This is the sixth of ten articles I intend to write onHong Kong’s so-called deep structural contradictions. It is best read alongside my many articles on public sector housing policies in Hong Kong andSingaporepublished in this column.


Harvard Professor Dani Rodrik has for many years presented an important argument on the inescapable trilemma of the world economy, which he calls the “impossibility theorem”. This says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full. The idea is simple and bold but it helps us to see more clearly a complex reality that requires nuanced approaches.


Rodrik’s argument has gained increasing significance in light of the present Eurozone Crisis and the economic tensions that have emerged in the G20 world sinceAmerica’s Financial Tsunami. His most comprehensive statement is presented in his recently published book , The Globalization Paradox: Why Global Markets, States, and Democracy Can’t Coexist. Here is what his theorem looks like in a picture reproduced from his study:


Rodrik notes that deep economic integration requires that we eliminate most if not all transaction costs traders and financiers face in their cross-border economic activities. In other words, there must be one set of rules to govern all economic activities regardless of where they take place. The globalization that has occurred in the past 30 years has been accompanied by attempts to create, step by step, a common set of rules to reduce the transaction costs of cross border transactions.


Nation States Source of Transaction Costs


For example, the General Agreement on Tariffs and Trade (GATT) was replaced by the World Trade Organization (WTO) in 1995 to promote deeper integration in trade and investments than envisaged under the GATT. The Basel Accords likewise attempt to create a global standard for banking regulation. Accounting standards is another area where the migration towards a common set of standards has been on-going.


Nation-states, on the other hand, are a fundamental source of transaction costs for cross-border exchanges. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort an impossible dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.


In a democratic society, the domestic demands of workers, employers, and various special or popular interests are not aligned with the needs of deep economic integration. These domestic demands are one of the reasons why nation states create transaction costs at the border to thwart deeper economic integration.


For example, they may prevent immigration of foreign nationals to protect the jobs of local workers, particularly unskilled workers, but also professionals. They may establish a variety of protectionist barriers to limit goods, services and investments from crossing their border under the pretext of safe-guarding industries, jobs, health, safety, the environment, national security, public morality, and so on. They often go so far as to accuse other nations of engaging in unfair, anti-competitive, and dumping practices.


Consequences of the Golden Straitjacket


One option in addressing the trilemma is to maintain the sovereignty of the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives. The 19th century Gold Standard  provides a historical example of this kind of a state. However, the limitations that resulted from the currency union based on the Gold Standard leads Professor Rodrik to call this option the golden straitjacket. The collapse of the Argentine currency board experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with a democracy that had a propensity to incur fiscal deficits and public debts due to populist pressure.


The experience ofHong Kongunder the linked exchange rate system during the Asian Financial Crisis is particularly illuminating. In staying with the linked exchange rate,Hong Konglived through a period of intense deflationary pressure. Between 1997 and 2003, the cumulative consumer price deflation was 11.6%, the cumulative GDP deflator deflation was 17.5%, nominal GDP growth was -9.5%, and unemployment reached a peak level of 8.8%. The economic downturn would have been worst had it not been for an impeccable record of fiscal prudence, stellar sovereign credit ratings, flexible labor and product markets, and an ethic of individual self reliance.


It is useful to review the correspondingUSfigures during the Great Depression years of 1929-1939. The cumulative consumer price deflation was 18.7%, cumulative GDP deflator deflation was 19%, nominal GDP growth -11%, and unemployment 24.9 %. Deflation and economic output decline were comparable between Hong Kong and theUSduring these two episodes, although the unemployment impact was far weaker inHong Kong. Without our flexible labor markets, past fiscal austerity measures, and robust banking system, the economic consequences of the Asian Financial Crisis would have been far worse.


These attributes allowed Hong Kong to weather the economic crisis without descending into chaos likeArgentinain the 1990s or likeGreecemay experience today in the absence of a bail-in program. Still, half a million people inHong Kongmarched peacefully on the streets on 1 July 2003 to express their frustrations.


Free Rider Problem of Global Federalism


Another option under the trilemma is to go for global federalism, where the scope of democratic politics is aligned with the scope of global markets. This would require member nation states to adopt essentially similar fiscal and regulatory rules in economic affairs so that labor, capital and goods can cross borders with minimal barriers. For this to work democratic politics in each nation state must not be allowed to push their rulers into a perpetual reliance on fiscal deficits to get into office or to stay there.


