Whose Financial Crisis?

Posted by: Michael Mandel on July 13

Brad DeLong steps into my debate with Brad Setser over the impact of the trade deficit. He’s worried about the possibility of a financial crisis, writing:

By the end of 2003 I said that the chance of a major dollar-based financial crisis was one-in-a-hundred, and it was time for keeping that probability from growing any higher to become the highest economic policy priority.
By the end of 2004 I thought that the chance of a major dollar-based financial crisis was one-in-ten.
Now I think that the chances are one-in-five.

I agree with Brad D. that there’s a good chance of a financial crisis (remember that I’m the guy who wrote the book The Coming Internet Depression in 2000—I’m very aware that there’s an abyss out there).

However, I think that the financial crisis is much more likely to hit China than the U.S. Here’s my reasoning:

1) The U.S. has overinvested in housing, a market where the demand is not going to disappear overnight. By contrast, China arguably has massive overinvestment in factories of all types. Capacity is expanding at an exponential rate in many industries, with little regard to profitability. That’s a recipe for a boom-bust scenario.

2) The U.S. has a well-developed financial system, where risks are distributed and the well-tested regulators at the Fed stand ready to act if necessary. China, by contrast, has a first-rate economy connected to a third-rate financial system regulated by a communist government, with enormous amount of hidden debts and obligations. That raises the chance of a potential disaster if and when the bust comes.

3) Financial systems run by positive feedback. When things are good, investors pile in, but when things start turning sour, investors head for the door. That’s why financial crises cannot heal themselves—they require government regulators to step in. The regulators have to do two things. First, they have to pump money into the system to restore confidence. Second, they have to close down the banks or other institutions which are truly underwater—in effect, forced writedowns. That’s what the U.S. did during the S&L disaster of the 1980s, and that’s what the Japanese failed to do during the 1990s.

The problem is that faced with a financial crisis, the Chinese government will find it easy to pump in money—after all, it’s got plenty of reserves. However, the government will have a very hard time closing down the money-losing state-run factories and banks without triggering a political crisis.

In fact, I would guess that a financial crisis in China over the next five years, followed by a political crisis, remains the most likely scenario.

Let me put it this way. The global financial system is clearly under stress. Which part is more likely to break first—China or the U.S.?

TrackBack URL for this entry: http://blogs.businessweek.com/mt/mt-tb.cgi/

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

BW Mall - Sponsored Links

Buy a link now!