Research

Case studies in centralization: Europe and China

The "big danger" facing Europe today is not the collapse of the Eurozone, but the drift toward a more centralized fiscal union, according to Nobel Prize Laureate and Regents Professor Edward C. Prescott. He spoke at an executive forum held June 9 at the Shanghai National Accounting Institute. The forum preceded that afternoon’s graduation ceremony during which 110 top Chinese business and government leaders were awarded the W. P. Carey Executive MBA.

By Bill Marcus

2012-06-20

The "big danger" facing Europe today is not the collapse of the Eurozone, but the drift toward a more centralized fiscal union, according to Nobel Prize Laureate Edward C. Prescott.

"Is the collapse of the Euro system something to worry about? No," said Prescott, who is also a Regents Professor of Economics at the W. P. Carey School. He spoke at an executive forum entitled "Globalization of Financial Systems: Opportunities and Challenges for China," held June 9 at the international conference center of the Shanghai National Accounting Institute. The forum preceded that afternoon’s graduation ceremony during which 110 top Chinese business and government leaders were awarded the W. P. Carey Executive MBA.

Prescott said setting up the Euro monetary system in 1999 was folly to begin with. "Economists were skeptical when it was set up. It was done for political reasons and it wasn't thought through." But with defaults of Greek bonds and Spanish, Italian, Irish and Portuguese banks looming, one school of thought has held that aid packages may not be enough and that a fiscal union, though politically unpalatable, may be necessary. Prescott weighed in on that possibility in a interview before his speech: "You don't want to have centralization. What happened when China centralized? China was leader in the world - the Ming Dynasty came along, centralized, and technological regression set in. And a few people came in from the other end of the Euro-Asia landmass and totally humiliated the Chinese empire with the Opium Wars."

At the start of the 1400s, China, then a world economic leader, withdrew from global interaction. Three hundred years later, when traders were permitted to interact with Chinese under restricted conditions, British merchants began selling Chinese opium. By 1839 massive Chinese gold outflows lead agents of the emperor to intervene, destroying opium shipments. British military retaliated, resulting in the skirmishes known today as the "Opium Wars." The era is understood today by the Chinese, who downplay domestic failures that lead to their collapse, to be a historical period of national disgrace marked by the loss of territory, the invasion of foreign forces, and the eventual fall, in 1911, of China's last dynasty.

Prescott, commenting on globalization, noted that technological transfers which encourage economic growth flourish when there is trade between economically sovereign states.

"Competition and decentralization promotes productivity. This is an empirical fact," he said. Crucial to China becoming one of the rich advanced industrial countries is developing its high tech multinationals. He singled out Shanghai Electric Company, Ltd., a manufacturer and seller of nuclear reactors to Europe as one such company. He described the company as a modern day Chinese version of General Electric.

Foreign direct investment by multi-nationals, such as Shanghai Electric, is a great social invention: “This is the way that the know-how can be exploited not only in one place, but in locations throughout the world," he told the graduates.

An aging Europe and its labor laws

Prescott said Europe's problem is that it is aging. "They have no choice except to reform. You can't sustain unsustainable trends."

Those trends, he said, include early retirement policies that depress output and employment, and increases the burden of financing the consumption of retirees. Higher tax rates just will just depress their economies and reduce tax revenues. By bailing out member states, he said, policy makers would fuel addictive tax and spending policies without the restraint naturally engendered by competition, thus creating a moral hazard and a propensity to spend more, irresponsibly.

"The whole problem is demographics. There's a shortage of savings opportunities," said Prescott. "Europe is getting old."

By changing labor laws and forcing later retirements, the nations of Europe would reduce the need for savings because retirement life would be shorter, he said. Investment opportunities would also increase, since the working population would be larger, he said.

Prescott said European labor laws -- which allow retirements in Greece at age 50 -- and high marginal tax rates, have resulted in hours worked per person being 30 percent less than in the United States. These policies need to be ended, he said. "The last thing countries need is some centralized authority telling them how to spend their money. They'll just use this as their excuse to increase tax rates and to depress their economies further."

"Competition between countries has lead to corporate income tax rates falling throughout the world. All students of public finance agree: that the corporate income tax is bad. It makes future consumption more expensive in terms of current consumption and this depresses savings, he said. "It reduces the welfare of the people by a large amount."

