In our modern age more than ever the world appears smaller.

The actions of others are no

longer isolated and have an impact on others. The interactions between the United States and Asian
countries (particularly China) are evidently important to the current world crisis. The current economic
crisis is directly intertwined with the market interactions of China and the United States. Although each
party did not intend for this crash, the failure of each side to make the difficult decisions and
willingness to continue the status quo besides its forewarned dangers subsequently led to the current
economic crisis.
China has recently grown and developed into a major player in the global market. However, for
the most part of the twentieth century China was an underdeveloped country that had to learn what was
necessary to bring itself into the running with the other main participants of the world economy.
Fortunately, there were many other countries before China that had already gone under development
from which China could learn from. One of the models for Chinas development was its neighbor
Russia. Russia was a lesson of error without the trial for China; both China and Russia had their
foundation in Communism but to compete in the world market both would eventually stray into
capitalism. However, each country utilized a different approach.
China learned from its communist comrade what not to do during a transition from an economy
under control of a totalitarian regime to a more open market. In the late 80s to early 90s the USSR was
on the verge of collapse. The drop in oil prices and lack of foreign exchange reserve to buy grain forced
the Russians to turn away from communism. The democratization of Russia consequently weakened the
central government and with the guidance of American economists, the country began to privatize its
market. It was believed that in order for Russia to compete, it needed to privatize quickly. This sense of
urgency was due to the fear of Communist resurgence, the lack of organization of those against
privatization and most importantly the fear of Russia trailing back into the state of a third world
country.(Cohen and Schwartz, 5) However, the privatization was not enough to carry the market. There
needed to be a public administration that would act as a retaining wall: a functioning democracy.(Cohen
and Schwartz, 6) Privatizing ownership was not enough. Big companies and markets both require

external structures of law, finance, and regulation. The state, while the economy is in development,
must control imports and oversee the flow of capital while controlling substantial portions of major
industrial assets.(Cohen and Schwartz, 8) China learned from Russia and maintained strict control over
their market and society and then subsequently opened up the system to a free market more gradually.
An advantage that China enjoyed was not only learning the benefit of learning from Russias mistakes
but also the opportunity to reform with a functioning government that was far from a disintegrating
hollow shell of a once powerful institution. Soon, China with the right policies, have huge scope to
grow rapidly by importing capital, ideas and techniques from developed economies and using rich
countries markets as a springboard for growth. As a latecomer, China does not need to reinvent the
wheel, but rely to open its economy to ideas from the rich world. (The Economist, 6)
Before the reforms of its earlier more constrained regime to its later more open market,
Chinese trade took place within the context of a planned economy and therefore nearly all trade was
subject to very exacting quantitative guidelines.(Branstetter and Lardy, 4) Neither exports nor imports
were sensitive to exchange rates or relative prices and China did not capitalize on its comparative
advantage.(Branstetter and Lardy, 4) Instead of exploiting its available resources like good
infrastructure and an educated work force before the reform, the focus remained upon capital-intensive
goods including refined petroleum products. (The Economist, The Great Leap Forward) (Branstetter
and Lardy) Interventions by the government stagnated Chinas economy and it is apparent that as
Chinese policy grew lax the economy capitalized and grew.
Over the 1980 through the 1990s, China experimented with different ways of opening up the
market but the initial trials were complicated. As the authorities phased out the direct quantitative
planning of imports and exports, they began to rely more heavily on a complicated welter of alternative
trade policies, including conventional tools such as tariffs and quotas, and less conventional
instruments, limiting trading rights and tougher commodity inspection requirements. (CITE)
Although foreign trade was restricted throughout Chinas reform it still occurred and would prove to be
a successful for China. As time progressed, constraints such as tariffs became less popular. A

