China.org.cn, December 30, 2012

The global financial crisis which originated in the U.S. in 2008 is a precious historical experience for China to see the deleterious effects of the macroeconomic policies of John Manyard Keynes and Milton Friedman.

The U.S. government first implemented a large-scale expansionary monetary policy and then a large-scale fiscal policy. Although these policies have avoided a generalized run on banks, they have not broken the financial oligarchy's monopoly. Neither have they reformed the welfare system or military expansion, which led to a fiscal crisis. These policies have produced a high unemployment rate and sluggish economic recovery.

Recently, the U.S. Federal Reserve announced to expand its third-round quantitative easing program which has triggered global inflation and social unrest. We should be aware of the limitations of western macroeconomic policies and avoid falling into the trap of sacrificing our sustainable development for short-term interests, which Is what the West appears to be doing.

The Keynes-Friedman pitfall

Since the 1930s, Keynesian fiscal policy and monetary policy based on the teachings of Milton Friedman have been seen as an effective tool to save capitalism and avoid another Great Depression. Although these two policy tools have their respective focuses, their goals are confined to restoring the short-term economic balance: this in turn maintains the status quo for vested interest groups.

Macroeconomics attributes market fluctuations to a surface imbalance of aggregate demand. It also denies the division of labor caused by the technical revolution from the supply party and the rises and falls of the powers as well as the structural changes caused by the new world order. It fools people with presumptive regulations based on the theories of mass psychology. But it refuses to make any structural adjustment on politics and economy.

Such policymaking centers on the domestic economy and neglects the influence from international competition on domestic policy in an open economy. Instead of facing problems, Western governments use the neo-classical economics to cover this game of interest groups. With this kind of thinking, it becomes nearly impossible for them to walk out of an economic crisis unscathed.

It was not Roosevelt's new deal that pulled the U.S. out of the Great Depression. It had to wage wars to boost its economy. As I warned at the Melbourne Conference in 2009, if the U.S. does not desire to work with China and the EU to restructure world order, it will not be able to fully recover from the financial crisis.

The Libyan War and the tensions in Northeast Asia and the South China Sea have shown that the U.S. and Western Europe have already fallen into the Keynes-Friedman trap.

The question now is how will Chinese economists learn from these lessons and promote the independent development of economics.

China adopted similar fiscal and monetary policies as other large countries during the 2008 financial crisis, but the effect was much better than those applied in the U.S., Western Europe and Japan. Why? Chinese policy makers understood the pitfalls of applying Keynes/Friedman theories to apply an expansionary fiscal policy while easing monetary policy to fuel domestic demand and lessen international pressure.

Short-term stimulus will aggravate the crisis

Western macroeconomic policies put undue emphasis on the role of the demand side, while neglecting the supply side. Adam Smith, Karl Marx and Joseph Schumpeter all stressed the industrial revolution and the development of the division of labor. This has sped up technological progress and structural evolution. But neo-classical economics creates a myth of consumerism and overstates the self-stability of market competition based on allocation of resources.

Keynes discovered that the shortage of aggregate demand would cause voluntary unemployment, thus justifying a fiscal expansion to boost consumption. However, he did not realize that the real cause of short-term aggregate demand is the rise and fall of industries and their plights in the transition. A high unemployment rate produced by such structural factors cannot be cured by short term fiscal or monetary policies.

The US's problem lies in the excessive debt ratios of its residents, companies and governments at various levels. The high cost of social welfare, military expenses and the U.S. legal system has gradually weakened its companies' international competitiveness.

Consumers and companies do not dare to consume or invest after servicing interest on their debts.

In contrast, China's problem lies in its companies' low profit margins. Most Chinese companies lack indigenous core technologies or marketing channels. Therefore their profits are much smaller than that of Western companies. But if China expands its social welfare or increase workers' salaries largely by administrative means, this may cause mass bankruptcies among the small and medium enterprises. This would be exactly the opposite of its motive to boost consumption.

Whether the purpose of the fiscal expansion policy is to stimulate consumption or to improve companies' core competences, it should be analyzed on a case-by-case basis. Governments should not blindly follow other countries' policies. In China's case, the government should improve the international competence of its enterprises and workers as well as create jobs by developing new industries. A short-term consumption stimulus, in contrast, will squeeze out companies' technological innovation capacity and therefore aggravate the current crisis.

The peril of increasing interest rates

Monetary policy looks easy to operate, but its effect is a double-edged sword. Friedman mistakenly assumed that market prices can be determined by the quantity of money alone. Therefore he thought that monetary expansion can avoid interest conflicts and prevent a financial crisis. But this is only a theoretical fantasy which works in a closed economy without any financial innovation or international competition.

In the shadow of the international financial crisis, the U.S. implemented zero interest rates and a monetary expansion which has triggered a large sum of capital outflow. The money flowed to the East Asian market, which has a high growth rate, or to the European dollar market which has a high interest rate. The Fed monetary policy has become feeble and impotent since the money drain.

