My Blog

September 18, 2008

I finally got back to Beijing on Monday, but after an interesting lunch with a group of pessimistic Brazilian hedge fund managers who were concerned about financial fragility in China and its impact on Brazilian markets, I had to fly that afternoon to Hong Kong for two days of meetings.  It is not a lot of fun traveling in a period like this, especially when people are asking your advice on market events, because whenever you are away from the screens for more than an hour or so it seems that another earth shattering event has taken place that makes all of your comments immediately out of date.

Not surprisingly, the Chinese stock markets did very badly this week.  Monday was a holiday, but when the market opened Tuesday the SSE composite quickly lost 4.4%, and dropped a further 2.3% on Wednesday and 1.7% today to close at 1898.  Clearly 2000 was not the bottom.  In an effort to stop the decline the authorities announced today that effective Friday they will cancel altogether the stamp tax on stock buying.  

Big deal.  They have tried so often to signal the market up or down that I am pretty sure that they have little credibility left, and so I suspect that this cancellation will have absolutely no effect.  Real news – either domestic or from abroad – is going to drive the market tomorrow.

Unlike in the rest of the world the local media seems to have been fairly muted in reporting the developing financial crisis.  For example there seem to be more visible headlines in the People’s Daily and in Xinhua about the successful end of the Paralympics and of the tainted milk scandal than about the global financial crisis, much of which reporting was relegated to the business sections.  I suspect that the authorities are worried about the impact of the rising gloom on retail spending, as perhaps they should be.  Rising consumer demand was one of the few bright spots in recent economic data releases, and although I suspect that the Olympics had a lot to do with that, it won’t pay to scare Chinese consumers into saving more in reaction to the growing global uncertainty. 

Actually a lot of journalists have been asking me today about the impact of the stock market on consumption and confidence.  I don’t think there is likely to be a very strong direct impact since in China the stock market is still very small relative to overall GDP, but of course watching the market fall so quickly is likely to have an adverse psychological impact on consumer spending, and maybe a large one.  More important, I think, is the property market.  Chinese consumers, banks and corporates are far more heavily invested in real estate than in stocks, and it is here that declining prices can really impact the economy.  Unfortunately I don’t think is a very good story either

For example yesterday’s South China Morning Post had a massive front page headline in its Property section:  “Price war fails to lift mainland sales”.  The article starts off with:

Mainland property developers have resorted to steep price discounting to lure buyers back to the market this month and next, the traditional peak home-buying season.  

“It is the first time we have seen a price war happening in all the major mainland cities. Almost all projects in Beijing have now cut their asking prices,” said Li Wenjie, the general manager of Centaline (China) in Beijing. However, the tactic has so far shown no sign of reversing the decline in property sales and analysts do not expect lower prices alone will be enough to restore buyer confidence.

The authors follow up today with another article entitled “Sweeteners may leave potential buyers with bad taste in their mouth.”  As long as property prices were rising, the trend was reinforced by buyers who, expecting continued rising prices, rushed in to accelerate their purchases or even bought for speculative purposes.  Now, however, according to the authors, declining prices are having the opposite effect.  Even people who want apartments or offices, and even if they find current prices acceptable, are holding off on purchases because of concerns that prices will soon be lower.  Speculative buying, of course, is likely to be negative.  These are the kinds of self-reinforcing tendencies typical in booms and busts that guarantee volatility.  There are many more in China.

One impact of the crisis is to worry more about sources of volatility.  According to an article in today’s Bloomberg,

China's government may thwart new financial products including derivatives to avoid the subprime crisis that's wrecked havoc on the U.S. credit market, said the Chinese bank regulator's deputy research chief.  The regulator will instead improve risk-management practices and force banks to put checks in place to prevent Asia's second-biggest capital market from being roiled, said the China Banking Regulatory Commission's deputy research chief Fan Wenzhong.

“The subprime crisis is far from over, so China's regulator should enhance risk awareness and protection,” putting the emphasis on ensuring financial stability rather than innovation, Fan said today at a conference in Beijing. The point of China's financial reforms is “not speed, it's about stability,” he said.

I have always thought China’s markets were far too speculative for the introduction of derivatives, which were likely to be used largely to multiply the force of speculative buying and selling, so exacerbating market volatility.  I am glad they are more reluctant then ever to move this forward.  

Derivatives can improve the efficiency of markets, but they cannot create an efficient and stable market.  It is only the existence of a diverse investor base, with plenty of fundamental and relative value investors, as well as of course of some speculators, that can create a market that allocates capital efficiently.  In order for China to have such an investor base it is far more important that investors have better financial and economic information and a mechanism to enforce discipline on managers than the shiny but dangerous derivative toys, which can exacerbate self-reinforcing behavior.

Still, it is important that regulators not draw the wrong conclusions.  The US financial crisis was not caused by too free markets or too little regulation (or even by high bonuses and complex securitizations).  We have had very similar financial crises for thousands of years without any of these things.  In fact one of the “obvious” solutions to this year’s crisis – force unstable investment banks to become part of stable commercial banks – is exactly the opposite of the solution proposed for the 1929-31 crisis – separate commercial banks from investment banks.  Clearly our analytic framework leaves something to be desired if these two very opposite solutions can be proposed for the same problem.