Realistically, this is something that cannot be done on a global scale in any foreseeable future because there will always be not a few sovereigns who will succumb to populist political pressure somewhere in the world. The experience of the European Union demonstrates it is difficult to achieve federalism even among a group of relatively like-minded and similar countries. Across the border on the mainland, such barriers continue to exist among provinces, municipalities, and localities despite the wishes of the central government and despiteChinabeing a nation with a shared history of several millennia. Hong Kong, as part ofChinaunder the “one-country two-system” formula, has the country’s most severe barriers to entry, which are seen by some inHong Kongas insufficient and by others as too severe. Global fiscal federalism is not relevant forHong Kongas such since we are not a sovereign nation state to begin with.


Finally, we can downgrade our ambitions with respect to how much international economic integration we can or should achieve. In this case we go for a limited version of globalization, which is what the post-war Bretton Woods regime represented with its capital controls and limited trade liberalization so that governments can have some scope to accommodate democratic populist demands. Unfortunately half a century of Keynesian social welfare policies have culminated in governments running public debts so large that they now threaten to roll back globalization.


The choice facingHong Kongis not a difficult one. For over a century,Hong Kong’s economy has pursued deep economic integration with the world economy. The fact that the local currency has operated under a Currency Board System during most of the post-war era, first anchored to theSterlingand then linked to the US Dollar after 1983, is a litmus test of Professor Rodrik’s golden straitjacket of economic integration. In essence, the monetary authorities surrendered their right to a separate and independent monetary policy in pursuit of monetary union.


For deep economic integration with the world economy to work it is necessary to maintain trade, finance, and fiscal policies inHong Kongthat are compatible with this goal. This means pursuing a laissez faire policy, maintaining a free and open economy, limiting spending on entitlements, and avoiding an aggressive interventionist industrial policy. These core fiscal and pro market choices are intended to avoid public debt and downgrades to sovereign credit ratings that would put stress on the commitment to the golden straitjacket. The collapse of Argentina in the 1990’s and the stress Greece is coming under today remind Hong Kong that we should think twice about heeding the calls of populist politicians to spend and spend like there is no tomorrow.


Hong Kong Gains from Laissez Faire


Hong Kong’s economy has benefitted enormously in the past 60 years from pursuing currency union and economic laissez faire. The economy has maintained a high level of sustained per capita GDP growth. Any attempt to exit from deep economic integration would wreck Hong Kong’s future as the international trade and financial center ofAsia. The Bretton Woods compromise would mean retaining the currency union, but introducing some limited trade and capital controls. Some versions of these policies have recently been advocated by certain quarters inHong Kong. The call to prevent pregnant Mainland mothers from coming toHong Kongto give birth or at least to reduce their numbers is a form of trade control over the export of medical services. The call to impose a levy or to stop non-Hong Kong residents from purchasing properties inHong Kongis a form of capital control over foreign transactions in the asset market.


The cumulative impact of these and other similar measures, if adopted, would inevitably impact negatively onHong Kong’s economic performance over time. Such controls would of course also encourage these transactions to go underground. Over time black markets would emerge in all kinds of activities with damaging consequences to not only the economic sphere, but also social and ethical aspects of life inHong Kong. The golden straitjacket or deep economic integration with the world market is not merely a beneficial economic arrangement forHong Kong; it is the anchor for many of our society’s core values, notably freedom and liberty.


Unfortunately, staying with the linked exchange rate and maintaining deep economic integration has social and economic costs. ForHong Kong, the macroeconomic shocks of the past two decades have been unusually large compared to earlier periods. Their effects have been amplified by the linked exchange rate because we have lost monetary policy as a counter-cyclical stabilization tool. Property price fluctuations have therefore been enormous following these shocks. One of the consequences has been to worsen the distribution of housing property wealth among households inHong Kong. Rising property prices help the haves to accumulate wealth even faster and the divide between the haves and have-nots widens. Falling property prices do not help the have-nots as hardly anyone enters the market at that time and certainly not the have-nots.


The deflationary pressures of the Asian Financial Crisis were amplified by the linked exchange rate and property owners were severely hurt. Young households who bought property a few short years before the property market crashed saw their future vanishing with each passing month, and then with each passing year.  When the crisis finally ended, real property prices had fallen by a cumulative 57%.  Property prices eventually recovered. They would rebound remarkably in the years ahead but in the meantime,Hong Kong’s middle class was half devastated by the property crisis. Those that survived lost precious time at the prime of their careers and their entrepreneurial and risk taking spirit was dulled.


