RIETI Symposium

# Asian Economic Integration - Current Status and Future Prospects -

## Report

### Opening Remarks

Joseph E. STIGLITZ, Columbia University

It is a real pleasure to be here. What I want to do this morning is to talk about several different aspects of integration, both integration with respect to financial markets and trade, and also both their economic and political implications. I want to put the subject in the context of some broader trends that have been going on in the world for the last 10-12 years. I think one has to do that to get ideas about the role and design of Asian economic integration. Probably the most important single event, of course, is the end of the Cold War, which resulted in a single super military power. Of course, the existence of a single military power does not necessarily translate into a dominant economic power, but there are clearly important relationships between that military presence and the consequences for the political and economic sphere.

Unfortunately, the world has evolved in ways that are not necessarily the best for global political and economic stability as I will try to illustrate in the following remarks, and one of the themes I am going to try to put forward is that, in light of these developments there is a strong case to be made for much closer economic integration within Asia. The most important aspect of this evolving trend at the end of the Cold War is an increasing role of what is sometimes called American exceptionalism, or more recently American unilateralism, a view which has repeatedly taken a perspective where the United States demonstrates its own views of political reality and uses its position of global political leadership to push a particular perspective on economic and political issues. In the context of Asia, and in the context of the economic crisis of 1997-98, that was seen most dramatically by the rejection of the US Treasury of what I thought of as a very important initiative, the Asian Monetary Fund. That fund, I think, would have not only provided longer-term financial stability to the region, a point I am coming back to, but in the short run would have enabled the region to recover much more quickly from the crisis than it did. The policies that were pushed in that crisis undoubtedly worsened the crisis.

The problem is exacerbated by the fact of the American dominance of the international economic institutions, exemplified by the fact that the IMF has, by convention, always been headed by a European, and though there was a very credible Asian candidate for the head, it was basically assumed that, even thought the IMF is a global international institution, the search for the most appropriate person to head it is not done globally, it was clearly limited to Europe. In fact, the irony was that while the business of the IMF is mainly today in the developing world, no one even mentioned that the person who ought to be chosen as the head ought to have experience within the developing world. It would be like choosing somebody to be the head of a car company who had never seen an automobile. The problem with it is not only that that has resulted in these international economic institutions pushing American interests over global interests, but also that they have pushed a particular view of the market economy, which is sometimes called the Anglo-American view, or market fundamentalism, and it is the view into which doubts have been increasingly raised. The examples of that more recently have come to abound. While in the East Asia crisis there was an enormous amount of talk about firms using, in Asian and elsewhere, American-style accounting practices, those discussions have now come under a somewhat different light after the major Enron and Arthur Anderson scandal. But what I don't think is fully appreciated was that the hypocrisy went back way earlier.

In 1993-94-to just tell a couple stories-I was in the Council of Economic Advisers and the independent accounting board, FASBI, had proposed a change in the accounting rules to deal with options, options associated with executive pensions. The companies tried to give the impression that when you give options to your senior executives, it was like printing money, something that came from nowhere, so you gave your executive something and it didn't cost anybody anything. Now, of course as economists, we know that you cannot just create something out of nothing, that if you give your executives something that is of value it has to come from somewhere, and the accounting framework is supposed to make it clear where it is coming from. Well, stock options represent potential dilution of ownership of other current shareholders. Now, the argument that was used most forcefully against these stock options was one that remarkably should have been the major argument in favor. The argument that was used against it was that, if shareholders knew how much their shares were being diluted, that is to say how much the value of these stock options, which are sometimes 5%, 10%, 15% of the value of the shares in which enormous dilution was going on, that the share price would go down. That is to say that they were saying that if people only knew what was going on, they would value the shares less. Our point of view was that that was exactly right. If you have a market economy that is going to work well, you have to provide information, and if you provide bad information it is going to provide bad signals, and the result of bad signals you are going to get bad resource allocations, as you did in the late 1990s that led to the stock market bubble and the misallocation that led to our current recession. All these are issues that are of great concern to me because they represent parts of the economics information and that emphasize the importance of having good information systems.

The critics of the FASBI proposal also said it was difficult to value options. That of course was true, but every aspect of valuation is difficult. It is difficult to value depreciation, and the rules that we use for depreciation are very rough estimates. The formula that is used for options are far better as an accurate estimate of the value of the stock options than the value of the estimates of depreciation are of the true value of depreciation. And in fact, at the Council we developed a formula that represented a lower bound to the value of these stock options. To put it another way, one of the things that we do know is that the accounting frameworks that have been used which set the value of options at zero is clearly wrong. And there are lots of ways of doing that are far better than that.