In my humble opinion the problem is not (and never is) the specific circumstances of the crisis.  The problem is very different.  Hyman Minsky has already argued extensively (and conclusively, in my opinion) that there is no such thing as a permanently stable financial system.  You can read a decent summary of his thought on crises here.  

According to Minsky any attempt to remove or regulate away volatility or risk automatically changes the behavior of financial institutions so that they engage in greater risk-taking behavior (among other things, in a lower-risk environment, institutions and individuals that take “too much” risk will grow at the expense of prudent and risk averse players), until at some point the system is as risky as it ever was.  The sound bite for his Financial Instability Hypothesis was “financial stability is destabilizing.”

Minsky focused very much on tendencies within balance sheets and the institutional structure towards automatic destabilizers (what I usually call self-reinforcing tendencies), and argued that rather than eliminate crises we should minimize these self-reinforcing tendencies and their economic impacts.  "We can, so to speak, stabilize instability," he wrote, by creating automatic fiscal and monetary stabilizers that counteract expansion and contractions in the financial system. 

I have been a hard-core Minskyite since the early 1990s (he was a big influence on my own understanding of financial crises) and it is for this reason that I have harped on so long in my blog and in the press about the weaknesses in Chinese balance sheets, which include so many automatic destabilizers (the South China Morning Post articles cited above describe exactly one such process).

So if it wasn’t evil or stupid bankers playing with toxic toys that “caused” the current crisis, what was the real problem?  In my book on the last 200 hundred years of capital flows from rich to poor countries (which is, not coincidentally, also the history of the last 200 years of financial crisis), I argue that periods of rapid monetary expansion preceded every financial crisis – and these crises, although they seemed to have occurred for a plethora of different “reasons”, all looked practically the same.

This is not a coincidence.  Excess money increases risk appetite and forces financial institutions into riskier behavior.  At first, riskier behavior is highly rewarding because as risk premia decline, institutions that took the most risk benefit most, and prudent institutions go out of business.  But as companies, banks, and households build increasingly risky balance sheets it takes a smaller and smaller shock to cause a rapid unwind.  To understand how destructive the subsequent “unwind” will be we need to get a sense of how strong the self-reinforcing processes are and whether regulators, the government or other institutions have automatic stabilizers in place.

It is excess monetary expansion, in other words, that leads to overextended financial systems, leveraged balance sheets, and destabilizing tendencies.  If this is correct, what does that say about China’s susceptibility to the global economic crisis?  Well, regular readers know that I think there has been way too rapid money growth in China.

Comments (49) for "Is China safe?"

China is not safe, since nowhere is safe. However, the oft stated assumption that Chinese banks and markets are worse at risk management than American ones is pretty much dead, and it's interesting that the balance sheet losses we have seen this week, weren't from real estate holdings but from holdings of Lehmann Brothers securities. Also, I very much disagree that excess monetary expansion leads to overextended financial systems, leveraged balance sheets, and destabilization. It's a lack of regulation and required capital reserves that led to these problems. One thing that gives me some more confidence in the banking system is that there hasn't been a lack of regulation, and also China has a system of financial regulation that is much more integrated than the US one. By Twofish - 9/17/2008 9:02 PM

I just do not see too much money in China financial system. The FX reserve is high, yes. But that does not translate to excess money in economy automatically. The shrinking aggregate demand is another matter. By fatbrick - 9/17/2008 9:29 PM

Michael, I have read your book. It is probably one of the best I have read in regard to understanding the "destabilising" or reinforcing effects of crises. It was very helpful in understanding the transmission mechanisms of crisis through a debt-exchange rate framework. I am looking to understand the transmission mechanisms within a monetary, fiscal and baking sector framework. I have read Bernanke's "Non monetary effects of the financial Crisis in the Propagation of the Great Depression" Which I have found helpful. Could you suggest where I could look to obtain further information? Thanks, and congratulations on such a well established blog. It is amongst my favourites. By Cedric - 9/17/2008 9:40 PM

I agree with you that the regulators and the bankers are not primarily responsible, but they are such politically easy targets! By RebelEconomist - 9/18/2008 12:35 AM

Almost forgot; thanks for your response about Chinese stock indices on the previous post, Michael. By RebelEconomist - 9/18/2008 12:37 AM

"The US financial crisis was not caused by too free markets or too little regulation (or even by high bonuses and complex securitizations). " Wow! You and Stiglitz (among so many others) are on the same page. NOT. I'm disappointed to know you have such an ideological cast to your views. I've found your blog v. interesting. At least you are only an academic! "We have had very similar financial crises for thousands of years without any of these things." Oh, right. Never useful to study history, distinctions without a difference, etc. Spare me. By lark - 9/18/2008 1:02 AM

hey, moron, why don't you stop this nonsense about being a "hard core mynskinite" and start reading what the Austrian Theory of the Business Cycle has to say about "Caopitalism inherent instability". You ignorant loser. By soros1 - 9/18/2008 1:34 AM

Michael, Nice nice penultimate paragraph, you got it in one there. All the best, Anton London By Anton - 9/18/2008 1:39 AM

