Mike McFaul's public talk at SCPKU July 6, 2015

FSI Director and SCPKU Mingde Distinguished Faculty Fellow Mike McFaul shares with SCPKU intern Nathalie Chun key insights during his month-long academic residence at the Stanford Center at Peking University (SCPKU) this summer.

What is the purpose of your current visit? Could you tell us about your experiences and findings?

Michael McFaul: My main intellectual interest was to understand more about Chinese foreign policy and in particular the bilateral relationship between China and the US but also the bilateral relationship between China and Russia. I’m thinking of writing something, a new project, about this trilateral relationship. And so I spent the most of my time over the last several weeks speaking to two sets of people that are very different: those that focus on United States and those that focus on Russia. In addition, I have an interest in the politics of economic reform and the politics of political reform so I’ve also been speaking to academics, business people, and a few journalists to talk about the change that is going on here in China both on the political and economic dimensions

Is there in particular that you’ve learned about here in China that has surprised you? You’ve mentioned that you’ve talked to many different people so I was wondering if there was anything in particular that made you go ‘Oh that’s really interesting!’

MM: That’s good question. In terms of my subject matter, the thing that was most interesting to me as a concept of dual rising powers. So, the conventional wisdom is that China is rising and the rest are fading. But one academic, and it actually came up more than once, reformulated that idea. It’s not that China is rising and everybody else is fading, it’s actually that the United States is rising with China, just at a slower pace. And so maybe eventually they catch up, but it’d be incorrect to say that one is declining and that one is rising, and vis-á-vis the rest of the countries in the world. I also think that’s a better formulation because actually the United States continues to grow at a higher rate. It still has the largest military in the world; in terms of soft power [it still] has great reach and that has not been declining, that’s still rising. It’s just that when we look at this rate of change relative to the rate of change in China, the United States feels like it’s falling behind. Or China is catching up is a better way to put it. I thought that was interesting.

Second interesting point is, you know I just spent two years as Ambassador to Russia from the United States, and there I would say there is a feeling of… envy towards the United States. Like we have wronged them or that we are guilty for some of the difficult periods that they have had, kind of like a chip on their shoulder. Here I don’t feel that. Here I see a kind of self-confidence that people have, wanting to work with United States. Most certainly when I met with officials there was a very strong sense of wanting to have cooperative relations with the United States and in particular it jumped out at me when I was at the Ministry of Foreign affairs yesterday, they kept using the phrase ‘win-win outcomes’ for China and the United States. Well that’s exactly what we’re trying to do with Russia when I was in the government; during the early period of the Obama administration we used that phrase too. And I find it interesting that here the bilateral relationship with China, the Chinese still talk about that, and most certainly do the Americans too. I met with Ambassador Baucus and his team, and they most certainly talk that way. I find it kind of tragic that in the bilateral relationship with Russia, we no longer talk that way.

You’ve just mentioned the whole idea of zero-sum perspective of looking at the world and I guess in IR theory that would be a more realist perspective, as opposed to a liberalist perspective. So do you think that this sort of liberalist perspective should the future of looking at and that this ‘win-win’ perspective is one that future diplomats should hold?

MM: I worked on the Obama campaign in 2008 and one time on a flight with him when I was briefing him, I started to talk about these two camps, realist and liberal camps, as a way to understand foreign policy and you know how he responded to me? He said “Come on, the real world, requires you to use both of those theories depending on the issue and the country and the bilateral relationship” and when I was in the government, I most certainly felt that way. These are useful paradigms to kind of clarify arguments but I wouldn’t want to be labeled in one camp or the other and I think it’s analytically distorting, not revealing, to say the world is either realist or liberal. That said, I lean towards liberalism personally. I do believe in the 21^st Century, maybe not early centuries it was possible, but in the 21^st Century it is possible to construct outcomes that are good for both countries especially through the use of treaties and institutions. And I come away from my month here in China feeling that there are real challenges in the bilateral relationship, complicated issues, but they’re not irreconcilable issues. Even South China sea right, even Taiwan, I see the possibility, with smart diplomacy, that we can find ways to manage these issues so that it doesn’t lead to conflict between the United States and China

While you were here at SCPKU you have given talks on both the upcoming US elections and current US-Russia relations. Putting those two themes together, what do you think are the implications of the current US-Russia relations on the upcoming elections in 2016 and the way the next president will tackle these issues?

MM: I would say, I predict continuity, more or less. That is to say, that the policy that you see now was a reaction to Russia annexation of Ukraine, of Crimea, and intervention in Eastern Ukraine, is one of deterrence and punishment. There are three dimensions to it: sanctions to punish Putin’s bad behavior, strengthening of NATO to deter him from going further and third, shoring up Ukraine to try and make the economy there recover from this very difficult period. And I basically think those three main policy trajectories will continue, I don’t see a change. But in each one of them, you might see more or less the same paths. I predict that if a Republican candidate is elected, the ones who’s policies I know, or even Secretary Clinton, you would see for instance maybe military assistance to Ukraine, which is something the Obama administration has so far been reluctant to do, but I don’t foresee major change. And that disappoints people here in China. When I say that they are disappointed, it is because they are hopeful after an election there might be a new president that may try to reset relations with Russia again. I’m not optimistic.