Well, the final aspect of this in telling the story is that it also illustrates an aspect of crony capitalism in American style, because the same people, the US Treasury, the Department of Commerce, that were so critical of crony capitalism in East Asia in 1997-1998 demonstrated crony capitalism American-style. Their friends on Wall Street and their friends in Silicon Valley called them up, and the FASBI, which is supposedly an independent accounting board, and you hear all the time the importance of institutional independence and creating independent institutions, Wall Street and Silicon Valley called up Rubin and they called up Treasury, and they put on pressure, and the US Government, through Treasury and Commerce put pressure on FASBI to change the regulation and FASBI caved, conceded. And many of the problems of Enron and Arthur Andersen would have been avoided had that political interference in the independent accounting standards not occurred.

Just as another slight joke, problems in this area have been well recognized and the Securities and Exchange Commission appointed a commission to look at the problems of valuation in the new economy, on which I served. It was a small commission. One of the other commissioners was Ken Lay, who as many of you know was the head of Enron. His particular view, and that of many of the other people on the commission was let the market take care of it; you don't need any more government intervention. And of course the market eventually took care of it, but in the meanwhile there was enormous damage.

All of this is a side point to the single point that I want to make, which is that America's dominance of international economic institutions has been used to promote a particular view of the market economy, a view which I would argue has many deficiencies in it. There are alternative views. For instance, Sweden has been every bit as successful in promoting new economic developments and technological change as the American economy and is much more transparent and less subject to crony capitalism, at least arguably so, then the United States. The reason I am emphasizing this is that, as I say I am going to try to come to a vision of Asian integration which sees Asia as putting forward an alternative to this particular structure.

The international institutional framework was established, one remembers, at the end of World War II, at a time in which many of the emerging markets were still colonies, a time in which the international financial arrangements were markedly different and in which trade was much smaller. Since then there have been very marked changes. Partly the rise of China, the relative growth of emerging markets. These make it more increasingly important to formulate an alternative vision of global economic arrangements. And as people have looked at the global economic arrangements as they are today, there is a heightened sense that there are some important deficiencies in theses global economic arrangements, and I have mentioned here just three aspects of this: the recognition of the inequities in the North-South trade relations, a recognition of the instability in the global financial arrangements, and a recognition of the inequities in the global financial arrangements.

To talk about, for instance, the instability of the global financial arrangements, somewhere between around 80 to 100 countries have had crises in the last quarter century. These crises have become more frequent and deeper. Similarly, while the IMF was originally founded in order to promote expansionary fiscal policy for economies in an economic downturn, and with respect to countries like Japan it has pushed for expansionary fiscal policy in event of an economic downturn, in the Third World the IMF has consistently pushed for contractionary policies in the presence of an economic downturn. As I travel around many parts of the world, I continually get asked this question: Why is there this inconsistency? This was particularly strong this fall when the United States was debating a stimulus package for the economic downturn, and yet it was telling country after country in Latin America as they face their economic downturns that they had to contract and contract markedly. Well, as I say, the conclusion from this is that we need an alternative vision, one which entails broader global consensus based on a shared view of social justice and global solidarity.

Now, I want to come to the specific issue at hand today, which is integration, and I emphasize these preliminary remarks because I would argue that integration should not be viewed as an end in itself, but as something that should be designed to lead to higher living standards and social justice, and lead to greater economic and political stability. Depending on how integration proceeds, it can be an important means to achieving those goals. But one has to have very much in mind those goals as one proceeds to think about Asian economic integration. I would argue that strengthened Asian integration would lead to a strengthened Asian perspective that could serve as a counter-weight to the US dominance, that would diminish the reliance on this particular view of economics, which is sometimes called market fundamentalism or capitalism American-style (but it doesn't really describe capitalism as it occurs in the United States), and could help achieve these global goals.

I am going to divide the remainder of my remarks around two broad themes, focusing first on finance and then on trade, and I am going to begin by describing the deficiencies in the global reserve system, which I think are very serious, and unless they are addressed will lead to continued instability in the global financial system as I have already described. The system, as I said, has led to an enormous amount of instability. There have been the marked changes in exchange rates that have not only affected the smaller economies in the world but even the major currency systems, with the yen-dollar going from 106 down to 80, up to a 130-140, down to where it is today; where the Euro-dollar exchange rate has also fluctuated; and those fluctuations themselves have been an enormous part of the strain on the rest of the system. Many people believe, for instance, that Thailand's crisis was largely caused by these huge changes in the major exchange rate systems that they have to deal with.