Prof Pettis: To paraphrase what you wrote above, financial systems are intrinsically unstable and that attempts to stabilize financial systems lead to financial innovations that return markets to points of instability. Financial crises are monetary phenomena. This raises several questions for policy makers: 1. In a globally interconnected financial system, how do policy makers attenuate the severity of financial instability where there is decentralized monetary policy? For example, we are seeing spillover effects from the extremely loose monetary policy in the United States during the housing bubble. 2. Following from 1., does this imply that the larger, more important economies in the global financial system have a greater responsibility for prudent monetary policy and, by extension, that emerging market policy makers have less control (or are helpless, to some extent) regarding the health of their financial systems? 3. Does 2. make an argument for capital controls? 4. If crises have followed rapid monetary expansion, how do policy makers address this given that the goal is not to attempt to temper volatility, but to mute the destructive effects of it when it comes, instead? The U.S. central bank has been managing monetary policy for a long time and America still tends to run into these crises almost every decade since the beginning of Bretton Woods II. Do they just not understand that these are monetary phenomena, or is monetary policy too complex for them to manage (i.e., maybe the Federal Reserve should stick to its role as a regulator and drop open market operations)? (Or, do political pressures always throw a wrench in a circumspect central banker's plans?) I would love it if you could find time to address some of these. By matt - 9/18/2008 5:42 AM

Michael: From my perspective much of the difficulties of the current financial crisis results from derivative contracts which have been allowed to fester either on or off financial firm balance shees. Contrast what is happening in financial land, with the fall in the price of oil from 147 to 91. This decline of 38% has been as severe as most of the housing declines in the US and has not resulted in a single bankruptcy that I am aware of. This is because oil is an exchange traded contract, with third party clearing. If you don’t have enough money to cover the margin call when your futures contract declines you are sold out; end of story. The shenanigans that we have seen in the financial derivatives space is exactly the opposite. Bear and Lehman were able to sit on declining contracts and pretend the par values were close to 100 when in actual fact they were trading 15 cent to the dollar. Third party clear of derivative contracts would have forced either sales or capital infusions long before the crisis stage. The only trouble with this scenario, according to Ken Rogoff, is that the sale of these specialized derivatives are very profitable, and the banking system doesn’t want to give up their best profit stream. My contention is that the Feds will push derivatives to the exchanges regardless of the screams and yell from the banking sector. By DMG555 - 9/18/2008 7:02 AM

Dear Professor Pettis: Welcome back blogging. Enjoy your blog and analysis very much. Your analysis on current crisis is dead on (I hope all the talking heads had read Minsky's works) (As someone born in China, my wishful thinking is your analysis on China is wrong. But, the law of economics has no nationality). I am a big fan of Hyman Minsky and Charlie Kindleberger. As an investor, I wish I had read them much earlier along with Warren Buffett/Charlie Munger's letters and writings. Thanks very much and looking forwards reading your blog and other writings. By Cirrus - 9/18/2008 7:44 AM

Minsky and deregulatory excess are orthogonal issues, duh. By dissent - 9/18/2008 10:42 AM

Always interesting to read your thoughts. But is it an oversimplification to pin all the blame on excess money? 1. Investment banks have a strong appetite for risk that bears watching, it seems, apart from concerns over the money supply. Proper regulation appears appropriate, especially considering some of the moral hazard issues we are now seeing (e.g., such as the “too big to fail” perception). As for Minsky: why does he think regulation necessarily drives financial companies to greater and greater risk-taking? Why regulate at all then? If the public is going to have to bail out large financial companies that make bad decisions, the sensible question seems to be, what kind of regulation best balances free market principles and reasonable oversight? 2. It seems that derivatives and other financial instruments, through leverage and other means, have had the de facto effect of “creating money.” This volatile, artificial money, however, has great potential to be destabilizing, not just in immature China, but in sophisticated markets. The growth of exotic financial instruments has exploded over the last five or six years. Investment banks are largely free to create these products without supervision, it seems (see the regulatory vacuum for credit default swaps). I think you may be glossing over the wider potential for havoc created by various “shiny derivative toys.” 3. In making a financial crisis, it doesn’t help to have large, irresponsible actors running around. Fannie Mae and Freddie Mac were both a train wreck waiting to happen: quasi-private entities taking risks like a private company but enjoying an implicitly guaranteed federal bailout if they get in trouble. How much did they contribute to this subprime mortgage mess? Anyway, you’ve certainly chosen a good topic. I hope you revisit it to clarify further how you think this crisis came about. By Chinawatcher - 9/18/2008 12:08 PM

Debt is a social and ideological construct, not a simple economic fact. Furthermore, as understood long ago, liberalisation of capital flow serves as a powerful weapon against social justice and democracy. Recent policy decisions are choices by the powerful, based on perceived self-interest, not mysterious “economic laws”. Technical devices to alleviate their worst effects were proposed years ago, but have been dismissed by powerful interests that benefit. And the institutions that design the national and global systems are no more exempt from the need to demonstrate their legitimacy than predecessors that have thankfully been dismantled. By Whosaid That - 9/18/2008 2:45 PM