Hong Kongis now experiencing the inflationary pressures of the global Financial Tsunami and these effects, too, are amplified by the linked exchange rate. All those without property are feeling miserable and frustrated because they are unable to share in the rising tide of property prices. Their incomes also suffered in the Asian Financial Crisis years and they see themselves as missing out on opportunity again while the haves are able to benefit in more than one way, such as refinancing their mortgage loans to take advantage of lower interest rates and even financing the purchase of another property.


Bricks and Mortar a Recipe for Disaster


When Tung Chee-Hwa came to office on 1 July 1997, the property market was at its peak and was about to crash in the aftermath of the Asian Financial Crisis. The public had been unhappy about high property prices for quite a few years. Tung responded by increasing housing supply with a vision to create a society with 70% homeownership. He was blamed for precipitating the housing market depression. Donald Tsang who succeeded Tung failed to increase housing supply in the face of rising property prices and a Financial Tsunami in the background. He was blamed by the public for failing to act. Tsang has now responded by increasing land supply and introducing new subsidized housing programs. This is called a “bricks and mortars” counter-cyclical stabilization policy to stabilize the housing market. It is not only farcical, but a recipe for disaster.


Every student of economics knows that trying to stabilize an economy is very difficult because it is difficult to get the timing right for conducting counter-cyclical monetary and fiscal policy interventions. Fiscal policy is worse than monetary policy because it is slow moving by comparison and so even more difficult to get the timing right. Now, can you imagine how we can get an even more slow moving policy – that of land and housing – to perform counter-cyclical stabilization policy for the housing market and make it work? It is next to impossible as the experiences of Mr. Tung and Mr. Tsang have demonstrated. I hope the next Chief Executive will not have to repeat this farcical history when he or she is in office, but I am almost 100% certain that they will.


What, then, canHong Kongdo under the circumstances? To make deep economic integration work forHong Kong, its domestic policies must address both economic and social concerns. The economic concern is to keep markets flexible so that they can respond to shocks and absorb them as efficiently as possible. A small government unencumbered with public debt combined with a large market sector enhances flexibility and responsiveness. Interventions in the market typically make the adjustment periods last longer and people suffer longer.


The social concern is about providing households with a means to insure their welfare against shocks. These shocks impact different people in different ways. A deflationary shock causes some to lose their jobs, some to lose their income, some to lose their savings and investments, and some to lower their consumption. Many societies have devised a variety of means to help, including small business loans, unemployment compensation, low income support, social security, health care, subsidies for rent, food, transportation, tuition, and many others.


ForHong Kong, an important part of the economic and social concern can be addressed by finding out what is behind people’s aspirations for homeownership. Is it for shelter? Is it an asset to hold as a form of savings and investment? Is it a security to finance consumption spending in old age? Is it a source of financing to fund education and health expenditures? Is it collateral to be used for financing a business?  Is it a bequest one leaves to a spouse or children? Or is it used to re-finance another property purchase? The answer has to be all of the above. An appropriate housing policy to support public housing occupants to own their property will go a long way to meeting such aspirations.


Society today is providing subsidized housing for 47% of households – 16% in HOS units and 31% in Public Rental Housing (PRH) units. Making these households bona fide homeowners would eliminate in one fell swoop a big part of the divide between haves and have-nots. Together with the 37% who are private sector owners, the total percentage of homeowners inHong Kongcould become as high as 84%. Since the land values have already been factored in by society, there is no significant additional cost to letting the occupants capture the value of the land.  If free lunches ever existed, this has to be the biggest free lunch inHong Kong.


A society with 84% homeownership has to be the best defense for the golden straitjacket of deep economic integration. It could be achieved at no cost to society. One of the main benefits is that it would reduce the demand for public resources to provide other means of insuring households against macroeconomic shocks. Public spending would be better contained in the end. It would also reduce our need to downgrade our ambitions for the deeper international economic integration thatHong Kongcan and should achieve. Why should the freest economy in the world settle for a Bretton Woods compromise? Let the rest of the world settle for a second-best solution.


(6 of 10)




Dani Rodrik, The Globalization Paradox: Why Global Markets, States, and Democracy Can’t Coexist,OxfordUniversity Press, 2011.

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