Did Financial Innovation Cause Deng Xiaoping’s Economic Reforms?
Eugene Fama makes a curious claim on behalf of financial innovation since 1980:
But suppose we buy into the more common negative current view of finance. There is still a big open question. Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. Despite any role of finance in the current recession, are the market naysayers really ready to argue that worldwide wealth would be higher today if financial markets and financial institutions didn’t develop as they did?
A banker in Frankfurt put this same point to me, apparently believing it’s a brilliant argumentative trump card. In reality, it’s a bit nuts—it’s relying on a post-1980 boom that didn’t happen. The United States didn’t start growing faster in 1980:
The claim you’re supposed to make on behalf of the post-1980 US economy isn’t that it’s grown faster (it hasn’t!) but that it’s been less variable than was growth in the early postwar decades. That’s why the term “Great Moderation” was termed. Except in the wake of the current bust, it’s clear that no such decrease in variation was actually achieved. Growth has been the same as it was before, and yet median income growth has been substantially slower. In Europe and Japan growth post-1980 has been much worse than growth was in the previous decades.
The place where growth really has been much better since 1980 than it was before is China. This is not a fact to be neglected. Chinese growth has been very rapid, and very consistently maintained. And a very large number of people live in China, people who started this process being very poor. The past 30 years’ worth of economic growth in China have done an enormous amount to improve human welfare.
But the cause of this turnaround pretty clearly wasn’t financial deregulation in the developed world. It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy. This doesn’t strike me as even remotely debatable. When we look at impressive growth over the past 30 years were looking at policy shifts in China, the success of container shipping, and to an extent shifts in developed world trade policy.
32 Responses to “Did Financial Innovation Cause Deng Xiaoping’s Economic Reforms?”
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November 5th, 2009 at 1:51 pm
There’s a lot of imprecision and suggestion in that quote, no coat can be hung on that. “The way they did”? Who’s to say it wouldn’t have been greater had a smarter method been employed? How are we measuring the actual positive impact of what did occur against other means? Who is actually arguing we don’t need a financial system to move savings around to productive investment?
November 5th, 2009 at 1:54 pm
Actually, “financial markets and financial institutions didn’t develop as they did?”.
I second most of what Matt is saying too.
November 5th, 2009 at 2:02 pm
Where did Fama reference “financial innovation” or “financial deregulation”? He is just standing up for the importance of the very existence of financial markets and financial institutions. And even if his argument is wrong in some details, I think he has a point about those things being useful, even if it would have been better if they had been less innovative and much more tightly regulated.
By the way, Justin Fox has responded.
Justin seems like a smart and reasonable guy without a dog in the efficient markets debate, and it seems clear to me he has come around to the view that the EMH as understood by academics wasn’t really the problem. He now has a more complex thesis about the EMH as (mis)understood by regulators, central bankers, and other important players being a problem, and that is likely true–I certainly think a lot of people oversold the implications of the EMH for various purposes.
November 5th, 2009 at 2:04 pm
It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy.
Forget “moving away from central planning”. Joining the global economy was the key.
I wonder if MattY has any idea just how much neoliberal BS he has internalized.
November 5th, 2009 at 2:08 pm
Who is actually arguing we don’t need a financial system to move savings around to productive investment?
I don’t if anyone has put it that way, but I have seen people like Matt argue as if they really didn’t see any value at all to finance. And the practical issue is that as we think about how to restructure and re-regulate the financial industry, you won’t get very far unless you have some basic sense of what counts as baby versus bathwater.
November 5th, 2009 at 2:10 pm
“It doesn’t matter if the cat is black or white – so long as it catches the mouse.” (Deng Xiaoping)
Incidentally, an excellent book detailing Deng’s rise to power after being forced into a life of misery by the Cultural Revolution is Harrison Salisbury’s THE NEW EMPERORS: CHINA AFTER MAO. The little man always had Mao’s eye and he just couldn’t quite bring himself to kill him.
November 5th, 2009 at 2:11 pm
It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy. This doesn’t strike me as even remotely debatable.
I’m not clear they moved away from central planning, exactly. Basically most of the factories are still state-owned. And a lot of their output is similar to old Soviet output, simple and often well-designed but of low production quality. Further to that, I did see it suggested that they were simply giving away containers for container shipping.
What they did was people to take some for themselves, started attempting to export to the West, and actually paid attention to what various capitalists wanted in factory production.
They DIDN’T really open themselves to the West. That would threaten the CP, and anyways, if the western capitalists had been allowed to run the industrialization of the China, the place would probably have wound up even more miserable than before. (cf the Congo.)
max
['It also helped immensely that the Western capitalists were eager to fuck their own workers as much and as often as possible.']
November 5th, 2009 at 2:14 pm
I think there is value in financial markets. Lets set a target that the overhead cost of the financial sector be about half of what it is now.
November 5th, 2009 at 2:21 pm
The “genius” of Deng’s reforms was to say: China should stop following the crazy, stupid policies Mao came up with. So after thirty years, the country came back from the abyss, and now the average Chinese is about as well-off as the average African (although in much better health and slightly better educated). Nothing that impressive, yet.