"The US financial crisis was not caused by too free markets or too little regulation (or even by high bonuses and complex securitizations). We have had very similar financial crises for thousands of years without any of these things. In fact one of the “obvious” solutions to this year’s crisis – force unstable investment banks to become part of stable commercial banks – is exactly the opposite of the solution proposed for the 1929-31 crisis – separate commercial banks from investment banks. Clearly our analytic framework leaves something to be desired if these two very opposite solutions can be proposed for the same problem." Well let us say that I disagree. This is mild understatement. But I can accept that in your current position and in view of the ones held or to be held by those who were or are your students, you cannot and should not say otherwise. Whatever your political positions. I'm quite cool since I never money because of Wall Street (not exactly what others around me did) and made some shorting the whole junk in due time, thanks to the honest feedback the US blogosphere made (and they are quite rougher than you are...). I should say you helped me and others grasping the what is beyond the mirror, in Chinance markets. What you do on this blog is extremely valueable. Sorry to be a bit sour at times. Kind regards By François - 9/18/2008 2:55 PM

Fatbrick, the typical consequences of excess money tend to be rapid loan growth, speculative stock, real estate, and art markets, low real interest rates, inflation, etc. I think we have seen all of these things in China, which seems consistent with the argument that China’s currency regime has exacerbated monetary looseness. My Monday column in SCMP will argue that historically when that occurs, there are two different typical adjustments – inflation, which causes the nominal value of the economy to rise to meet the money supply, or deflation, which causes the nominal value of the money supply to decline to meet the economy. Which one we get depends on the health and structure of the banking system and the actions of the central bank, and although we seem to be going through a deflationary process in China and the world, I would argue that the jury is still out. I think we have definitely seen excess money in China although, who knows?, we may be in the early stages of a reversal. To that extent it is interesting to watch Russia, which had many of same monetary and balance of payments conditions as China. Cedric, thanks for your comments. I think the transmission is via the mechanism I outline above. RE, only foreigners are easier targets. As someone who has been writing about the dangerous consequences of our too-loose monetary expansion for a long time, I find it a tad annoying that people who never saw it coming are now so certain that it was inevitable and inevitably due to the specific circumstances. The fact is we have had many financial crises before and they always seem to follow the same two or three paths, and yet the specific circumstances before each crisis were completely different. Clearly it is not “derivatives”, or “bonuses”, or “stupidity”, or one type of regulatory framework versus another. It is something else that draws all these things together. By Michael Pettis - 9/18/2008 3:16 PM

Pure example of Ponzi Finance. Now, pass the milk, please. By LoveMinsky2 - 9/18/2008 3:52 PM

Matt, these are all complicated questions, but my very brief responses are: 1. I think the focus needs to be on the strength of balance sheets and on automatic stabilizers. Charlie Calomiris at Columbia has written extensively on counter-cyclical structures that force banks to shrink balance sheets in response to expansive market conditions. I would add that regulators need to focus not so much on the risks taken by banks but rather on modifying processes that create self-reinforcing behavior. For example portfolio insurance – a massive self-reinforcing system – was blamed for the 1987 crash. Delta hedging and margin transactions are also massively self-reinforcing. The impact of indexing on behavior has already been widely discussed. Very briefly I would say this is where regulation should focus, not on second guessing the riskiness of individual transactions. 2. Developing countries have always been at the mercy of monetary conditions in the major economies. Ensuring strong balance sheets at the national and bank/corporate level is more important for them. Chile since the 1990s has been a good model of how to do this. 3. I think of capital controls as one way, though not a particularly efficient way, of strengthening balance sheets – by reducing the liquidity of liabilities relative to assets. It is not a costless way, however, and generally raises the cost of capital for local companies while reducing the efficiency of capital allocation, among other things. For small economies, and those with low credibility, capital controls might make more sense than for large economies or those with high credibility, but they are always, in my opinion, a second-best solution. 4. I think the goal IS to temper volatility, but it can never be to eliminate it. Fowling Minshy I would focus on automatic stabilizers versus destabilizers. I know this sounds vague but I can only be vague in such short space. I discuss what this might mean a lot more in my blog and in my book. By Michael Pettis - 9/18/2008 3:58 PM

Michael, I question the presently fashionable idea that positive feedback mechanisms are a fundamental cause (as opposed to part of the dynamics) of the present crisis. Such feedback loops are, and have always been, part of the financial system, and it is up to participants to make proper allowance for their effects. In fact, the internal mechanisms of the financial system are irrelevant. What matters is the outcomes that the system delivers, in terms of market valuations. I set out my argument on my blog at: http://reservedplace.blogspot.com/2008/08/its-wind-up.html In my view, the biggest problem has been the erosion of negative feedback loops, above all the "once bit, twice shy" mechanism, as the Fed under Greeny repeatedly mitigated the fallout from burst bubbles. The huge bailouts we are now seeing are the logical conclusion of that path, and I think with the RTC, we have now reached the end of the beginning. By RebelEconomist - 9/18/2008 4:42 PM