What roles, in your opinion, is SCPKU playing in China, and what do you hope the Center will achieve in the future?

MM: Well what I hope the Center will achieve for the future is to create greater connectivity between hundreds of Stanford scholars working in all fields. This is an incredible place, I’ve never seen it before until this trip, absolutely beautiful, 21^st century technology, and the second thing is, Peking University is an incredible university, beautiful campus, really all of my interactions with scholars here have been very positive, they’ve been very warm in greeting me as a fellow scholar and I’ve been impressed by the students as well. So that is my hope, over the coming years and decades, that this serves as a bridge between PKU, but also all of China, and Stanford University because there are many difference issues in all different fields of study where there’s room to cooperate. In my field, I also see a very concrete role to help develop what we call Track II dialogues, with China scholars, in terms of helping to manage US-China bilateral relationships. It’s very clear to me there’s a close relationship between senior scholars here at PKU and the government and the Party and the business community and the People’s Congress. I’ve met many people and they know all the people here and we have those connections in terms of Washington as well at Stanford. So my hope is that in a concrete way, and for me personally, that I might be involved in that, and we have an incredible platform here to be able to do so.

China's tight control over its economy is one reason why it is facing an economic slowdown of global implications, Stanford scholars say.

China's stock market fall is now in its third week, and share prices have lost a third of their value since mid-June, though the market is still higher than a year ago. China has the world's second-largest economy, with deep financial links to the United States.

Nicholas Hope, director of the China Program at the Stanford Center for International Development, which is part of the Stanford Institute for Economic Policy Research, said the simple answer behind the slowdown is that "nothing grows at 10 percent forever."

However, the dropoff is sharper than the government of China expected or desires, he noted.

Hope said the deceleration is due to the effects of slow growth globally on international trade, slower progress than hoped in rebalancing the Chinese economy toward spending more on consumption and less on investment, and the inefficiency of much of Chinese investment. Another big problem is the debt load of local and regional governments.

Hope does not think the steep fall of China's stock market is comparable to the American crash of 1929 – "so long as the Shanghai market index remains comfortably above where it was a year ago."

Yet the "frighteningly sharp correction" over the past few weeks highlights the fragility of the Chinese financial system, he said. It also serves as a cautionary tale for the many small investors who speculated on high returns with borrowed money.

"Borrowed funds have financed many risky economic investments in infrastructure by subnational [regional and local] governments as well as stock purchases by unwise investors," he said. "The result threatens to be an unwanted increase in non-performing loans in the banking system as borrowers are unable to repay."

Hope believes China can overcome its problems if it adopts economic reforms aimed at fostering more private enterprise and less state control over the market. Back in 1993, China's Communist Party announced those reforms and updated them in 2013, so they are technically on the books.

"Paradoxically, current weaknesses could be a longer-term source of strength, as the shares of income and consumption in Chinese GDP rise, investment is increasingly more efficiently allocated by a transformed financial system and all factors of production – land, capital and labor – are put to more productive uses," he said.

To counteract the market drop, the government ordered state-owned companies to buy shares, hiked the amount of equities insurance companies can hold and offered more credit to finance trading. Hope said this may cause a problem.

"It is introducing considerable moral hazard by attempting to bail out small investors because of the concern over the potential for social unrest if too many of those investors lose all of their savings," he said.

Charlotte Lee, associate director of the China Program at Stanford's Walter H. Shorenstein Asia-Pacific Research Center, says it is too early to tell if the market fall will diminish the credibility of the government and Communist Party in the eyes of the people. China's President, Xi Jinping, does want to maintain his popularity.

"The government's management of the economy is, however, one of the pillars of its credibility," Lee said.

She described this as a "small dent" in that credibility, as the government has many other ways it aids the Chinese people.

Opening up the economy

Stanford Professor Darrell Duffie says that it will be hard for China to maintain its past high growth rates.

"China's growth rate is still very high, but it is less high than it was because most of the giant pool of cheap and underutilized labor that China had 20 years ago has by now been put to work relatively productively," said Duffie, the Dean Witter Distinguished Professor of Finance at the Graduate School of Business.

"Additional sources of productivity gains are harder to find," he added.

Duffie is concerned about excessive leverage in China's equity markets.

"Chinese investors have borrowed a lot of money to invest in equities. This margin financing was used too aggressively. China's corporations and local governments are heavily indebted, and that will be a drag on future growth," he said.

He suggests that China would do well to continue on its current course of opening up its economy to cross-border capital flows and reducing its economy's reliance on state-owned enterprises.

If China's economy slows down, the country will decrease its demand for American goods and services, he added. American businesses that plan to operate in China should learn as much as possible about how China's economy and government works.

