James K.Galbraith：China should maintain capital controls

James K. Galbraith Professor, the University of Texas at Austin; Former Executive Director of the Joint Economic Committee of the U.S. Congress

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1、A US recession is possible but not certain

Thank you very much, it’s my pleasure to be with you. I also would like to thank the previous speakers for their very detailed and wide-ranging remarks on a large range of relevant topics.

I'm going to take a different tack here and restrict my comments to the three questions that were specifically posed for the panelists in this part of the program. Before I do that, I do want to acknowledge and thank the organizers and previous commentators for their very kind remarks about the influence of my father. I also would like to call your attention to the fact that four of his books have just now been published for the first time in China by CITIC. This one is “Anatomy of Power”; and this one is “The Age of Uncertainty;” the other two are “Money” and “The New Industrial State.” I hope they will be of some interest.

The first question is, will there be a recession in the United States and a return to high growth in China? It’s a question about business cycles. It is not a question that I feel particularly able to answer directly. I am not an economic forecaster. And to relate a famous remark of my father, he once wrote that there are two kinds of economic forecasters: “those who don’t know, and those who don’t know they don’t know.” We all should bear in mind those words. As a point of amusement, let me add that contrary to many claims on the Internet, it was not my father who said that “the only purpose served by economic forecasting is to make astrology appear respectable.” That remark was made by Professor Ezra Solomon of Stanford University, a Republican who served on the Council of Economic Advisers under President Nixon. So there is bipartisan sentiment in favor of skepticism about economic forecasts. And of all the forecasters one should be skeptical of, the mainstream economists stand at the top of the list. Even though that school claims to have high scientific status, it was completely unaware of the factors that were leading to world financial crisis in 2007-2008. Normally if the apparent laws of physics are violated to such an extent, one begins to wonder whether they really are laws or whether one needs a system of, let's say, planetary motion which is not dependent on epicycles. So, I say again, bear in mind, the forecasting profession is one that does not have a very high reputation.

As a political economist, I can tell you that the Federal Reserve, which is the leading economic policy-making institution in the United States – the agency that tends to act on a discretionary basis when the Administration or Congress are operating on inertia – wants a recession. It definitely wants a recession. This is very clearly implied objective of Mr. Jerome Powell, Chair of the Board of Governors of the Federal Reserve System. His declared objective is to slow down the growth of wages. For wage growth to slow, normally, unemployment has to rise. Unemployment recently has been quite low, though I don’t think that means the United States has a particularly hot so-called labor market. But the fact is that the past pattern of a large reserve of actively unemployed people is no longer there. To get the unemployment rate up, if that's your object, you have to throw the brakes on economic growth. A recession, which is negative economic growth, is normally necessary. Normally, the strategy of rising interest rates will produce a recession after a certain amount of time. That is the stated function of a policy of high interest rates. That is the practice of that policy. That is the result of that policy, many times in past experience.

Let me illustrate this point with a few headlines, that slower wage growth is the objective of the Federal Reserve. That's my article, from the early days of 2022, on the upper left: “The Fed's Target is Workers”. The point has been made by others who are closer to the center of, let's say, financial authority. Forbes, for example, states explicitly, in December of 2022, that 5% wage growth is driving the Federal Reserve to lift the 2023 interest rate target.

Chairman Powell is determined to drive down wages. He often links this to inflation. And yet, in May 2023, after all of those headlines and over a year of rising interest rates, the Federal Reserve itself published a study showing that wages are not driving inflation. This raises a question. If higher worker pay isn't a major cause of inflation, according to the Federal Reserve itself, why are they pursuing a policy of high interest rates, slower growth, recession and rising unemployment?

The whole thing brings to mind, and I hope I'm not making too obscure a literary reference, the great work of Lewis Carroll, Alice in Wonderland, when the red queen proclaims “Sentence first! Verdict afterwards!” Alice, being a sensible young lady, replies “stuff and nonsense.” The Queen retorts, “hold your tongue!” and turns purple. Then Alice wakes up and realizes that she was a dreaming about a pack of playing cards. Unfortunately for Americans, the Federal Reserve is full of stuff and nonsense but it's more dangerous than a pack of playing cards.

In sum, the Federal Reserve is embarked upon a policy which they now themselves admit is not geared to the objective that they proclaimed, namely conquering inflation. It is geared toward a policy they do not admit to directly, namely causing a recession. Given this very basic lack of honesty, it's very hard to take anything that they say that's analytical very seriously at this point. This is not a new problem with respect to the Federal Reserve.

This is a chart of the yield curve, the 10-year bond rate minus the 30-day Treasury Bill rate. It does suggest that a recession is on the way. Historically, after the yield curve is inverted, and then starts returning toward the positive direction, recessions tend to develop. The negative position of the yield curve is exceedingly highly pronounced at the present time and has been for quite some time. So again, by historical patterns, one might well predict and expect a recession.