Chinawatcher, Minsky doesn’t think financial regulation drives banks to greater risk-taking, and if I implied that, then my piece was badly written. He actually believes strongly in a role of government in the regulatory process. His point is that changes in the regulatory framework aimed at eliminating specific types of risk simply cause players to change their behavior in ways that undermine the initial change. An obvious case is if the government imposes deposit insurance to protect banks from the risk of sudden deposit withdrawals, it automatically changes the system so that riskier banks (whose activity normally would be tempered by higher deposit costs) are less constrained than they should be and, in the early stages of a liquidity cycle, would so outperform prudent banks that eventually they would either seize market share or the prudent banks would have to change their behavior. Either way, risk sneaks back into the system. Minsky would argue that we can’t eliminate risk, but we can “stabilize” it. To that end, putting into place automatically countercyclical processes (which includes what I called ‘correlated’ debt structures in my book) is the most useful form of regulation. I agree that derivatives in speculative markets can increase riskiness (which is why I am against their introduction into China), but my main point is that it is not derivatives per se but rather a system that encourages and even forces the financial system into speculative and risk-enhancing behavior that is the problem. For example, the 1920s crisis could not be blamed on derivatives, but the various leveraged “trust companies” turned out to have the same toxic, pro-cyclical impact then as derivatives do today. By the way, as to your point that derivatives “create” money, I hadn’t though of that, but I do think securitizations definitely create money in the Mundellian sense. The classic example, I think, is MBS, which convert very illiquid portfolios of mortgages into highly liquid securities, and that has the effect of increasing the “money-ness” of a huge asset class. Francois, thanks for your kind comments. I try to address in earlier comments why I continue to believe strongly that it is excess liquidity, not evil intentions, or even stupidity, that drives financial markets into risky behavior. I suspect that when and if the Chinese markets go though their own “adjustment”, the same people who were extolling the genius of Chinese financial policy-makers a few months ago will be excoriating their stupidity. In both cases, I would argue, they are wrong. By Michael Pettis - 9/18/2008 5:13 PM

RE, I think I agree with both your statements (and your blog entry). Feedback loops have always been part of the financial process ands will never disappear. Since positive feedback enhances volatility and negative feedback dissipates it, if you are arguing that we need to strengthen the negative feedback processes then I think you are thoroughly in Minsky's camp re the regulatory role in stabilizing volatility. By Michael Pettis - 9/18/2008 5:25 PM

By the way, RE, you truly merit the epithet "rebel" for trying to rehabilitate Mellon's "liquidate, liquidate." I have a sneaking suspicion, however, that you may be right -- that a rapid liquidation followed by very accomodative fiscal and monetary polcies (which he actually opposed) might have been the best way out of the Great Depression. By Michael Pettis - 9/18/2008 5:29 PM

While I have never read Minsky directly, I came across his ideas a few years ago when I was an academic at a UK university, and, as you would expect, was interested. I asked my colleagues with interest in monetary economics about Minsky, and not one of them had heard of him. I dare say that the academic approach to economics has also made a small contribution to the current mess. By RebelEconomist - 9/18/2008 5:44 PM

Dr Anastasia Nesvetailova, also at a UK university, has heard of Minsky, and has written/is writing books about this very subject, Minsky, and how these ideas pertain to what has been happening since August 2007. Leave it to the Russians to know what really is going on. Dr Anastasia Nesvetailova's university is City University of London. Now in the process of writing Ponzi Finance and Global Liquidity Meltdown: Lessons From Minsky Interesting! By Ponzinomics - 9/18/2008 6:44 PM

Michael, The comments and answers made here certainly make your explanation and your position a lot more intelligible and nuanced on all accounts, from academics to ethics. I'm quite glad to be in more in tune with the content of this great blog. Thanks again By François - 9/18/2008 6:58 PM

Minsky wrote few academic journal pieces and published mostly in the financial press and in policy journals. Unfortunately that pretty much left him out in the cold as far as the academic economists go. He seems to have enjoyed a huge resurgence in the past few years, which is good because he, Fischer, Kindleberger and a few others have more to say about financial instability than most of the other academics I have read (with the exception, perhaps, of Keynes). As a general rule I think the financial historians have had a far better grasp of financial instability than the straight economists. By TR - 9/18/2008 7:01 PM

TR: "As a general rule I think the financial historians have had a far better grasp of financial instability than the straight economists." Perhaps you might want to modify that to: As a general rule financial historians have had a far better grasp of EVERYTHING than the straight economists By jerry - 9/18/2008 7:07 PM

Ponzinomics, No doubt lots of academics are now writing about Minsky and his ideas. That is exactly the problem. Universities are no longer places of objective enquiry that can allow original individuals to develop revolutionary ideas. They have become publication and degree factories, with little regard to relevance or rigor in either. A good strategy for getting published is to work on fashionable topics. By RebelEconomist - 9/18/2008 7:08 PM

Dear Professor Pettis: With the ongoing financial crisis and all the actions by the Central Banks around the world and since we really cannot avoid financial crisis completely, what is your opinion on the lender of last resort? Could you elaborate on this topic in your future blog? I am wondering if there is different consequences or moral hazard issue, etc between US and country like China. Thanks. Cirrus By Cirrus - 9/18/2008 8:25 PM

