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Global Market Volatility: The Role of China, Central Banks and Monetary Policies The Real Risks and the Implications for the Global Economy J. A. Dorn ICTF Global Credit Professionals Symposium, Chicago, April 18, 2016 “Yellen warns global turbulence could hit growth” Financial Times, February 10, 2016 Sam Fleming in Washington China • • • • • • • • China Growth Slowdown Financial Repression Capital Outflows State-Dominated Financial Sector No Free Market for Ideas Politicization of Finance Power vs. Free Markets Supply-Side Economics: Rise and Fall Financial Turmoil • • • • • • • • Since 2008 Unconventional Monetary Policy ZIRP and QE Increased Risk Taking, Leverage A Tiger by the Tail Regime Uncertainty: The Regulatory State Backlash against Free Markets The Debt Trap: Fiscal Dominance Financial Turmoil in EMEs No Monetary Rule • “Monetary policy is by no means on a preset course.” Janet Yellen Semiannual Monetary Policy Report to Congress February 10, 2016 Unconventional Monetary Policy 2008– • • • • • • • • Zero Interest Rate Policy (ZIRP) Quantitative Easing (QE) Negative Interest Policy (NIRP), ECB Search for Yield, Increased Risk Taking Penalizing Savers, Private Investment Pseudo Wealth Effect, Slow Growth Increased Leverage Credit Misallocation ZIRP: Zero Interest Rate Policy QE 1, 2, 3 U.S. Nonfinancial Debt/GDP Global Debt Source: McKinsey Global Institute, 2015. IOR (06.10.08) Plugged up Monetary Transition Mechanism 𝛼 = 𝑀1/𝑀𝐵 Fed Failure “Whatever it takes ….” “Whatever it takes ….” “The ECB is ready to do whatever it takes to preserve the euro.” —Mario Draghi (2012) “Mario Draghi Throws the Kitchen Sink at Europe’s Economic Distress. Again.” New York Times Neil Irwin, March 10, 2016 “Whatever it takes …” Expiration Date on Zimbabwe Dollar (2008) The Limits of Monetary Policy • • • • What Monetary Policy Can and Can’t Do Overburdening Monetary Policy Good vs. Bad Deflation Simple Rules for a Complex World (Richard Epstein) • Hubris • Importance of Sound Monetary Regime INSTITUTIONS MATTER The Wealth of Nations “The first and chief design of every system of government is to . . . prevent the members of society from encroaching on one another’s property, or seizing what is not their own.” —Adam Smith (1762, Lectures on Jurisprudence) Adam Smith in China, SWUFE A Simple System of Natural Liberty • “[If] all systems either of preference or of restraint” were “completely taken away,” a “simple system of natural liberty” would evolve “of its own accord.” • Each individual would then be “left perfectly free to pursue his own interest in his own way [provided] he does not violate the laws of justice.” —Adam Smith (1776) Ideas Matter “Society’s course will be changed only by a change in ideas.” —F. A. Hayek “Ideas and leadership are the two most important forces in all institutional changes.” —Weiying Zhang Principle of Spontaneous Order • “The most important central principle in economics” (J. M. Buchanan, 1979) Hayek on Spontaneous Order “Under the enforcement of universal rules of just conduct, protecting a recognizable private domain of individuals, a spontaneous order of human activities of much greater complexity will form itself than could ever be produced by deliberate arrangement, and in consequence the coercive activities of government should be limited to the enforcement of such rules.” —F. A. Hayek (1967) F. A. Hayek Freedom and Development “I regard the extension of the range of choice . . . as the principal objective and criterion of economic development.” —Peter Bauer Peter T. Bauer Hong Kong’s Development Model • “Big Market, Small Government” • Trade liberalization widened the range of choices open to people. • Capital freedom increased investment possibilities. • Entrepreneurship thrived in a climate of limited government, rule of law, and freedom. Hong Kong 1938 Hong Kong Today The Miracle of Freedom Financial Freedom 100 Hong Kong 90 United States 70 60 50 World 40 30 China Source: Heritage Foundation/Wall Street Journal, 2016 Index of Economic Freedom . 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 20 1995 Financial Freedom Score 80 FREEDOM AND ORDER COMPETING VISIONS Xi Jinping’s View of Freedom and Order “Freedom is the purpose of order, and order the guarantee of freedom” (WSJ Interview, 2015). View of Market Liberals • Freedom is not the purpose of order. • Freedom is the source of an emergent order. • “The ‘order’ of the market emerges only from the process of voluntary exchange among the participating individuals.” —James M. Buchanan (1982) The Invisible Hand • China needs “to make good use of both the invisible hand and the visible hand.” —President Xi Jinping (2015) • But the invisible hand doesn’t work well without the freedom that stems from widespread private property and limited government. Wu Wei & Spontaneous Order • “Through my non-action, people are spontaneously transformed.” • “Through my non-interfering (wu wei), people spontaneously increase their wealth.” —Lao Tzu (6th century B.C.) Lao Tzu The Tao of the Market “When all work willingly at their trade, … things will appear unsought and people will produce them without being asked [commanded].” —Sima Qian (Han, 206 BC to 220 AD) Sima Qian The Tension between State and Market • “When taxes are too high, people go hungry.” • “When the government is too intrusive, people lose their spirit.” • “Act for the people’s benefit. Trust them; leave them alone.” —Lao Tzu Spontaneous Order and the Rule of Law • Spontaneous order is not independent of the institutions w/in which individuals make choices. • Han Fei Tzu blended Taoist thought with Legalism (3rd century B.C.): Rules are necessary to ensure that freedom generates harmony by limiting state power and adhering to equality under the law. Han Fei Tzu’s Liberal Legalism • Self-interest postulate • Theft vs. voluntary exchange • Need for laws against plunder by individuals and the state. Confucian virtue is not sufficient for social order. • The ideal of “Great Good Government”—If everyone is subject to the law and people are free to choose, social and economic harmony will result. Han Fei Tzu Equality under the Law • “When ruler and minister, superior and inferior, noble and humble all obey the law, this is called having Great Good Government.” —The Kuan Tzu Li Keqiang’s Vision • “Everyone is equal before the law.” • Government should “eliminate roadblocks and pave the way for people to tap their entrepreneurship.” • Fight corruption and rent seeking by “institution-building.” —Li Keqiang (2015) China’s Challenge • “To get the relationship right between the government and the market.” • To defeat vested interests—”taking a knife to one’s own flesh.” • To boost the “vitality of the market.” —Li Keqiang (2015) A Free Market for Ideas • More freedom, less power. • “When the market for goods and the market for ideas are together in full swing . . . Human creativity and happiness stand the best chance to prevail.” —Ronald Coase and Ning Wang (2012) Dornzi RISKS AND IMPLICATIONS FOR THE GLOBAL ECONOMY Risks • “Inciting more spending through taking on higher levels of debt . . . cannot go on forever.” —William R. White (OECD 8/14) • Dollar liabilities of foreign borrowers • Fed’s exit strategy and rate normalization • Asset bubbles • Government debt resistance • Letting the Tiger’s tail go • TBTF Implications • Structural Change Difficult but Necessary for Long-Run Growth • China and the U.S. • Avoiding a Trade War • Ending Fiscal Dominance and Financial Repression • Creating a Harmonious Global Financial Regime “Monetary Policy Is Not a Panacea” A Tiger by the Tail