Politics, I have to add, from some research of my own, also suggests that a recession is coming. Our statistical analysis that shows the Federal Reserve typically pursues a much tighter policy in presidential election years when a Democrat is in office than when a Republican is, after controlling for economic conditions such as inflation and unemployment. Not by coincidence, the Federal Reserve Chair has been initially appointed by Republican presidents for quite a long time with limited exceptions, and Democratic presidents tend to reappoint Republican appointees. Alan Greenspan, Ben Bernanke and Jerome Powell are all examples. In 2024, there will be a presidential election with a Democrat in the White House. Whether the past pattern will hold this year, one cannot of course entirely say. But the statistical pattern is there. I give you a reference to a paper which will be published in a refereed journal sometime soon; it was submitted in 2007 to a committee of Congress, the House Financial Services Committee.

All of those things suggest that there is significant recession risk. But there are qualifying factors. And the qualifying factors are quite important. Let me give you three or four of them.

First, as a result of changed spending habits in the pandemic, the top tier of American households – say the top quartile – is quite rich at this time by historical standards. And so it is not as sensitive to rising interest rates as it might have been, for example, in the matter of durable goods purchases, as these households might have been in past business cycles.

Second, ongoing since 2009, direct payment of interest on bank reserves provides large income flows to banks, which was not the case in business cycles in the 1970s and 1980s. Businesses have not necessarily yet exhausted their credit lines, and banks are not in a position where they're reluctant to make business loans, so far.

The further point is that the federal debt in relation to the scale of the economy is much larger than it was, let's say, in the 1980s when I first came on the scene as a professional economist. At that time the ratio was about 30%; it is now 122%. Therefore, when the Federal Reserve raises interest rates that are paid on that debt, you get very large transfers of cash to the holders of federal debt, in the banking sector, but also in the private household sector. This is a highly regressive transfer, but it nevertheless will play a supporting role through the fiscal channel.

Further still, we're in an interesting period from the standpoint of federal fiscal policy. The Biden administration in its early days enacted a number of major new initiatives, the Inflation Reduction Act, the CHIPS Act, and some other bills, which have the effect of supporting business investment in various sectors of the economy. The Federal budget deficit is presently very high, as everyone knows. And that has a compensating and supportive effect on economic activity.

So the policy of high interest rates has so far not produced an economic slowdown, although many people expected it would. There was a brief slowdown in construction that didn't spread to the whole economy. It's possible, but there's no guarantee, that there will be a general slowdown next year. It's also possible that high interest rates will add to inflation next year and in the years ahead, because for businesses, interest is a cost has to be covered. To the extent that they have pricing capacity, they may raise their prices in order to meet those obligations. With upward pressure on prices and downward pressure on jobs, you get the combination known as “stagflation.”

There is, however, in this picture, a significant wild card, and that is the price of oil. The American economy is very sensitive to the price of oil and to the price of gasoline. The world oil price, about $90 a barrel, has been rising. Major producers, Saudi Arabia and Russia and others, are coordinating output reductions to keep prices high. This is very important for the United States. I live and teach in Texas, so one keeps an eye on these things.

The prospects in the Permian Basin, which is our major source of domestic supply, are uncertain because of reasons of geology and the course of the fracking industry, which has dominated here for a couple of decades. And also there is the profit seeking strategy of private equity firms, which took a strong position in the Basin when the price of oil properties was very low in the pandemic. Further, the US Strategic Petroleum Reserve, which was used in 2022 to break the price of gasoline, has been depleted. Now it's at levels that have not been seen since the 1980s. It's unlikely that it can be used again to the same extent. There is no sign that we'll see price controls, output mandates or any sort of mobilizing factor. So oil will be left to the private market. And it is very possible that rising oil and energy prices could precipitate a recession or a stagflation, if you like, in the United States. We'll see.

2、China Should Maintain Capital Controls for Financial Stability.

As for China, I'm not going to impinge on the expertise of our Chinese colleagues here. I'll just say that a return to strong growth in China is not necessary, it's not likely, and it's not really desirable either. China has moved past the phase of its development in which spectacular rates of growth are necessary to improve the welfare of the Chinese people. Population has peaked, the workforce is unlikely to grow. There are well known surpluses in real estate. The infrastructure is now in far better shape than it has ever been. And China is in a position, a rather enviable position, where it can support living standards, stabilize its resource costs -- which it is doing in part through the Belt and Road Initiative – provide employment, support new technologies and innovative development -- which is clearly happening with some encouragement, it has to be said, from the sanctions policy. We have seen that Huawei is able to innovate around the restrictions on semiconductor sales to China. China can also work to protect the environment.