Thanks for taking the time to reply, Michael. Ever since I found this blog I’ve been a big fan and am glad that its readership keeps growing and growing. On deposit insurance: I don’t profess to know exactly how such insurance works, but might that be the real issue here, as I suspect that the pricing isn’t based on the perceived riskiness of the insured, but rather is flat rate right? If so, that seems to be the real problem, not the concept of insurance. I agree that excess money would seem logical as a precondition for a financial crisis, but in a way it also seems akin to a dry field that still requires a match for a brushfire to start. A point of curiosity: Have you ever tried to correlate money supply with a given economy’s financial health, over decades? As in, do you always find that when money supply reaches a certain degree of looseness as defined by x, a financial crisis occurs? By Chinawatcher - 9/18/2008 9:30 PM

Pettis: the system so that riskier banks (whose activity normally would be tempered by higher deposit costs) are less constrained than they should be and, in the early stages of a liquidity cycle, would so outperform prudent banks that eventually they would either seize market share or the prudent banks would have to change their behavior. It's actually worse than that. What happens is "regulatory arbitrage". Money from low return insured prudent banks ends up in high return uninsured risky securities. What happens is that you make a lot of money if you can take FDIC insured deposits and invest them in agency bonds, and then Freddie Mac makes lots of money from taking that money and invests them in subprimes. When subprimes fall apart, then you have a bad chain reaction. Bank takes FDIC insurance puts it into seemingly stable companies, those companies by insurance, that insurance money is used to issue credit default swaps. Etc. Etc. What happens in the end depends on what happens when the dominos start to fall. Basically when each domino hits the next domino, either the problem becomes bigger or smaller. If you have negative feedback then things frizzle out. If you have positive feedback, then one bang cause a larger bang, and you have an explosion. What the Treasury and the Fed are doing now is basically firefighting. I don't think that monetary expansion is in itself the main cause of the problem. Certainly it causes problems since monetary expansion makes it easier to leverage, and leverage causes problems when things blow up. By Twofish - 9/18/2008 9:30 PM

Actually emerging markets aren't doing too badly right now because they learned from the 1990's, and built up really strong balance sheets, which they are putting to use to prop up their markets. This makes this current situation very, very different from the crises that Prof. Pettis talks about in his book. By Twofish - 9/18/2008 9:32 PM

matt: In a globally interconnected financial system, how do policy makers attenuate the severity of financial instability where there is decentralized monetary policy? One other thing that is happening now which is that central banks are very much cooperating with each other. The problem with everyone saying "I know that there was a problem" is a common one. Just for the record, I don't think that there will be a Chinese banking crisis in the next two years, so if one happens, I'll have to say "well I guess I was wrong then" rather than claiming any sort of forethought. By Twofish - 9/18/2008 9:59 PM

Pettis: a system that encourages and even forces the financial system into speculative and risk-enhancing behavior that is the problem. True, but to understand the system I think it is a bad idea to look at the high level. Instead you need to look at the low level of individuals. Austrians call this methodically individualism. So you have a bond trader or corporate CEO, what sort of actions get rewards and what sort of actions get punished. If you look at banks, there are all sorts of things that will encourage risk taking, stock option compensation, the bonus system, the tendency to hop from job to job based on who pays the most, winner take all culture etc. etc. One thing that has to be addressed is the salary difference between traders and regulators. You don't have college students going out and saying "I want to be a bank regulator" because the rewards either in status or in salary aren't there, and one thing that makes me somewhat more optimistic about China, is that the difference in salary/status between the regulators and the regulated hasn't gotten as out of balance as it did in the United States. By Twofish - 9/18/2008 10:06 PM

The title of today's blog entry was, Is China Safe? And, perhaps, this was an unintended double entendre, but perhaps also knowing Mr. Pettis' writing skills and the great hullabaloo over the milk scandal, in the China news, these days, probably this figure of speech was to intentionally poke fun at the powers that be, who not only can not manage the economy, but, also, can not even control the melamine which factory owners feed to kids and pets, causing death and kidney disease to both. Which is still a very minor blip considering all the other health risks in China, these days. Truly, China is no longer safe. It once was QUITE safe. But, not now. One of many reasons that China is not safe is that the people can not own land. And, so have no invested interest in protecting the land. One other reason is that China has such a rotten form of government, with most control from the Top Down, instead of the other way around. This kind of government will NEVER work. And it is not only fragile, BUT, also futile. Of course, this blog is extremely interesting and very informative, exceptionally well written, for just one man. But one might speculate how even much more interesting a 2nd blog might be if Mr. Pettis would start it, one which incorporated some major thinkers from Columbia and other schools, to use more fields of science on one blog, to collaborate to try to give the readers a true perspective about what is going on in China. Now, this would be a blog worth paying for. But not worth dying for. So, hopefully, Mr. Pettis would not choose contributors from inside China, otherwise, it might be off to the gulag, they go. A question always arises when reading the entries on this blog. One might wonder just how true this blog, truly is? For example, how much of the views expressed by the blogger, here, are in some small way BENT, by being in China with its extremely strong arm control on all publications, all media, and even so many blogs? This is probably not an unreasonable question to ponder. And, probably, in truth, even Mr. Pettis can not tell us, himself. Because when one lives for so long in a closed society, this has an extreme effect on most people, unless one might be another Aleksander Solzhenitsyn. And even Mr. Pettis is probably not of this man's calibre. Either way, we are all far too old to have breast milk. So, pls pass the Melamine Milk, and may the Red Queen have mercy on our kidneys. By Mothersbreast Isbest - 9/19/2008 12:17 AM