Bailouts

Of the Euro, he said, "its benefits are modest.” The nations that stayed out of the Eurozone - Denmark, Sweden and the UK -- have done better. "Countries pulling out of the Eurozone will result in only minor consequences for output and employment of a country."

"A good system is to have markets evaluate credit worthiness," said Prescott, arguing that lenders should accept their losses if they "do bad evaluations." He added: "German and French politicians, I say, are as corrupt as the Greek politicians. They foster irresponsible lending to unsound creditors, which is why I say they are corrupt."

Citing the writings of fellow economist Thomas J. Sargent, who won the Nobel Prize for economics in 2011, Prescott noted the history of several U.S. states that defaulted in the early 1840s. Lenders suffered losses, and these states could not borrow. This financial crises did result in half the states rewriting their constitutions to require their annual budgets to be balanced.

Prescott said he saw similarities between the two crises: America in the 1840s and Europe 2012. "These defaults did not depress the U.S. economy significantly.

According to his February 1 paper titled "United States then, Europe now," Sargent argued that a moral hazard was created by the nationalization of the Revolutionary War debt held by the states in 1790. In writing the present-day constitution, Sargent said, the nation's founding fathers first "rearranged fiscal affairs and then approached monetary arrangements as an afterthought."

But, Sargent points out the central government bailout of the states in 1790 was "comprehensive," while European states now only seek loans. Americans, many of whom were slaves, were also poorer at that time, and most people worked until they died, with few saving for retirement. The U.S. federal government of 1840 also redistributed a minuscule amount of its GDP, while European states today often provide medical, unemployment and disability insurance to their citizens.

Central bankers throughout the globe as well as the International Monetary Fund say they fear that bank runs and another credit market freeze -- similar to the one that followed the collapse of Lehman Brothers and the American housing financing crisis -- could result from a Eurozone collapse. The social, political, and economic upheaval had been predicted to be severe.

[Eurozone ministers agreed to lend Spain up to 100 billion euros ($125 billion) to recapitalize the bad debts of its banks making it the fourth and largest member of the monetary group to ask for a bailout. The other three are Italy, Portugal, and Greece. Greek voters go to the polls June 17 after declining earlier this month to form a government willing to make deep cuts upon which a German bailout was conditioned. Ireland's economy is also weak, but is making some deep cuts.

The Renminbi

In addition to his remarks on the Eurozone, Prescott suggested that it would be "neither a good thing nor a bad thing" if the Renminbi (RMB), the unit of Chinese currency, were to ascend to become a reserve currency, but to accomplish this, the RMB would have to be convertible. He said China could peg the value of the RMB to the US dollar or peg to its price level but not both. Up until 2005 China's RMB was pegged to the dollar. Today it is pegged to a basket of currencies which includes the dollar and the Euro. The peg is a creeping peg and there has been some appreciation of the RMB relative to the US dollar.

Prescott suggested China maximize its wealth by developing its domestic technology -- much in the same way it constructed the Grand Canal in the 14th century -- and export that technology. He suggested China use some of its accumulated foreign reserves, now totaling more than $1.5 trillion, to finance its foreign direct investment. "This means developing high technology industry and making investments that broaden these industries," he said. "China needs to make a lot of investments abroad with their knowledge and know-how." He added "China would be a lot richer if it did this."

But with a nod to the aspirations of central planners and their supporters in the audience, and those with whom he has met during his eight visits to China, he outlined how far the nation has to go to achieve the same goal as Switzerland, whose Franc is a secondary reserve currency. "China does not have this long reputation of fiscal stability as does Switzerland."

To be encouraged to invest in China, he said, foreigners need assurances their technology "will not be expropriated or stolen."

Japan provides an example of how stifling competition hurts the economy, he noted. There, foreign banks are highly restricted, and Japanese banks are not as productive because they do not have competition.

He predicted the Chinese stock market would become the biggest in the world because Chinese retirees need investment vehicles to save for retirement. Toward that end he suggested China privatize its highway and high speed rail system and further reform its tax system as this would increase private savings opportunities.

He also suggested that China embrace a financial system that enables its workers to channel their savings into investments by creating a system in which risk can be hedged, diversified, and shared. This would encourage medium and small enterprises to thrive and create what should be the largest stock market in the world. Countries need to create places where aging populations can save for retirement, he said. "My advice is to start thinking about that now."

Economic Development & International Trade Economics