November 5th, 2009 at 2:21 pm
I think there is value in financial markets. Lets set a target that the overhead cost of the financial sector be about half of what it is now.
If you make finance boring and low-margin again, this problem will basically take care of itself.
November 5th, 2009 at 2:24 pm
The Brook Lapping doc, “China’s Capitalist Revolution”, is well worth a look — though you’ll have to do a bit of trawling in the murk to find it online.
November 5th, 2009 at 2:36 pm
[...] Matthew Yglesias catches Eugene Fama making a strange assertion: Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth. [...]
November 5th, 2009 at 2:46 pm
There might be a slightly better argument for INDIA here, where increased liberalization and openness to foreign investment (coupled with developed-world policies that allowed more capital to flow to these developing states) actually did lead to some impressive growth.
But I agree that it’s far from universal.
November 5th, 2009 at 2:48 pm
It was policy shifts in China—the process, commenced by Deng Xiaoping, of moving away from central planning and joining the global economy. This doesn’t strike me as even remotely debatable. When we look at impressive growth over the past 30 years were looking at policy shifts in China, the success of container shipping, and to an extent shifts in developed world trade policy.
Don’t forget catch up growth. That is the term you are looking for. That is what is happening in China right now.
November 5th, 2009 at 3:05 pm
There is little argument in management theory about the efficacy of central planning. GE does it, Japan does it, S. Korea does it.
Japan funneled private savings to banks and then on to industries. Manufacturers were encouraged to adopt quality control systems. Inter-company cooperation was encouraged.
In fact, Japan is probably more centrally-planned that China. The Japanese are more amenable to regimentation, while the Chinese are more like a herd of cats.
The dispute isn’t really a theoretical one about central planning, it is a political fight about WHO does the planning. GE is all for central planning inside GE. But outside GE, the possibility that government central plans might not favor GE are too real to risk.
November 5th, 2009 at 3:07 pm
MY re: central planning
Matty, I am personally coming down to Washington to give you the double dipsy doodle combination. Do you want to know what it is? Sorry, old chap, I keep it a secret. But this is the result.
http://www.youtube.com/watch?v=TWFh0Yg49Rw
We are hung up on words. Central planning. Soviets. Command-Style Economy. FAILURE!!!
Let’s call it a Firm Guiding Hand. Let’s call it something. But let’s acknowledge that China’s central government has a plan.
Do we have a plan, Matt? Does Steven Chu over at Energy have plan? Is he preparing the nation for the inevitable oil shock that is just around the corner? Fuck no. He can’t. He is powerless.
Can the US build a Smart Grid, Matt? Obama doesn’t think so. He knows there are 231 state regulatory bodies that would have to sign off on any major changes, and 500 different corporations that own pieces of our existing grid. Obama took one look at hurdles and said “fuck that.”
China is building a Smart Grid. China is building the largest road network in the world. China is building the largest HSR network in the world, and not just for passengers, but for cargo as well. China is going to provide Universal Healthcare. China’s government and its citizens are working together to buy all the world’s precious minerals. China is will have the most electric cars, the most wind turbines, and the most solar panels on the planet within five years. All this is directly planned for, paid for, or subsidized by the central government.
I could list 20 more things off the top of my head that China’s government is planning or in the process of constructing. Are they going to get everything right? No. But China’s central government has a solid vision for the future of their nation and for the citizens in their care. And isn’t that a better idea than for a nation to appoint a few Wall Street financiers and foreign bankers to make all its decisions for them.
Let’s face it, Matt, the United States is centrally planned too. The difference is we are centrally planned from a different location than the center of our government. In our case, our central planning occurs on Manhattan.
November 5th, 2009 at 3:23 pm
the question is whether overall, financial liberalization contributed to the Great Moderation, ie free financial markets act as an automatic stabilizer or destabilizer.
for instance, if you can still get credit when you’re between jobs, you won’t cut back spending as much. on the other hand, if everyone is overextended and over-levered, a small drop in income leads to ruin.
November 5th, 2009 at 3:28 pm
– Eugene Fama, November 2, 2007.
November 5th, 2009 at 3:36 pm
Re Professor Fama’s assertion, I think the give away words start at the sentence when he states “It is reasonable to argue” and by the end of the paragraph he is concluding, completely data free, that financial innovation was key to all that growth. This from a Nobel Prize nominee. And these people think of themselves as “scientists.” Ah, Bartleby, ah humanity.
I think MAX424 has a good point right now about where the decision makers in the U.S. are, and has been since the early 1980s, and it may be reduced to two places, the headquarters of Goldman Sachs and J.P. Morgan. he also makes a good point about the quality of the decision making.
November 5th, 2009 at 3:39 pm
Well, did that liberalization alone do it? India has a large, well-educated sector of its population that speaks English. That had to provide an advantage as well.