Now, the consequence of this, in turn, is that countries have to have large amounts of reserves. The standard wisdom today is that countries ought to set aside reserves equal at least to their dollar-denominated short-term liabilities. That means that, when they borrow more short term, they have to set aside more reserves. There is also the view that you need reserves equal to at least four, six, or eight months of imports depending on volatility. So the increased volatility has made it more and more important for particularly poor countries to put aside large amounts of reserves. There are enormous opportunity costs for reserves. Reserves are typically held in US Treasury Bills (US T-bills). Right now US T-bills are yielding 1.75%. For most developing countries the opportunity cost is enormous. They could get returns of somewhere between 10% and 20% in real terms in investments in their own countries. So what they are foregoing by holding these reserves is very large; it is part of the real cost of our global reserve system. As I say, these costs are borne disproportionately by the poor countries. The US actually benefits from this system. Because of the demand for T-bills to be held in reserves, the US is able to get capital at more favorable terms than it otherwise would.

Think about it in the following way, from a macro-economic point of view that I think highlights the problem: Think of a poor country, say, in Africa in which a firm in that country decides to borrow $US100 million from an American bank and has to pay that American bank 18% interest. Then that poor country has to put US$100 million away in reserves, in which it will hold in US T-bills, earning 1.75%. Look at from a macro point of view: That poor African country is borrowing US$100 million from the United States and lending US$100 million to the United States, so there is no cash flow, there is no flow of resources. But when it lends to the United States it gets 1.75%; when it borrows from the United States it pays 18%. The US gets a net profit out of the deal of about US$16 million. Now you understand why the US Treasury is so much in favor of the current financial system. It believes in free flow of capital; US firms and the US economy benefits the more this goes on. But it is very hard to see how this is supposed to promote the development of the African country, and in fact statistical studies show that it does not. The other aspect of this is that we have a really peculiar system in place, when you think about it from a particular perspective. The theory is that rich countries should be sending capital to poor countries. But under the current system, it is the poor countries that are sending capital to the rich. In fact, if you look at all financial flows right now, not foreign direct investment but all portfolio flows, the net of all portfolio flows is from the less developed countries to the developed countries. So, again, it is something that you can understand why the developed countries need the help (particularly the United States needs the help right now), but it is very hard to see how this helps the developing countries. Look at it from the other point of view: The flipside is that poor countries needing to invest and grow need to borrow and live beyond their means, because they are investing. But you look around the world, What is the one country that is living beyond its means? The United States, with a trade deficit of around US$450 billion. So we have a global reserve system that allows (in fact, one might argue that it necessitates) the US doing this, year after year consuming beyond its income. It has the highest income in the world, but then the world says "Consume more than that". Now, anybody from Mars looking at this system would find this very, very peculiar.

There is, in addition, a deflationary bias in the global reserve system. Why do I say that? Well, every year you take all the income, particularly the developing countries, and some of that income has to go into holding reserves. Right now there is roughly US$2 trillion in reserves, and about every year an additional US$100 billion to US$200 billion is put in reserves. What does that mean? That is income that is not spent, that doesn't generate a further demand for goods, and that puts a downward deflationary bias in the global economy, a deflationary bias that became clear in this current economic downturn but normally is only offset by the high consumption of American consumers. In addition, this system has a strong bias for instability. The reason comes from a basic tautology in international economics, which says that the sum of the surpluses equals the sum of the deficits; the sum of the trade surpluses equals the sum of the trade deficits. If somebody exports more than others, than somebody has to import more than others, that is just basic arithmetic. That means that if a few countries like China and Japan consistently have surpluses then the rest of the world as a whole has to have deficits. Now, when the Bretton Woods institutions were established, Keynes recognized this, and in the regional discussions there was a lot of talk about penalizing the surplus countries, because the surplus countries cause deficits. The surplus countries cause deficits because if there are surpluses on one side, there have to be deficits on the other. But somehow that view got destroyed, and today the IMF only focuses on the deficits. Well, the deficits are never going to disappear as long as the surpluses don't disappear. So the deficits are like hot potatoes. Korea has a deficit, it gets large, it has a crisis, and then the Korean government does something and gets rid of the deficit. But does that mean the deficit disappears from the system as a whole? No, by arithmetic it cannot, it just has to show up somewhere else; some other country gets the deficit. Well, maybe it is Brazil that time, so Brazil now has a nice deficit. The arithmetic says that somebody has to have that deficit as long as somebody has that surplus. So now Brazil has the deficit, and the IMF starts lecturing them, "You have a deficit, you are going to have a crisis." And the IMF says that pretty soon you are going to have a crisis, and then what happens? They have a crisis. And then Brazil gets rid of its deficit, and that deficit then shows up somewhere else in the system. So the system is inherently crisis-prone. There is an alternative which involves the issuance of global reserves, a kind of global money, and this would in effect increase the liquidity, undo the deflationary bias of the system, would not be inflationary. Effectively, in principle that kind of system has already been accepted, it is the special drawing right (SDR) system. But the SDR system, which are funds that are given to countries that eventually wind up in reserves, is only done on an occasional basis. What needs to be done is to make it occur on a regular basis. What is nice about this system is that it can simultaneously serve several functions. It can undo the deflationary bias, it can help create global financial stability, and it can be used to finance global public goods, including development, which are estimated to need an additional US$50 billions. One of the problems under the current economic arrangement is that one individual country can hold hostage the whole global economic system.

