COLUMBIA BUSINESS SCHOOL’S R. GLENN HUBBARD
Interview By Tom Leander

As chairman of President George W Bush’s Council of Economic Advisors, R Glenn Hubbard led the push for the controversial tax cuts in the US in 2001. He became dean of Columbia Business School in New York in 2004. Still very much part of the US debate on domestic and international economic policy, Hubbard was short-listed as a
candidate for governor of the Federal Reserve Board following Alan Greenspan’s retirement earlier this year. He writes frequently on China and Japan.

What are the implications of massive debt in the US versus a savings glut in China?
We [in the US] barely save enough to buy a bagel. China’s saving almost 40% of its GDP, but it’s wasting almost a like amount. [Governments] can add to GDP in the near term with inefficient projects, because mechanically it’s a component of GDP. But in the long term you have to have very productive investments and the way to do that is to create better capital markets.

Japan strikes me as how this can become a cropper. It grew very rapidly in the 1980s. But you can only grow so far when you have poorly directed credit. This is eerily familiar when you look at what’s unfurling in China. Certainly the non-performing loan situation is worse in China than in Japan. It is true that the authorities have fixed the problem a little bit – they’ve recapitalized some of the banks. But they haven’t solved the problem of state-directed credit to weaker state-owned firms as opposed to allowing the market to work. If I were thinking of what were to be on the top of the list of economic issues in China, it would be financial reform.

Not the appreciation of the renminbi?
I’m a little bit puzzled why the US is focused only on the renminbi issue, which I think is an important question, but it’s not the first.

But the financial reform will take years to play out. The RMB debate is an immediate policy issue affecting both parties.
Just to be provocative, I’d go the other way. It strikes me that you can’t fix the exchange rate system until you get the banks working better. You can’t float the renminbi today, even if you want to, because you have such a weak financial system. So I think you’ve got to do both in parallel. It would be better to ask China to do what’s in China’s interest, and it should be in China’s self-interest to gradually move the RMB to a more market-oriented system. I worry that China’s investing a lot in things that won’t be economic at a more market-oriented exchange rate.

Do you have an example?
Investment projects that might be economic at the current exchange rate, but not at the equilibrium exchange rate where we’d see a 15% to 20% difference. When you realize that, China’s locking in essentially very large capital losses the longer this goes on. I think China might see it in its own interest [to gradually change]. And it would be easier if countries like the United States don’t keep whacking them

Is the Chinese government doing enough, then, to reform its banks?
Americans are very impatient, and American economists are even worse – very, very impatient. If you look at the Japanese experience – Japan is obviously a more market-oriented economy to begin with than China – it took a long time. With patience and focus on financial sector reform, we now have a recovery in Japan. The same is possible for China. China has taken more steps than many Americans give China credit for. China has made progress in finance, just not enough.

Market-based reform on this level has never been tried before. It would involve a lot of ceding of authority on the part of the government.
Therein lies the rub. The parallel to Japan is closer than you might think, because the Japanese economy was in recent years two economies. One was comprised of large multinationals that were the envy of the world, because of their productivity. And then there was a lot domestic rot – in construction, retail, wholesale, and anything that could be understood as the inward looking part of the economy. That represented the Liberal Democratic Party’s power base. So the link between politicians and credit allocation doesn’t look too dissimilar to what we’re talking about in China. Over time what happened was the realization that the economy will suffer greatly if [reform] doesn’t happen. China, of course, hasn’t experienced that yet, because the economy is still growing at 9%. But it will.

And the pressures would build in China even quicker than they did in Japan.
Japan is a rich country so it can socialize the cost of its errors. China really can’t afford that. There’s really no huge pile of savings to draw on.

Is the Chinese government aware of that danger?
Chinese officials are on the horns of a dilemma. On the one hand, they clearly understand the risk of letting this go on. On the other, if you’re trying to move large numbers of people from unproductive rural sectors into productive work in the cities every year you tend to run policies that are extremely pro-growth even if you think pro-growth is inefficient. Now, economists would say that it would be better to grow a little bit more slowly and accommodate fewer of these people, but I could see why Chinese politicians need to run this bet. I don’t see this as an issue where the US needs to lecture China. It’s more a matter of making sure that politicians understand that the cost is greater than they might imagine.

