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.

Japan must transform its economy in a way that mirrors the innovation ethos in places like Silicon Valley and Stanford University, Japanese Prime Minister Shinzo Abe said Thursday during a speech on campus.

As an example of how to encourage such creativity, Abe hailed a new partnership starting this fall with Stanford that will train the next generation of biomedical experts. In doing so, he urged a "fundamental change" in how Japanese society views the process of innovation, from how ideas originate to competition in the marketplace.

Japan Biodesign will be launched in collaboration with the Stanford Biodesign program and five higher education and research institutions in Japan. Faculty members will work together to create new interdisciplinary systems based on Stanford Biodesign. Stanford leaders will train and mentor their Japanese colleagues.

Abe, who is the first Japanese prime minister to visit Stanford, marveled at how the tech sector in the United States has "consistently evolved at top speed."

He said, "I want the best and brightest Japanese talent" to learn about Silicon Valley.

Image

Abe shared the Bing Concert Hall stage with Stanford President John Hennessy and George Shultz, the former U.S. Secretary of State and distinguished fellow at the Hoover Institution. Abe's talk, titled "Innovation, Japan and Silicon Valley Symposium," included an introduction and remarks by Hennessy and Shultz. The event drew a full house of invited guests and members of the Stanford community.

"It is a great honor" to be at Stanford, Abe said in beginning his remarks.

He noted that Japan is revisiting its regulatory and tax systems in order to encourage more economic dynamism and competition. "The Japanese people will benefit from innovation," he said.

The challenge, he acknowledged, has been the slow pace of innovation in Japan. Today, however, the Internet economy and big data are creating "enormous changes" in his country's economic approach, he said. "We have to catch up, or otherwise Japan will lose vitality," Abe added.

Cultural connections

In his introduction of Abe, Hennessy chronicled Stanford's long history and friendship with Japan and its people.

Japan, he said, is home to more Stanford alumni than any other Asian country, and when the university's doors first opened in 1891, the pioneer class included a Japanese student. Currently, 139 students from Japan are enrolled at Stanford.

Hennessey described Abe as focused on revitalizing Japan's economy and stewarding it toward a greater global role.

Shultz, who knew Abe's parents, shared recollections of poignant moments between Abe's politically prominent family and his own.

Abe joined a roundtable discussion after his speech with Michael McFaul, director of the Freeman Spogli Institute for International Studies; Stanford Board of Trustees Chair Steve Denning; Stanford School of Medicine Dean Lloyd Minor; Stanford political science Professor Emeritus Daniel Okimoto; Yahoo co-founder Jerry Yang; and Twitter co-founder Jack Dorsey, among other scholars and dignitaries. He also met with Stanford students before leaving campus.

Afterward, McFaul wrote in an email, "I think it is fantastic that Prime Minister Abe came to Stanford and Silicon Valley after his very successful visit to Washington. He demonstrated that deepening U.S.-Japanese relations requires not only strong government-to-government ties, but also deepening ties between our societies, including educational institutions like Stanford."

Abe's state visit to the United States this week included the first address by a Japanese leader to a joint session of Congress. Abe served as prime minister of Japan in 2006-07 and returned to the position in 2012.

'Working together'

On Tuesday, U.S. President Barack Obama said after a meeting with Abe that the two countries had made progress in trade talks on a massive 12-nation trade deal that would open markets around the Pacific Rim to U.S. exports. Both nations face domestic political obstacles to concluding the Trans-Pacific Partnership agreement.

"This agreement would expand the coverage of the free trade agreements for both Japan and the U.S. substantially," said Stanford economist Takeo Hoshi, director of the Japan Program at the Shorenstein Asia-Pacific Research Center, in an interview. "The U.S. and Japan have been working together to maintain peace and sustain economic growth in the Pacific Asia."

Hoshi said that Abe's visit to the Silicon Valley confirms that Japan is serious about transforming its economy from one based on exports to one focused on innovations.

"Going forward, we can learn a lot from Japanese experience and their reform attempts," said Hoshi, who is also a senior fellow at the Freeman Spogli Institute.

Hoshi spoke with The Associated Press just before Abe’s arrival to California, citing Silicon Valley as the ideal place for Japan to learn about innovation. He also joined KQED’s Forum to discuss the current state of the U.S.-Japan alliance. Later, he was interviewed by BBC Business about Abe's visit to Stanford.

Stanford Biodesign

Founded in 2001, Stanford Biodesign has pioneered a new training methodology in which interdisciplinary teams of engineers and physicians go through a rigorous process of carefully characterizing unsolved clinical needs before jumping to technology solutions.

For the Japan Biodesign program, the bulk of the educational activities will take place at the campuses of the partner Japanese universities.

Clifton Parker is a writer for the Stanford News Service.