And Duffie advised, "Whenever possible work with trusted partners in China."

Asian power games?

With China ramping up its military in recent years, what are the risks to U.S. national security if China's economy plunges?

Amy Zegart, co-director of Stanford's Center for International Security and Cooperation, said it is possible that a slowing economy might make China behave differently in terms of its hard and soft power.

"For all the worry about a rising China, a fragile China is bad for the United States. The Chinese Communist Party's legitimacy rests on a promise of economic prosperity. The more China's growth falters, the more party leaders will be driven to stoke the fires of nationalism to secure domestic support," said Zegart, who is also a senior fellow at the Hoover Institution.

She added, "We've seen this movie before. It stars Vladimir Putin behaving recklessly abroad to win political support at home as his economy stalls."

Clifton Parker is a writer for the Stanford News Service.

The United States and European countries can take steps to avoid making the same economic mistakes that Japan committed during the latter's "lost decade," a Stanford economist wrote in a new paper.

The study, published in the IMF Economic Review, describes the reasons Japan was not able to pull out of its long recession in the 1990s, offering some lessons for U.S. and European leaders in the wake of the 2007-09 meltdown.

In particular, the delay in bank recapitalization and the lack of structural reforms in the economic sphere kept Japan from realizing a full recovery, wrote Takeo Hoshi, the Henri and Tomoye Takahashi senior fellow at Stanford's Freeman Spogli Institute for International Studies.

"Bank recapitalization" refers to a governmental reorganization of failing banks, often involving the use of public money to keep them solvent. "Structural reforms" describes how a government might overhaul its economic structures to increase business competition – such as deregulation to cut costs for firms.

The shortcomings in these two policy areas "retarded Japan's recovery from the crisis and were responsible for its stagnant post-crisis growth," said Hoshi, whose co-author was Anil K. Kashyap, an economics professor at the University of Chicago Booth School of Business.

Risky bank lending

Japan's "lost decade" originally referred to the 1990s, though the country has still not regained the economic power it enjoyed in the 1970s and 1980s. Some say Japan has actually experienced two lost decades if the 2000s are counted as well.

Faced with a huge financial crisis at the dawn of its lost decade, Japan had to navigate challenges that other advanced economies had not confronted since the Great Depression, Hoshi and Kashyap wrote.

However, government leaders made mistakes, Hoshi said. One was failure to rehabilitate the banks and another was to misunderstand the nature of the problems afflicting the Japanese economy. For example, much like the United States in 2007-09, the Japanese banks had made many dubious loans to risky customers.

"Instead of recognizing that major structural adjustments were needed, much of the policy response was calibrated under the assumption that Japan faced a simple cyclical problem that could be addressed with indiscriminate fiscal stimulus," wrote Hoshi, the director of the Japan Program at the Walter H. Shorenstein Asia-Pacific Research Center.

For example, on the demand side, monetary policy was not as expansionary as it could have been, he said. Deflation persisted for a long time. And fiscal stimulus packages – such as tax cuts – were inconsistent. Meanwhile, much of Japan's fiscal spending took the form of public works projects that had low productivity.

As for structural reforms, the Japanese government lacked a sense of urgency. For example, even in the reform-minded administration of former Prime Minister Junichiro Koizumi, only eight of the proposed 35 reform initiatives would have directly boosted growth. Of the others, 16 might have indirectly supported growth and 11 would have had no effect on growth, Hoshi said.

Drastic change needed

Unfortunately, some European nations seem to be following Japan's lead, Hoshi said.

"In France, Italy and Spain, bank recapitalization has been delayed and the structural reforms have been slow. Without drastic changes, they are likely to follow Japan's path to long economic stagnation," Hoshi and Kashyap wrote.

The problems that held back Japan seem to be less serious in the U.S., Hoshi said: "Employment protection is low in the United States and the labor market shows high mobility. The regulatory advantage for incumbent firms is smaller than in Europe or Japan and starting new business is relatively easy."

As the researchers noted, the United States and Germany are in a bit better economic shape, partly due to the fact that they did undertake structural reforms sooner rather than later. The U.S. was able to recapitalize its banks more quickly, for example.

Still, five years after the failure of the Lehman Brothers investment bank left the world's financial markets in chaos, the U.S. and Europe are not yet back to what had looked normal before the crisis, according to the research. For instance, employment levels have not reached the levels seen before the 2007-09 crash.

"The U.S. recovery has been tepid despite a number of extraordinary macroeconomic policies (at least in the traditional sense). This suggests that the U.S. economy also has problems, but they are just different from those in Japan and in Europe," Hoshi said.

In the years leading up to the financial crisis, the researchers wrote, U.S. growth was fueled by a consumption boom from rapid housing price increases and rising debt levels.

"In a broad sense, the U.S. economy before the crisis was similar to the Japanese or Spanish economies," noted Hoshi, adding that in Japan, the speculative investment boom in the late 1980s masked structural problems.

Clifton Parker is a writer for the Stanford News Service.