One way of thinking about these arrangements is that it is a club, a club in which each of the members agrees to provide assistance to other members of the club by an amount equal to the amounts that are in the reserves. Once one views it from that perspective, one can think about how one can design a framework which would engender a desire to have everybody join the club. The club could agree only to hold reserves of those that are member countries, and this would put pressure on everyone to participate.

The reason I have gone so long is that this is really an important prelude to the notion of trying to create an Asian monetary arrangement. As I said before, I thought that the proposal that was made in 1997-98 for an Asian Monetary Fund was a very good proposal, and it was too bad that it was squashed by the US Treasury. The view that I want to put forward here is that an Asian monetary arrangement, an expansion of what is already going on, could serve as the basis of this beginning of this new global regime, and it is a particularly good basis, a place to start for this global regime, because of the large amounts of reserves that the countries within the region already have. They could share their reserves, they would not need to have fixed exchange rates, they can engage in surveillance of each other, not requiring, in other words, the kind of surveillance that comes under Article IV consultations, and this would have some marked advantages over IMF surveillance because of not only the increased awareness of each of the countries of the particular institutional features of the other countries in the region, but also because of the broader economic perspectives that they bring to bear than the IMF typically does in its Article IV consultations. In short, the surveillance would be based on a broader set of goals and a use of alternative economic models.

I believe that this creation of a new institutional arrangement would have some other values in promoting democracy, because I think that the principal of there being alternative views of economic arrangements is very important, sometimes it is called the principle of competitive pluralism, and I believe that principle of competitive pluralism that the Asian Development Bank has in fact spoken of, is important as part of supporting democracy and supporting a competitive market place for ideas. It also makes a great deal of sense when one thinks about the incentives to come to mutual assistance given the greater interdependence. It was not an accident, for instance, that the United States put a great deal of pressure, successfully, for the other countries in the IMF, including Germany, to come to the assistance of Mexico, but was very unsupportive when Thailand had a crisis. It reflects the fact that the United States, in the Mexico crisis, saw that much more of its own interests were at stake and quite openly said that there were very little economic consequences for a crisis in Thailand, and therefore it was not deserving of corresponding levels of assistance. It seems to me that having an Asian monetary arrangement would offset this kind of particular perspective which had dominated the international financial institutions.

Let me now turn to the second major area, the trading arrangement. Here, the most important change that one has to recognize is the increased role that China has in the global economy and the regional economy, which is going to change patterns of global comparative advantage, and Japan's efficiency advantage is likely not to be sufficient to offset wage differentials. Countries throughout East Asia, in fact, countries throughout the world, are trying to come to terms with the implications of China's rise and what that implies for global economic patterns in the coming decades. One implication, I think, that a number of people have come to is that it is going to strengthen the importance of the non-trading sector, and in particular the service sector of the economy. I want to emphasize that because, if you look around the world, if you look through the nineteenth century, there was a major change in economic relations. In the nineteenth century agriculture was the base of the economy. Over 60% of the population was engaged in agriculture, and in some countries it was 80%. And what has happened over the last century and a half to agriculture? Today, agriculture in the advanced industrialized countries occupies maybe 3% of the population. A small percentage of the population, 3%, 4%, grows enough food to feed everybody, and in fact part of the problem is that they grow enough food not only to feed everybody, but to create a surplus. So there has been this enormous increase in productivity in agriculture. That, as is traditionally described, released resources to go into manufacturing, and in the twentieth century there was the great increase in the manufacturing sector. Exports, based on manufacturing, were the basis of the success of the Japanese economy and the other East Asian economies. But we have to recognize today that the era of manufacturing may be ending just as the era of agriculture ended a century ago. Of course, the end of agriculture doesn't mean that it is not important, it is very important, we obviously cannot live without food. But the point is that a very small fraction of the economic population are engaged in the production of these very important commodities.

Similarly, the enormous increase in productivity in manufacturing has meant that the fraction of the population that is engaged in the production of those manufactured goods, those manufactured tradable goods, is going to be getting smaller and smaller. And a look at some of the statistics of the economies that appear successful and the economies that appear unsuccessful sheds a great deal of light in this restructuring process. It at least suggests the possibility that what may distinguish more successful countries from the less successful countries is their embracing of the new economy and in particular embracing the service sector.

Just as a joke, I remember traveling around China about ten years ago, and I went into a factory in a region in which they were trying to promote tourism, and there was a big sign in Chinese that was translated to me as saying "remember the tertiary sector". I have always remembered the tertiary sector as a result of that sign. The point is to remember the importance of the service sector in the economy.