Prof. Pettis I appreciate your entries in the comment section on counter-cyclical regulation, as well as counter cyclical fiscal and monetary policy. It's been my intuitive position for some time. One thing on derivitives and some of the other more complex financial instruments specifically though, is their general opacity seem to be destabilizing in and of itself. It's more difficult both to regulate or knowledgeably invest in an environment where the real obligations of companies is so poorly understood. By Joel - 9/19/2008 12:20 AM

Very funny when commentors, such as Soros1, addresses Prof Pettis, "hey moron". One can only imagine that this is done VERY MUCH "tongue-in-cheek". How could it be otherwise? Also, this seems to be some throwback to all the times students wished they could say such things to their professors, from afar, and get away with it without sacrificing their grades. Still, extremely humorous and entertaining to wonder what Soros1 was really thinking. By Keepbreaking Themonotony Soros1 - 9/19/2008 12:45 AM

One very interesting question, touched on in today's entry, is the question of real estate values, and how these might fluctuate in the near term. There are some among us who actually do own property in China. But, since most comments today do not seem to care about this extremely important issue, one can assume that most commentors actually have very little stake in China, and probably do not own any property here. It would be good if Mr. Pettis could continue to ferret out any info which might provide a better understanding of whether or not the people who hold property will have their property undergo the same devaluation as happened some time back in 1993 - 1996. Perhaps these dates are not exactly right when the Shanghai office prices began to dive, but it was just about around that time. As I recall, I think it was 1994, or so. From a historical point of view, there have always been big fluctuations in Hong Kong and in China, regarding property prices, which come on very suddenly. But, also, as Mr. Pettis knows, the basic quality of the buildings in China are NOT up to the standards of Hong Kong, and can be expected to depreciate much more rapidly, simply because many are just falling apart even before they are even completed. Since Mr. Pettis has stated that property values, and their fluctuations, might be even more important than the SSEC, then why not spend much more time talking about this than has been done, thus far? Just as a matter of interest. Of course, China is basically doomed, and has been, ever since its population exceeded 600 million people. Right at this moment, the quality of life for most people in China is extremely low. Chinese People, according to Pew, are the most optimistic in the world. But, they are now living in a dream world. The fact is, that even with some miraculous discovery of cheap energy, tomorrow, still, with the ultimate burden of 1.4 billion people, this overpopulation will finally, and TOTALLY negate the chance for any Chinese people to live a decent life in a decent environment. People such as Mr. Pettis, who only live in the big cities, using big expense accounts, with plenty of cash, living the upscale lives, truly do not have any inkling of what most people are dealing with, day by day, just as the environmental degradation continues to progress, day by day. All of the comments, today, are fun and intellectually stimulating. But, none of the comments even allude to the real economic hardship and the environmental hardship, suffered by the majority of the people in China. It would be good if any reader of this blog, with money, could send Mr. Pettis around the country, to go from province to province, with a translator, to see this great nation, and get a much better handle on, what is what! Then, Mr. Pettis could come back and speak with a great deal more authority. By Spermacide? Anyone? - 9/19/2008 2:41 AM

Recently, it has been reported on Bloomberg, that this blog receives 5000 hits each day. No one can doubt that this blog does not deserve even 10,000 hits each day. And some day, soon, it surely will attain this level. However, it would be interesting for the readers of this blog to see that this 5000 hits per day level can be substantiated. Everyone knows that there is software which can highlight this on one's blog. So, it might be interesting to have a counter to show just how many readers are reading this blog, on every given day. The computer savvy students of Mr. Pettis could easily install a counter on this blog to show the stats for readership. After all, they were the ones who Mr. Pettis stated helped him to circumvent the censors when he was trying to contact his own blog server, past the Great Firewall. So, why not have the students install a counter, for everyone to see, and not rely on Bloomberg to tell the world just how popular this good blog truly is? Or, is it that the reason this is not done is because you do not care about how many people read this blog? No Way, Man! By Giveus Thenumbers - 9/19/2008 4:23 AM

I have deleted a number of comments that were irrrelevant to this discussion. Please try to stick to the subject By Michael Pettis - 9/19/2008 3:54 PM

