until it deals the benefit, and to cut down the government budget deficit. That is the content in the euro zone. In the US, financial deleveraging, and also improving the social, the medical care system. In the case of Japan to improve the efficiency of their domestic non tradable sectors. Those are all the structural reforms in a high income country. Any of those kinds of structural reforms, at least in the short run means contraction, but they already have a high unemployment rate.
Under this consideration I think that, because high income countries, they cannot use devaluation as a way out to create a space for structural reform, we need to find an alternative that can create large enough exports for the high income countries so they will have the possibility to carry out a structural reform. Just like the function of devaluation in the past perform for the country in crisis to get out of their crisis, to resume their competitiveness.

I recommend some kind of [inaudible 08:30] the sense that the best way is to make investments in the productivity enhancing type of infrastructure to release the bottleneck of growth and to enhance the productivity. Those kinds of investments in the short run can create demand, generate growth, and jobs.

Viv: This is what you talk about in the book as the "Global Marshall Plan."

Justin: Right. The reason why I call it the "Global Marshall Plan" is because the high income country alone may not have enough opportunity for those kinds of investment, but developing countries have a lot of those kinds of bottlenecks. If you have a global initiative to make investments in infrastructure then you will create large enough demand for high income countries to carry out a structural reform. Help them to get out of the crisis. It's good for the high income country. It's also good for eh developing country because those kinds of investments, once their completed, it will enhance their growth potential. It's a win win.

Viv: You also proposed creating a new super national, global reserve currency that you call "paper gold," or "p gold." What is this exactly? Why do you think it will help prevent the recurrence of a global crisis?

Justin: I think that, as I mentioned, the main reason for this global crisis is the conflict of interest of using national currency as he global reserve currency. With that, the reserve issuing country, their monetary policy is mainly for their domestic interests. It can be at a cost of the global interest. This global crisis demonstrates that. I think that to avoid a similar crisis in the future is to have a supranational currency. Along the line of Keynes' proposal, post war period about paper gold is an improvement of bank gold, that was proposed by Keynes.

Paper gold is a supranational currency issued by the global monetary authority. It has the function like gold. Every country uses that as a reserve to issue their domestic currency. This proposal, I think you can avoid all the drawbacks that we've observed for the international monetary system.

Viv: Do you think there's an infrastructure, internationally, to be able to implement that system?

Justin: I think that certainly it needs to be accepted the governments in the world, because it's a fiat money. It needs to be accepted. But I think that this proposal will be a better alternative than the alternative we have now, because I think that we may be entering into a period of revolt to [?] the international monetary. It's better for everyone, so it would give the opportunity to consider some alternative.

Viv: What are your views on industrial policy as a means of development for developing countries?

Justin: I think that because economic development is a process of structural changes in technology, in industries, in infrastructural, in financial legal institutions. Those processes, you need to have the first mover who initiates those changes. A first mover may encounter all kind of difficulties. You need to provide incentives for people to be a first mover. Also, the success of the first mover depends on whether there is some coordination in necessary improvements in the infrastructure, the financial system, and in the supply of other intermediate goods. Individuals and firms will not be able to internalize all those changes.

For these two reasons, the government should play some kind of proactive role to compensate for the externalities that were created by the first mover and to help the first mover with the coordination in necessary improvements in other areas. The government can play those roles.

Viv: But is there a danger of creeping protectionism?

Justin: The industrial policy, I propose actually we're not creating protectionism, because to be competitive in the international markets, I think that certainly the product produced or the service generated should be competitive, in a sense that the cost of producing those goods or providing those services should be competitive internationally. The cost consists of two components. One is the effective cost of production. The other one is transaction cost. The effective cost of production is determined by whether these production activities are consistent with the country's competitive advantages. If it is so, certainly the cost will be low.

Then, the transaction cost is related to what I what I just said. Whether they have good infrastructure, whether they have a good financial system and ecosystem. The government's industrial policy actually is meant to help lowering the transaction cost. The issue is, if the government works with the private sector to lower the cost, they will be competitive, they don't need to be protected.

I think that an industrial policy is important. I mentioned that to get out of the current global crisis, it's very important to include the developing countries in the picture, to support the investment, to release the button of infrastructure. Those kinds of investment will become self liquidating who're not.

Very much depends on whether the developing country that receives those investments can have phenomenal economic growth. If they have growth, it's very dynamic. The usage of those infrastructure will be high, then the return on investment will be high. But if they have a very slow growth, then the investment in the infrastructure will not be able to generate high enough return to pay back that.

As I said, economy development is a process of structure changes. If the government plays the facilitation role and helps, the sectors that they help competitive advantage to grow quickly, certainly under the current situation, they will have high enough return to pay back the infrastructure. I think that we need to combine the counter cyclical intervention with long term growth in the policy to design the way out for the global crisis.

Viv: If there is one principal policy message which is coming out from your book that you would like to convey to policymakers, what is it?

Justin: I think that we need to be open minded, because we are entering into a new regime in the world, because the high income countries may not be able to get out of the current challenges. They may be entering into something like Japan, and they do have a lot at stakes. Very sluggish in their growth, high unemployment, quickly accumulation of government debt, and a very loose monetary policy. That kind of situation certainly is bad for a high income country, but it can also cause all kind of challenges in macroeconomic policy management in the developing country.

That is something we may encounter. But as a Chinese, the phrase about the crisis, "It's a danger, but it's an opportunity." If we innovate, we may turn this challenges as an opportunity to have a better world.

Viv: Out of crisis comes opportunity.

Justin: Right.

Viv: Justin Lin, thanks very much.

Justin: Thanks very much.

Topics:  Global crisis

Lin, J (2013), Against the Consensus: Reflections on the Great Recession, Cambridge University Press, July.

National School of Development at Peking University; and former Chief Economist at the World Bank


CEPR Policy Research