substantial portion of this decline reflects the enormous expansion of foreign direct investment, the
increasing importance of exporting processing, and the exemption of selected industries and
organizations form import tariffs altogether.(Branstetter and Lardy, 6) Other actions China took
towards reform was lowering tariffs; indeed, chinas average tariffs have fallen from 41% in 1992 to
6% after it joined the WTO in December 2001, giving it the lowest tariff protection of any developing
country.(The Economist, 6) Many non-tariff barriers have also been dismantled. Moreover, China has
welcomed foreign direct investment, which has bolstered growth by increasing the stock of fixed capital
and providing new technology and management know how. Joint ventures with foreign firms produce
27% of Chinas industrial output.(The Economist, 6)
Foreign trade expanded and its growth was alleviated with changes in foreign exchange and
tax policy. Prior to reform, the regime maintained an overvalued exchange rate in order to subsidize the
import of capital goods that could be produced domestically. Overvaluation led to excess demand for
foreign exchange, necessitating an extensive system of rigid exchange controls. (Branstetter and
Lardy, 9) This was the opposite of the current situation where there are huge sums of foreign exchange,
specifically U.S. dollars within Chinas possession. This shift is attributed to the reevaluation of the
RMB (Yuan, Chinese Currency) where it lost about 70 percent of its value against the dollar in real
terms over the period of 1980 and 1995, substantially enhancing the international competitiveness of
China-based export operations(Branstetter and Lardy, 9)
Chinas focus on products to be exported during reforms also shifted. Branstetter and Lardy
points out that: a decade and a half ago Chinas leading exports were crude oil, refined petroleum
products and apparel. In a seemingly complete transformation China has emerged in recent years as a
major producer and exporter of electronic and information technology products, such as consumer
electronics, office equipment and computers, and communications equipment. (Branstetter and Lardy,
37) Although their exports are products of high technology, China is only able to do so because it
imports most high value-added parts and components that go into its goods.(Branstetter and Lardy 38)
Chinas development into electronic and information technology is consistent with its underlying

comparative advantage, which is relatively low-wage assembly service.(Branstetter and Lardy, 38)
China is not leapfrogging ahead technologically, because these exports are not primarily driven by the
expanding knowledge stock or innovative capabilities of domestic firms.(Branstetter and Lardy, 40)
At the root of Chinas development are foreign owned companies who classify their technology to
ensure competitiveness, and the foreign firms in the electronics and information technology space in
China are almost entirely wholly-owned companies rather than joint ventures.(Branstetter and Lardy,
40)
The partnership between the countries and the companies are mutually beneficial. However,
this type of growth creates an imbalance where countries exclusively produce for export. With the
reforms towards a more open market, Chinas foreign trade exploded from $21 billion in 1978 to $1.1
trillion in 2005, when China became the worlds third largest trading economy.(Branstetter and Lardy,
3) By 2006 Chinas GDP measured in purchasing-power parity would account for 13% of the worlds
output, second only to Americas. It grew to be largest recipient of foreign direct investment, and placed
as the third-biggest exporter behind America and Germany.(The Economist, 4)
China is not alone in adopting this model for growth it has applied throughout Asian countries
like Korea, Thailand and others where export flows are generated, in most developing Asia by flows of
inbound Direct Foreign Investment. (Cohen, China Asia Meltdown) The developments of the Asian
countries were built for export. This creates the framework for a trade imbalance where the Asian
countries are producing for export to the U.S. who has many companies within Asia with Direct Foreign
Investment. This system would effectively transform the U.S. from the worlds biggest creditor nation
in the early eighties to the worlds biggest debtor.(Cohen, China Asia Meltdown)
Over time with years of inward foreign investment, then speculative capital inflows and, more
recently, a swelling trade surplus in conjunction with Asias savings glut China accumulated a huge
sum of U.S. dollars. China has accumulated up to one trillion dollars in 2006, and they are struggling to
manage the money since if it is not well managed, any erosion of value will be source of shame for
whoever is responsible for it.(McGregor, London Times) The savings glut is the response of Asian