In each of these cases, the right policy is one of dealing with actual problems as they arise. This has been the historical experience of China in my observation. The growth rate is not an ultimate objective, and it may not be the prime nor the desirable objective so long as other things that are important are being attended to. We can also understand that the growth of GDP is not the same thing as a proper measure of national well being. Whether a particular set of policies that deals with the actual problems that China has, has a strongly positive effect on the GDP growth rate, is in some sense just an artifact.

So let me move to the second question. How can China balance financial openness with stability? I will deal with this very briefly. The answer is it can't. No country can. China can choose to have openness or stability. It cannot have both. In an unstable world economy with a world financial hegemon, the United States, pursuing its national interest through monetary policies – and please don't expect the United States to do anything else – and with underregulated transnational banks also pursuing their own interest – and please don't expect them to do anything else – openness is the enemy of stability. It is the enemy of national control

Stability is important. The Chinese course to a prosperous future depends on stability, which has always been a key priority for China. Openness is not important. Financial openness is certainly not important. So one has to choose, and it's clear, what is the proper choice.

Let me offer a historical footnote. In 1995, I had the privilege of serving as Chief Technical Advisor for Macroeconomic Reform to the State Planning Commission of the People's Republic. In that capacity, I organized a conference for government and university experts on international monetary policy out at Huairou, the site of the International Women's Conference the previous year. I invited the great economist Robert Eisner of Northwestern University, who had never been to China, to come and speak. I set a condition – because I had sensed that the issue was under discussion – that he speak strongly against liberalization of the capital account and in favor of the maintenance of capital controls. He did that.

Of course, one cannot say precisely what forces influenced the government of China to maintain capital controls at that time. But it is clear that in so doing, they helped China to avoid the Asian crisis of 1997. And as Professor Liu Kai already mentioned, they helped lay the foundation for the subsequent success of the Chinese economy. So I consider this story to be something of the case of the dog that didn't bark in the night. This is a reference, my second literary reference of this occasion, to a detective story featuring the famous Sherlock Holmes.

The question also addressed the issue of developing countries. And it's more difficult to make the choice that I'm speaking of if you're a small developing country, then if you're the world's largest, most self-contained economy, China. Developing countries compete with each other. They're vulnerable to divide-and-conquer tactics by global financial powers and global banks. This can produce and has produced on many occasions a regulatory race to the bottom. The best principle is national regulation of national banks and the financial sector generally. But many developing countries may need regional institutions that can maintain regional controls.

China can help establish such institutions in many parts of the world. The key to doing this is to focus on the actual interests of those regions and not to have the institution serving essentially interests of the opposed and contrary entities of the global financial center, which has been the case of the International Monetary Fund in the World Bank, of the Bretton Woods world system, for a long time.

3、Policy Suggestion

Third question: what practical policy suggestions for China and the United States? I will be very direct and blunt about this. I think first of all, the Shanghai Communique of 1972 needs to be maintained. This is clear. That communique stated that all Chinese agree there is only one China and that Taiwan is part of China.

Second, we need to reduce the rhetoric of confrontation with China which is now pervasive in the United States. I was pleased to see actually in the earlier comments that this rhetoric is not pervasive in the discussions offered by our Chinese colleagues. But let's not kid ourselves, the atmosphere in the United States is exceedingly toxic on this point. So let's (in the US) encourage the authorities on Taiwan to negotiate a permanent settlement with the People's Republic. Their interests are not diametrically opposed. There's no reason why they couldn't come to an agreement if the conditions were right and, if they were encouraged properly to do so.

Third, we in the US should reexamine and change the sanctions policies in view of their ineffectiveness, which I think is amply demonstrated. It may not be entirely in China's interest to be free of sanctions, but they are not a positive factor in our bilateral relations. I have a paper, by the way, examining the case of Russia, where the sanctions have greatly supported the rapid national development of the Russian economy in the last year.

Fourth, we must push urgently for a ceasefire in the Middle East and for the implementation of the United Nations Security Council resolutions for Palestine as the only way at this point that we can avoid a rapid move toward very dangerous global conflagration, which may well already be taking shape as we speak.

Finally, we should settle the Ukraine war on realistic terms, which have not been on the table up until now. What is realistic needs to be accepted by all parties. And that should happen as soon as possible.

In short and in general, peace is the best policy. China's rise is due largely to the fact that the People's Republic has remained at peace externally for most of the past 70 years and internally since the beginning of the reforms in the 1970s. With peace, you can do a lot of things. Without peace, you can't do very much. The troubles of the United States stem largely from the drain of constant warfare, which has been going on since the 1950s basically without interruption, along with the strategy of international domination in finance and high technology, which has occasioned industrial decline and declining domestic social cohesion, putting us in a very difficult position. You can't sustain either finance or a high technology position if you don't have the core industrial capacities on which these things are founded. So a strategy of peace and continued interaction with the world would permit to resume development in the United States, which needs it, and around the world.

And that's what I have to say, thank you.

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