Of course, there’s a good chance English’s primacy as a lingua franca may fade in the coming decades, so that advantage may not be a long-term one for India – or any other developing country with a similar population.
November 5th, 2009 at 4:36 pm
To quote Tall Paul Volcker, and shake my fist at the bullshit idea that financial “innovation” drove Deng’s reforms, the only worthwhile financial innovation of the last thirty years has been the automatic teller machine.
November 5th, 2009 at 4:45 pm
Matthew and Krugman are being tendentious. Fama didn’t say that the remarkable growth began on January 1, 1980. He said early 80s. In particular, beginning in 1983.
Matthew’s chart actually proves the point. For the 10-15 years before 1983, there are a LOT of red dots (growth below 1%). The period from 1983-1990 shows NO red dots.
November 5th, 2009 at 4:49 pm
But the average rate of growth was precisely the same.
November 5th, 2009 at 5:16 pm
What about South Korea, India, Brazil, Taiwan and other, non-China developing countries? How’d they do?
November 5th, 2009 at 5:20 pm
But the average rate of growth was precisely the same.
That seems doubtful.
November 5th, 2009 at 5:34 pm
Excellent post of course.
Fama’s crazy argument doesn’t even attempt to reach the crazier alleged conclusion suggested by your title. You have him claiming that financial innovation caused increased growth. He just referred to “financial markets and financial institutions.” Even he doesn’t pretend to present evidence that new financial products such as MBSs, CDSs, CDOs, and so forth played any role.
Now rapid Chinese growth could have been due to plain old finance in the form of foreign direct investment and loans to China. Neither would have been a financial innovation in 1900. The other problem, of course, is that the huge flow of capital has been from China to the USA.
Clearly Fama is deeply convinced that US growth spead up under Reagan. He is a Republican after all. The modest performance of US GNP in the 80s is unpossible. In fact, the pattern was that there were 2 severe recessions (one under Reagan and under Ford) which made the later Reagan Bush years look not so bad by comparison.
Aside from that, a slowdown starting basically a year after the Republicans took the White House (just looking at the data one finds the break in 1970) and a speed up soon after a Democrat not named Carter was elected. To Fama, this just can not be, so it isn’t.
November 5th, 2009 at 5:39 pm
Average growth, of course, was not the same after the great moderation as it was before. It was less. In the 25 years before 1980, US growth averaged 3.6% per year, since then it’s been 2.7%.
It’s hard to see any broad benefits from financial innovation in the macro US data.
November 5th, 2009 at 5:42 pm
In the 25 years before 1980, US growth averaged 3.6% per year, since then it’s been 2.7%
Again, early 80s – i.e., 1983 – not 1980.
Reading comprehension apparently isn’t the strong suit of the left wing crowd.
November 5th, 2009 at 10:17 pm
It seems to me that January 1983 is a good date to start your analysis if you want to do analysis starting in a trough (NBER trough dated at November 1982). Sometimes, this is legitimate: i.e., comparing trough-to-trough business cycles. However, if you’re going to use it as as an arbitrary dividing point (e.g., 1973-1983 as “before,” 1983-1993 as “after”), then this is going to make “after” look better.
November 6th, 2009 at 12:42 am
Dude! Matt! You totally buried the lead with this one man! Luckily, two of the best macro-economists in the world (Krugman and Delong) gave context some context to your humble little blog post. All the same, kick-ass post. It is time to kick the “desalinators” out of the “estuary”! Down with freshwater! Down with Chicago! All hail saltwater!
November 6th, 2009 at 4:39 am
@30 Shmoe: “Down with freshwater! Down with Chicago! All hail saltwater!”
I’m with ya Shmoe. I would rather drown in saltwater than take one sip of freshwater with those stupid fucks at the Chicago School.
So much evil unleashed on the world all from one little university. The planet would have been better off Enrico Fermi had accidentally blown the place up in 1942.
November 6th, 2009 at 5:46 pm
Matthew: comparing the volatile US economy prior to 1980 to the more stable, less explosive growth afterwards should have flagged the need to integrate the quarterly GDP over time. In this way you could have seen how much growth was actually accumulating, before simply waiving away the “post-1980 boom”. See a five year average I constructed from the same BEA quarterly GDP data here:
http://i38.tinypic.com/qnpbq1.jpg
This five year running average shows that by 1989 GDP was averaging almost 3%, which had not been seen since 1968. Not as strong as the mid 60’s and mid 50’s, but the 80’s earns my boom label.
Regarding the developing world GDP, what possible relevance do you imagine is obtained by aping Krugman’s averages of nearly the ENTIRE developing world, when Fama clear says “SOME BIG PLAYERS in the developing world”? When I first read that, I I immediately thought South East Asia: Hong King, Singapore, China, which all boomed in the 80s/90s (minus the Asian crisis). I thought of anything BUT Cuba, Bangladesh and the like included in Maddison’s data. Indeed, Fama further qualifies by referring to money flows from the developed to the developing world, and SE Asia, Russia, E. Europe is where that money went for awhile, NOT the Dominican Republic.