Is the Japanese recovery sustainable, and what does that mean for Asia and the world?
I do believe the recovery is real – for two reasons. Financial reform really took hold and you can credit the administration of Prime Minister (Junichiro) Koizumi for keeping its focus. The turnaround in monetary policy has been excellent, and Toshihiko Fukui, governor of the Bank of Japan, has pushed the nation back toward a more neutral monetary policy. I wouldn’t take my foot off the accelerator yet, but I’m not as conservative as the typical Bank of Japan official appears to be. Japan is not going to grow as fast as the United States, because it has a shrinking workforce. But I think it will grow faster than it has been in a long time. Remember this is the second-largest economy in the world. I know people are focused a lot on China, because of the percentage changes, but China is a modest-size economy relative to Japan. The recovery in Japan is great for global growth, and it’s certainly great for China, in terms of selling to Japan. Of course, the political relations between the two countries are not good, but the economic relations are closer than they ever have been.

What changes will Japan’s recovery make to the world economic balance?
Japan is growing again. The US is growing quite rapidly by American standards. China and India are growing. And even the euro zone is seeing the edge of recovery. This is the first time that everyone has been in sync and growing at the same time. That’s going to put upward pressure on energy and resources prices. Another thing to watch is that the normalization of monetary policy in Japan might have some bumps on the road, as interest rates start to rise. This is something that Japan hasn’t seen for a while. And, indeed, in my memory, this is the first time that all three major central banks are normalizing policy at a time when there isn’t an inflation scare – they’re just trying to bring policy back to normal. In theory, that can be done without a hitch. In practice, we’ll have to see.

And the risk is?
It’s possible we don’t know exactly where a neutral interest rate is until we go past it. This is a typical central banking problem.

Do you agree with the pet argument in favor of China’s approach that India’s chaotic democracy hobbles growth there?
I don’t buy it. What has retarded Indian growth is an extremely bureaucratic and regulatory state, and that’s not a newsflash. India’s government instituted reforms in the early 1990s. Indeed, Prime Minister Manmohan Singh as finance minister [at the time] was responsible for many of those reforms. Now I worry that there will be too much of a compromise between a more egalitarian policy agenda, as opposed to an emphasis on economic growth. Obviously, these are domestic political issues that India will have to decide. But certainly a more pro-growth agenda would focus on more deregulation, more infrastructure investment.

Could you argue that democracy in India allows a political safety valve that doesn’t exist in China?
While China can grow more rapidly with more [state-directed] policies, it also can make a mistake more easily. Markets are usually better at being resilient than bureaucrats. This is particularly true in situations like China’s, when the government is trying to cool down certain sectors. There’s a real chance for a misstep, putting your foot on the brake too hard. Markets rarely make that mistake.

You’ve taken Joseph Schumpeter’s term ‘creative destruction’ to task in recent articles.
It doesn’t capture what is exciting about entrepreneurship. When you cast entrepreneurship in Schumpeterian terms such as creative destruction, you run the risk of creating policy protecting old incumbents to avoid the destruction. In fact, much of entrepreneurship is nondestructive creation. This came to me when I was reading an article by William Nordhouse, an American economist. He points out that most of the goods that are available today weren’t around a hundred years ago. It’s not a case of a car replacing a horse and buggy, it’s a case of new innovations like your MP3. Once you’ve figured out it is nondestructive creation that leads innovation, it’s a different way of looking at entrepreneurship. One thing I spend a lot of time doing with business school students is trying to figure out what are the opportunities for non-destructive creation when you see a business problem. I ask them, what are the new ways to approach a new business, a new service? It’s a different take than Schumpeter’s.

Do you think that non-destructive creation has led to productivity growth in the US?
Yes. In most economists’ minds the focus has been on the link between information technology and productivity. But this assessment is not compelling. In fact, IT is somewhat better outside the US. It is American institutions, such as risk-capital allocation and the ability to move labor around and so on, that have made the difference. Most of those financial innovations have been examples of non-destructive creation. Enabling new markets to spread and share risks isn’t destroying something; it’s simply creating markets that weren’t there before. That’s been the powerful part of American productivity growth.