The decisive factor of investment is not the borrowing cost, but the future economic growth point or the returns available in various regions or industries.

Therefore, China must be very prudent in its application of monetary policies like increasing interest rates or bank reserve requirements. These policies will not only increase pressure on the RMB revaluation and attract international hot money, but also raise risks on mortgages and SME financing and further worsen the employment outlook for college students and migrant workers.

Systemic reform is more important than price intervention

Neo-classical economics assumes that when market scale or resources are limitless, consumers or investors make decisions independently, and there is no market manipulation or speculation, prices will allocate resources appropriately.

But according to the famous Adam Smith theorem, the division of labor is limited by the extent of the market. If small groups of buyers or investors can own a large percentage of the market share, they can distort the price and create bubbles. So the systemic reform is more important than the price intervention in terms of overall economic stability.

The US's pillar industry – the automotive industry ―suffered a heavy blow during the 2008 financial crisis. The reason lies in the high welfare costs in America. The medical cost per capita in the U.S. is three times of that in Japan and twice that in Europe. One General Motors' worker, on average, has to support four retirees. The welfare costs for running a factory in Southern U.S. is two times than that in Japan, Germany and South Korea. Even though the company has access to the latest technology, it's still in an unfavorable position in terms of international competitiveness.

The Obama administration has tried to intervene in the health insurance market to break the private insurance oligarchy. In doing so, he was accused of implementing socialism and even Nazism. Extending medical coverage to all Americans without raising taxes or affecting vested interest groups is impossible; one of these will have to give if health care reform can be successfully implemented.

Compared with the incompetence of the gridlocked U.S. political system, China has applied bold reforms on the marketing of state-owned enterprises and banks during this crisis. As a result, millions of workers from state-owned enterprises have been laid off.

But China also has to address its problems in real estate, especially the high cost of housing in coastal cities caused by the hoard of speculators and local interest groups. The pilot property tax program only targets new buyers. China must quickly take action to prevent the housing bubble from spiraling out of control.

China must not be led by the nose

The thinking of Keynes and Friedman is to substitute a short-term stimulus of aggregate demand in the place of harder solutions to long-term systemic problems, thus sidestepping the core element needed to regain macroeconomic control - dealing with entrenched interests.

The root of the 2008 financial crisis is the "American disease", huge profits in banking and finance that have squeezed out its manufacturing industry and the real economy. Even after dropping the gold standard, the U.S. dollar still rules the global market with its innovative financial tools.

The financial deregulation implemented in the past twenty years has amplified freewheeling financial speculation. The virtual economy created by financial derivatives is 10 times of the global GDP and almost 50 times of the U.S. GDP.

To cure the financial crisis, the U.S. government must break the monopoly of financial oligarchies and work with other countries to tighten the control of capital flows, enhance financial regulation and limit speculative profits.

However, the U.S. government thus far has avoided pressing for such reforms, instead protecting the oligarchies and exporting the crisis. As a result, its economy is still sluggish. The global economy has been shadowed by inflation and social instability as well.

China should not follow this unreasonable international financial order led by the U.S. It needs to understand its own position, as well as the positions of its rivals, and change its strategy from passive defense to active. China must be brave and visionary and set up its own international financial strategies.

'Global imbalance theory' is unworkable

U.S. Federal Reserve Chairman Ben Bernanke once admitted in his "global imbalance theory" that the root of imbalance is a welfare crisis caused by the aging U.S. population. But he shielded attention away from another heavy fiscal burden — the military expense necessary to maintain U.S. hegemony and the EU's enlargement.

U.S. military expenditures account for half the world's defense spending, and are larger than the sum of the next-highest 15 countries on the list. If it does not make fundamental changes of its military budget, it will not be able to improve its stagnating economy and high unemployment levels.

Bernanke's "global imbalance theory" argues that developing countries must expand domestic consumption and developed countries must increase savings. In doing so, international capital can be redirected from developing countries to developed countries to keep a high-level return and consumption in western countries.

However, this theory is not workable either in theory or in practice. China's coastal mega-cities have fallen into the trap of aging population like their peers in the West. The welfare of residents of those cities is supported by large number of migrant workers, not the bubbled real estate market.

Bernanke's theory is not a remedy to the financial crisis, but a means to shift the crisis onto to the shoulders of developing countries, a plan to maintain the imbalance of resources currently favorable to the developed world.

China has made a good move by promoting settlement of transactions in local currencies among the BRICS. But it has not touched the heart of political ecology in the U.S. and Europe. The Southern European countries are stuck in mire of sovereign debt. If the Euro Zone collapses, the dollar's financial hegemony will be further enhanced.

Only China can help the EU out of the crisis and lessen its dependence on the U.S. The financial crisis has clearly proven that although Western countries still lead the world in technological development, they are now following China in economic development.

The author is a senior research fellow of Academic Committee Center for New Political Economy of Fudan University.

This article was first published in Chinese and translated by Li Shen.