this time really is different – and to inefficient and risky forms of borrowing.  After all during the heady boom times the biggest winners are systematically those that take more risk, so, as Hyman Minsky might theorize, during boom times the whole system tends towards greater and greater risk-taking.

 

Or as the old banking saw would have it, bad loans are made during good times.  Of course during the good times it is generally hard to believe that favorable conditions can so abruptly reverse themselves, so the best strategy seems to be one that effectively doubles the bet, but as I argue in The Volatility Machine, it is precisely those financing structures that magnify the impact of the boom times that make the busts so terrible. 

 

A lot of my blog readers may bridle at my discussing China in the context of “crisis-prone countries”, but before I get swamped with outrage, let me suggest that there is at least the possibility of regarding China as a crisis-prone country from a financial point of view.  And as long as that possibility exists it would be prudent for businesses and government officials to consider the risks very seriously. 

 

There are at least two reasons I would argue that China can be considered crisis-prone.  First, almost every country in history during its stage of rapid development has been crisis-prone, and it is useless simply to assume that China will be an exception – and I note, by the way, that nearly every other country has, at one time or another, considered itself an exception to this rule, to its great subsequent dismay.  Rapidly-growing and rapidly-transforming countries have always been, and are likely still to be, prone to crisis.  China’s economy is volatile, its financial system is rigid and very poor at allocating capital efficiently, and like any country undergoing rapid social and economic transformation, its social, political and institutional structures are unable to change as rapidly as the underlying economic and social circumstances.  All these create the conditions for serious imbalances, whose subsequent adjustments often come in the form of financial crises.

 

Second, and perhaps contrary to consensus opinion, so far China certainly hasn’t been an exception.  Over the past 200 years before 1949, the period I know best, China has had regular financial crises, as many as other developing countries have had, and the only reason these have not been as famous as some of those of other countries, e.g. Latin American countries, is because they occurred at lower levels of debt or with much smaller financial systems.  China’s pre-1949 history certainly doesn’t suggest anything exceptional.

 

From 1949 until the mid-1970s China has not really had a financial system as we would understand it, and so it is hard to argue that it has suffered from the same kinds of financial crises as market economies have, although it did suffer numerous economic crises, including, most spectacularly, the 1958-61 Great Leap Forward.  Over the past 30 years, however, with the re-establishing of a functioning financial system China has had at least three pretty serious monetary and financial crises.  The first, during the period 1985-1987, was a period of high inflation and instability.  Because of the very limited information available it is hard for me to get a very precise sense of the causes and consequences of the crisis, but many of my Chinese friends who lived though the period seem adamant that it was a period of very difficult economic adjustment.

 

Far better known was the second crisis, the 1993-94 inflation and banking crisis, which led, among other things, to the rise of Zhou Rongji and the series of radical and often unpopular reforms he implemented to repair the country’s tattered financial and monetary system.  Finally, in 1997-98 during the Asian crisis, China also experienced a series of sharp financial adjustments, after which time the country’s banking system was massively bankrupt.  I don’t have the numbers in front of me but I believe the World Bank estimated the cost of the banking cleanup at 55% of China’s GDP – making it one of the costliest banking crises of modern times.

 

To return to R/R’s point about sudden large capital inflows, remember that large capital inflows will never occur in countries about which there is a consensus that they are at significant risk of crisis, so please dismiss altogether the argument that China is different and money is entering the country because investors have correctly assessed the risk to be low.  Every country experiencing large capital inflows was firmly believed to be “different” – this is almost a necessary pre-condition for large capital inflows into risky, developing countries.  The point is that today China is experiencing large capital inflows, and historically, according to R/R, large capital inflows have often preceded financial crises.  That proves nothing about China’s future, of course, but it should at least create worry among policy-makers.

 

Third, the widely-held belief that sovereign debt crises are largely external debt crises is incorrect – historically they have been just as likely, or even more likely, to be domestic debt crises.  In fact I have been working on a piece that will argue that the next set of sovereign crises is likely to be driven largely by domestic debt, not external debt.

 

This is a particular important problem in the current environment, and not just for China.  One of the consequences of the Asian crisis of 1997 was the determination on the part of many governments, including that of China, that it was necessary to build balance sheets that would protect them from the re-occurrence of similar currency crises – by limiting external debt and accumulating reserves.  Unfortunately this meant explicitly or implicitly setting up currency regimes that resulted in the monetization of large capital inflows (as central banks created local currency or local-currency equivalents, like central bank bills, with which to purchase these inflows).

 

The net effect has been that the fight to protect national balance sheets from currency and external debt mismatches has led to excessively loose monetary policies which converted these external mismatches into over-extended domestic financial systems, with a wholly different but perhaps equally destabilizing set of mismatches.