countries to the Asian financial crisis of 1997-98 where countries began protecting themselves by
amassing huge war chests of foreign assets. (Krugman, Revenge of the Glut) The volatile nature of
savings is explained as huge sums of money would normally change the dynamics of the Chinese
economy by driving up the power of the reminibi. To offset the effects of the foreign money, the
central bank bought virtually all the incoming foreign currency and managed the money on its own
balance sheet.(McGregor, London Times)
A reason for the isolation of the foreign money was that its impact on the market would raise
the exchange rate, thus coastal export industries would suffer, due to relatively higher costs for the
foreign buyers, and the loss of any jobs there [coastal export industries] would be felt just as keenly in
poorer inland provinces, which rely on remittances from migrant workers employed on the
coast.(McGregor, London Times) Officials also feared that Japans lengthy recession had its roots in
large revaluation of the yen forced on it by the US in the mid -1980s.(McGregor, London Times) This
practice of artificially manipulating the exchange rates is practiced throughout Asian countries to limit
appreciation of their currencies in order sustain growth-oriented trade surpluses.(Branstetter and
Lardy, 41)
The Chinese government has artificially kept the value of the yuan low by pegging the currency
to the dollar; this method boosted the competitiveness of its industries abroad, earning the countries
hundreds of billions of dollars in foreign exchange. But it has also held down consumption at home by
keeping the price of imports high for consumers.(Too Much Money) With the yuan pegged to the
dollar China has been forced to import Americas easy monetary conditions. Its higher interest rates
have attracted large inflows of capital that have inflated domestic liquidity, encouraging excessive
investment and bank lending in some sectors which could lead to a bust.(The Economist, 4)
Branstetter and Lardy notes that for China that to continue to keep the currency pegged at 8.28 yuan to
the dollar, in the face of significant surpluses on both the current and capital accounts as well as
unrecorded capital inflows, Chinas authorities since 2001 have had to purchase massive amounts of
foreign exchange and reserves have risen accordingly. (Branstetter and Lardy, 42) This mass purchase

of US Treasury Bonds in conjunction with low interest rates would cultivate and prolong Americas
unhealthy consumer spending and borrowing(The Economist, 14)
China is urged to reconsider its methods, in undervaluing the yuan and storing wealth through US
Treasury bonds. In Washington, politicians argue that the Chinese intervention in foreign exchange
markets has kept its currency artificially low, making it harder for the US to export and thus reduce its
trade deficit.(McGregor, Financial Times, September 25, 2006) While the massive exports of China is
a cause to the trade deficit, critics against the revaluation of the yuan point out that it would do little to
reduce Americas trade deficit. (The Economist, 16) A study at Stanford University shows that only
20 cents in every dollar of Chinese exports to America reflect value added by domestic Chinese
production, so even a 20% rise in the yuan against the dollar would increase the price of Chinese
exports to America by only 4%. (The Economist 16)
China reaps the benefits of an undervalued currency because it makes them more competitive
against in the arena of exports but by far the strongest argument for a revaluation is for Chinas own
interest since the dollar peg in a way forced China to adopt Americas super-lax monetary policy.
Consequently the large capital inflows and rising foreign-exchange reserves have caused rapid growth
in the money supply and bank lending as well as rising inflation. Excessive credit has fuelled
overinvestment and property bubble, increasing the risk of yet more bad loans. The central bank cannot
easily raise interest rates to cool down its economy, because that would attract more foreign money.
(The Economist 17)
If the reminibi continued to be undervalued for 3 to 5 years there would be a substantial
adverse effects on Chinas trading partners and Chinas central bank would constitute to be very
constrained in using interest rates as macroeconomic policy tool.
Although there are many reasons for China to revaluate their currency and let the yuan
appreciate relative to the dollar, Chinas banking system is still unstable to China to open its capital
account and let its currency float.(The Economist, 17) Letting the currency float would risk massive
capital flight and a banking crisis.(The Economist 17) For China a convertible currency with a