Chinawatcher, the late Frank Fernandez and I worked on a long time trying to come to some reasonable measure of liquidity, but liquidity expansion has been caused by so many factors (reparations payments, financial innovation, petrodollar recycling, gold accumulation) and rising liquidity can take so many forms (as Mundell shows) that it seemed pretty topugh to come up with a measure. Before he died Frank was working on ways of measuring the “shadow” of liquidity – bid-offer spreads on liquid stocks, LIBOR spreads, on-the-run/off-the-run spreads, etc., but even that proved difficult. I am not sure it is even possible in theory to develop a warning signal. My model of financial crisis suggests that as balance sheets become more unstable and as self-reinforcing mechanisms stronger, it takes a smaller and smaller shock to bring the system down, but shocks are by definition unpredictable. Twofish, I agree with most of what you say except that I think there is good evidence that unstable balance sheets almost always follow periods of monetary expansion. It is the debt that is a typical result of this expansion that creates the balance sheet weaknesses. One small point, in my book I discuss balance sheet instability generally and I try to make the point that currency mismatches – although the most common type in the 1990s – are not the only type. In that light I am not sure I agree that EM countries have built up strong balance sheets. What they seemed to have learned from the 1990s is that financial crises are always caused by currency mismatches. They have successfully attacked that problem, but in so doing they created domestic imbalances. Brazil is a classic case. They have nearly eliminated the currency mismatch but now have a terrible domestic debt structure, partly as a result of their attempts to clean up the external side. Mothersbreast, no double-entendre intended. In this blog I am only interested in discussing China’s financial system and financial vulnerabilities. There are many other things, good and bad, I can write about China, but they would not be relevant. And for the record, for all its problems, including the milk scandal, I think this is one of the most interesting and exciting places in the world and I love living here. Sorry Spermacide, but I am not a property developer and in this blog I am only interested in property prices to the extent they affect the financial system. It hardly seems necessary to say that this isn’t meant to suggest the personal problems faced by ordinary people are not important – it is just that they are not relevant to this blog. By the way I do travel extensively around China and China is most certainly not “doomed”, and certainly not because of its population. China has a great future and some wonderful people but, of course, no rapidly growing poor country can expect a smooth ride. By Michael Pettis - 9/19/2008 4:10 PM

Albeit off topic, if I was a little dismissive of Anastasia Nesvetailova's work on Minsky, I apologise. I looked her up and noted that her first publication on Minsky was in 2005, which was before the bust made him fashionable. By RebelEconomist - 9/19/2008 4:54 PM

Mr. Rebel, No need to be so apologetic. Everyone makes mistakes. And, most, do not care. But, tks for your correction. I still love Hyman, Minsky too. (sorry for the misplaced comma) Still, it was very good of you to check out this lead, and then comment on it. Kudos to you. By Che Guevara Is My Name, And, Rebellion My Game - 9/19/2008 5:03 PM

Giveus, Prof Pettis seems too bemused by idiots with false names to respond to your query, or even to delete what is obviously an irrelvant comment, but actually Wikio ranks business and economic blogs around the world according to readership and links, and this month they rank him 58th in the world, which probably means more than 5,000 hits a day. Check http://www.wikio.com/blogs/top/business. I have seen his blog reproduced daily on other very popular sites, including RGE Monitor and SeekingAlpha, so I would guess that this undercounts his real readership. Perhaps in the future you could stick to the topic, or better, yet, start your own blog. Prof Pettis, I am sure there is no need to tell you that successful bloggers are often stalked by sad, obssessive individuals with little life or ability of their own. Keep up the good work. By John Humes - 9/19/2008 7:49 PM

Dear Mr. John Humes, It seems that you are one of the few among the commentors, who is NOT an idiot, and NOT one with a false name. Also, thank you very much for the link to http://www.wikio.com/blogs/top/business. However, can you please suggest other top blogs which pertain 95% only to China? Thank you very much for your help. By Goodcomment Humes - 9/19/2008 8:07 PM

Spermacide: All of the comments, today, are fun and intellectually stimulating. But, none of the comments even allude to the real economic hardship and the environmental hardship, suffered by the majority of the people in China. That may be because the majority of people in China aren't suffering great economic or environment hardship. Life is tough for people in the interior, but both anecdotal reports and statistics indicate that things are improving, and in any case having the world economy fall apart isn't going to improve their well-being. Pettis: I agree with most of what you say except that I think there is good evidence that unstable balance sheets almost always follow periods of monetary expansion. True, but it is the distribution of the balance sheet imbalance and how it unwinds itself that makes the difference between a minor problem and a full scale catastrophe. One thing that determines how bad things will get when they fall apart is linkage between the systems which expanded heavy and those that didn't. In Japan-1990 the linkage was in the form of bank ownership of stock. In the US-2008, the linkage was the result of securitization and credit default swaps. China will undergo a bust, but how severe that bust is depends on how tight the linkages are between the formal banking system and the informal one, and my suspicion is that the linkages are that tight. By Twofish - 9/20/2008 12:12 AM

Well, Twofish, if you are so interested in having the world economy not fall apart, then, you will be glad to know the following from Reuters, just in: The Bush administration is working through the weekend with the Democratic-led Congress to craft a plan to spend hundreds of billions of federal dollars to purge securities tied to bad mortgages and other assets from bank balance sheets to keep the financial system from collapsing. Now, doesn't everyone feel better knowing that the idiot in the White House is on top of the situation? By @#$%^&**(&^%$# - 9/20/2008 12:46 AM

Also, Twofish. If we can just get another blogger by the name of FiveLoaves, then you and he can feed the multitudes. But, you are ENTIRELY correct. Life is tough in the interior, as you say. By 2Fish5Loaves Feed5000 Noproblemo - 9/20/2008 1:13 AM

Now, people, is the time to break out your copy of THE GRAPES OF WRATH. Yeah, man! Nothing like a good ol depression to put the fear of Allah in everyone. And give us the Good Time Religion. Just, pls mind the jumpers. And, please pass the milk. THANKS. By J.S. Beck - 9/20/2008 2:02 AM