floating exchange rate is a risky option since Chinese households hold more than 13 trillion yuan, and
there are very few Chinese savers who had an opportunity to diversify the currency composition of
their financial savings.(Branstetter and Lardy, 43) Eliminating capital controls could lead to a
substantial move into foreign-currency dominated financial assets, most likely held outside of Chinese
banks.(Branstetter and Lardy, 43) Therefore the Chinese government does not relax capital controls
on household savings until they have fully addressed the solvency problems of the major state-owned
banks.(Branstetter and Lardy, 43)
Proposed solutions in handling the US dollars instead concentrating and pegging to the US currency
is to peg the yuan to a basket of several currencies, including the yen and the euro. (The Economist,
17) Chinas exchange rate would be increased by 15% and its permitted trading band widened modestly
to allow more flexibility (The Economist, 17) Later on, China could move on to liberalize capital
flows and adopt a floating exchange rate. (The Economist, 17) Another point about the yuan is that
Chinas exact currency value is that it is uncertainty. It is argued for the introduction of greater
exchange-rate flexibility for China as soon as possible rather than trying to settle on a particular
exchange rate.(The Economist, 17) The flexibility of Chinas exchange rate is said to be important
because it is said to help to buffer the economy against shocks. But greater flexibility should not be
confused with a fully opening up the capital account, which can not be safely be done yet.(The
Economist, 17)
The government realizes that the dependence on foreign currency (mainly the dollar) through
export is a problem, which is why in March and August 2004 the relevant regulators announced that
the national social security fund and domestic insurance companies could invest in offshore markets.
They are contemplating approving a qualified domestic institutional investor (QDII) program that
would allow individual Chinese investors to invest in securities traded on foreign markets. Each of
these measures tends to increase the demand for or reduce the supply of foreign exchange, thus
lessening the build-up of official foreign exchange reserves.(Branstetter and Lardy, 43)

The effect of the global imbalance has taken its toll, ignited by the housing bubble. The U.S is today
struggling in how to start the economy and revive deteriorating banks. The United States is faced with
many challenges in the crisis brought about by the housing bubble. But solving the problems caused by
the housing bubble does little to solve the underlying problem of the global imbalance.
Various leading economists and the current Fed Chairman Ben Bernanke agree that the current crisis
is traced directly to China. As mentioned before, Chinas growth strategy has forced it to invest heavily
on U.S. Treasury Bonds, effectively creating a global savings glut. Bernanke claims that this glut
artificially reduced global interest rates and created the perverse incentives for an unsustainable build
up of debt in the United States. The low interest rates supports consumer spending while the cycle of
money in essence, China buys dollar assets to ensure that Americans can afford to keep buying its
exports. (The Economist 14) Although it may be true that China and other Asian countries amassed a
huge amount of savings, they are not solely responsible for the current crisis: one must remember that
for there to be a lender there must be debtor.
Instead of blaming foreign entities, other critics argue that it was the Federal agencies cheap
monetary policies in the late 1990s and early 2000s that was responsible for fueling debt-driven
consumer boom, and sucking in record volumes of imports Funding all this requires issuing huge
volumes of debt, much of it securitized against dubious mortgage and consumer debts, and sold to
foreigners when domestic savings proved inadequate. Or as The Economist puts it gently, some
central banks, slow to grasp the effect of these structural changes on inflation and monetary policy, have
been running overly loose policies that have fuelled unsustainable booms in America and some other
economies.(The Economist, 6) Americas lax monetary policy has spilled over beyond its borders.
Low American interest rates have encouraged capital to flood into emerging economies. For those
countries that try to peg their currencies against the dollar, notably China and the rest of Asia, this has
caused a large build-up up in foreign-exchange reserves and excessive domestic liquidity. When central
banks buy dollars to hold down their currencies, they amplify the Feds loose monetary policy. All this

means that arguably the Fed has not only caused the Americas to save too little but also the Chinese to
invest too much. (19)
The global imbalance is the underlying problem but what set off the crisis was the rampant debt
accumulation fuelling the housing bubble. The surge of money coming from the China and various
other countries, combined with the desire for steady growth, interest rates were substantially low.
Thanks to low interest rates the price of assets specially homes, has risen steeply, which made
households feel richer and encouraged them to spend. (The Economist, 20) There was an overall
confidence in the market, and American households addicted to asset appreciation took advantage of
the housing bubble, and thanks to surging house prices and partial recovery in share prices, the value
of the households total assets rose by a record $6 trillion last year, equivalent to 70% of personal
disposable income. Increases in property wealth also tend to have bigger effect on consumer spending
than increases in equity wealth. This is because more people own homes than share and it is easier to
convert capital gains on a home spending power without having to sell the asset, by taking out a bigger
mortgage. (The Economist, 21) Deregulation has made borrowing much easier for households and
thus, debt in relation to income has steadily risen, for at least half a century.(The Economist, 20)
The American population has grown increasingly reliant on debt, likely due to the wage imbalance
that the average American experiences. From 1947 to 1973 the productivity within US doubled, and
median income kept in place; it too doubled.(Cohen, Income Distribution) But from 1973 to 2003
productivity increased 71% while the income of median male American worker did not rise at
all.(Cohen, Income Distribution) To correct for the relatively lower wages American families worked
more; now often both the mother and the father work.(Cohen, Income Distribution) When this was not
enough, Americans borrowed and borrowed big. Household debt as a percentage of GDP roughly
tripled from 1960 to 2005, mortgage debt rose from 1/3rd GDP in 1990 to 80% in 2005, while home
equity falls from 2/3rd GDP to .(Cohen, Income Distribution) Borrowing was rampant but real wealth
and equity decreased.

The perceived wealth from the housing bubble allowed for Americans to feel wealthier. In 2003
housing-equity withdrawal (the total increase in mortgage debt minus net household investment in
housing) rose 6% of personal disposable income in America. (The Economist, 20) Analyst warned
against the rampant borrowing, while optimists point out that 85% of American home owners have
fixed-interest-mortgages, so they are not at risk. (The Economist, 20) Unfortunately adjustable-rate
mortgages grew to account for half of all new mortgages in America, leaving households exposed at
exactly the wrong time. Despite low interest rates, households total debt-service as a proportion of
income is already close to a record high.(The Economist, 22) The lax lending policies combined with
deregulation allowed for increased borrowing of loans for houses that were believed to be appreciating
in value, since the market was overrun with buyers who recently qualified for these loans. The housing
stock has been turned into a gigantic cash machine. However there is little genuine wealth being
produced since in the long run, the only way to create genuine wealth is to consume less than your
income (ie, save), and invest in real income-creating assets.(The Economist, 21) Through the housing
bubble however America and some other economies have been enjoying a very different sort of wealth
creation. Central banks are, in effect printing wealth by running lax monetary policies. Illusory paper
wealth is boosting consumption at the expense of saving. Americas net nation saving rate, the share of
income that America is putting aside for their future, has fallen to a record low.(The Economist, 22)
Housing prices were only going up. Rising housing prices combined with cheap money available
coming from foreign economies like China through Treasury bonds made it easier to borrow money to
buy the expensive houses and thus continue the cycle that increases the value of houses. For this cycle
to work there must a supply of money to be borrowed, coming from foreign countries and borrowers
who wish to buy houses. To allow for more lending for the bank, the bank reduced standards on whom
they can lend money to. Soon people who cannot afford to pay the mortgages borrowed money to buy
houses. Eventually homeowners who borrowed huge amounts of money that they couldnt pay back
defaulted and the house they bought with borrowed money would become the banks. This happened

throughout and consistently thus flooding the market with houses, thus driving the value of houses
down. Now the banks are left with worthless houses and huge debt borrowed to lend as mortgages.
The aftermath of the housing bubble produced massive crisis debilitating the US banks. Although
optimists claim that the banking crisis is one of liquidity and not solvency,(Baker) there is evidence
of a mountain of toxic assets, housing market declines, a sharp economic recession, rising
unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital
strongly suggests that some American banks face a solvency problem and not merely a liquidity
one.(Baker) Japan has experienced the exact same problem caused by its own housing bubble in 1990.
(Tabuchi) The US parallels Japans initial approach of having ultra-low interest rates, employing fiscal
stimulus, and cash infusions. (Tabuchi) Japan even tried to tap private capital to buy some of the bad
assets form banks.(Tabuchi) However all these proved to be futile and brought about years of
economic stagnation.(Tabuchi) What finally recovered Japans economy and the urged solution for the
US is nationalizing the banks. Proponents of nationalization insist that the government must intervene
and organize the banks, leaving healthy banks alone, reorganizing and recapitalizing needy banks. This
proposed solution would be capital intensive and needs much time to see the effects, however the
alternative is anxiously hope for the economy to fix itself.
The US is a democracy where its many states that may have differing concerns and priorities
and can at times cause paralysis within the central government. There is much debate in how to resolve
the current crisis and there is much impetus for the nationalization of banks. But there is much hesitance
in bringing about the necessary changes. There is reluctance due to political anger and a wide range
of uncertainties-over the valuation of bad assets. (Wolf, 257) However China, reigns as a totalitarian
government where the decree comes from the top and must be obeyed down. This allows for one clear
goal that can immediately and directly be followed. This has been seen in the reformations brought
about by the Chinese government, which were effectively unquestioned and successfully brought about
change.

China now, however, is wrought with problems that stem from its dependency on US for
growth. The Dependence on the US dollar for foreign reserve is now being intensely questioned more
than ever because of the US no longer appears impervious. There are growing fears over the dollar; it is
seen by some as a huge pool of resources not being used that at home that will plunge in value if the
US dollar collapses.(Getty) There are proposals to spend the money at home, or to diversify their
investments instead of storing the wealth within US dollars. Part of the problem is the dependence on
US dollar as foreign reserves for liquid asset. No other currency can hold up against it, and if China
did not want to accumulate so many reserves, it would have to let its currency strengthenexactly what
the government does not want at a time when exports are crumbling.(Getty) This highlights Chinas
problem of relying on exports as their main source of income, as we have seen in the US and the Great
Depression the dangers of mass production. A possible solution to resolve both parts of the problem of
reserves and dependence on exports is to spend the money at home, to improve the infrastructure and
cultivate other means of income. If China was to invest heavily on the infrastructure of the country they
may improve education and other social amenities thus relieving dependence on other countries,
importing unfinished goods and technology for export.
It is human nature to take available opportunities so that he is at an advantage. However within
conglomerates as huge as an entire countries market, there is greater impetus for the beneficial status
quo. It is difficult for one person to decree a decision that ultimately is the best decision disrupts the
prosperous status quo. It is human to err, but it is the responsibility of the governing institution to
account for, or accommodate these human flaws. It was the strong governing body that Russia needed
to ease it out of communism into a free market. It is the success of the governing body to allocate and
capitalize on resources to bring about the growth and development of China. However it is when the
government fails to make the difficult decisions, and settles for the beneficial status quo, that wrecks the
country?? It is when the intrinsic human flaws combine and compound within a governing body instead
of working to restrict it is when government fails. This is what ultimately brought upon the current
crisis. It was the greed of direct foreign investors that created the trade imbalance. It was the

ambivalence of the Chinese government to keep its influx of money through exports, by manipulating
exchange rates, and hording the U.S. dollars for savings. It was the greed of companies to depress the
wages of Americans. It was the ambivalent greed of the banks to blindly lend out money for mortgages.
It was the greed of America to get everything for nothing. All of these flaws converged to create this
crisis that will ultimately bite us in the ass, it is only the government who has the power to make these
changes and regulate the market, to prevent the accumulation and magnification of these flaws.