Hong Kong and the road to recovery
We are following the road to perdition
There is increasing awareness that another financial crisis is in the offing, and, of course, everyone has an opinion as to what will trigger it and what form it will take. But there is broad agreement that since the Lehman crisis ten years ago, instead of resolving the problems that led to that crisis, governments and their monetary authorities have allowed the underlying position to deteriorate.
There have been many negative developments in the ten years following the Lehman crisis. Logically, you would expect the authorities would have been rethinking monetary and fiscal policies to ensure that the errors that led up to the Lehman crisis are not repeated. You would be wrong, both for the current credit cycle and for the next. The problem is one of not knowing who is responsible.
Modern economists insist that the state should have primacy over free markets. They argue that free markets have shown a track record of periodic booms and slumps, which can only be alleviated by the state. This belief has evolved from the Keynesians’ original proposition that the state should run a balanced budget over the business cycle, instead of all the time. The original idea was to increase spending by running budget deficits to create money during the slump in the hope of recouping government finances later when the recovery generates surplus tax revenues. Classic economic theory was replaced by a state theory of economic planning.
Since the Second World War, this has been the intellectual argument behind both fiscal and monetary policies. It has also been the prop behind socialism. In 1945, twelve weeks after the German surrender but before the Japanese surrendered, a Labour government was elected in Britain with a landslide and began a heavily socialist agenda, nationalising key industries without compensation, extending the welfare state and redistributing (in other words destroying) wealth. The emergency basic rate of income tax in wartime was barely reduced from 50% to 45%, and additional marginal rates increased to an unbelievable 147½% for the highest earners and savers.[i] Inflationary monetary policies provided cover for ruinous socialist dogmas, cover that concealed the true cost from the electorate that had voted for them.
We know only too well why these policies failed, not only in the UK but in all countries that adopted similar economic and monetary policies, leaving all socialising governments with escalating welfare commitments. The level of government debt already threatens to become beyond all control on just a small rise in borrowing rates, even before unfunded future commitments fall due.
Some time ago central bankers managed to cast themselves off from direct government control, so they could pursue monetary policy more objectively. But even without their political masters micromanaging them, they still manage to screw things up by deploying ever greater quantities of fiat currency in an vain attempt to manage the business cycle.
Some say the first sign of madness is to believe you are right and reality is wrong. It’s a problem that afflicts central bankers. They call the rhythm of boom and bust a business or economic cycle on the supposition that its origin is in unfettered free markets. The last culprit to be considered is monetary policy itself. Alright, we make mistakes, the central bankers say, but we are refining our monetary policies and tightening bank regulation to bring the business cycle under control. They fail to realise that the cycle has its origins in a cycle of credit, which is entirely their responsibility.
The state blames the private sector all same, and when it employs experts to support policy, it attempts to make itself unchallengeable. The Fed employs over 300 PhD economists “who represent an exceptionally diverse range of interests and specific areas of expertise.”[ii] And they still get it wrong. It shouldn’t take a genius to twig that if central banks stopped messing around with money, and stopped banks issuing it out of thin air as bank credit, the credit cycle would disappear and with it the business cycle. It does however elude those high-flying PhDs at the Fed and elsewhere.
But that is slamming the stable door shut, with the horse absent. It is time to remind today’s statist-educated elite that the world is a far better place without them, not least because it is becoming increasingly clear that they are impelling us towards yet another credit-induced crisis. They have kept us on the road to perdition, which sooner or later, like the ending of communism, will lead to the destruction of the status quo.
However, the establishment won’t be dislodged easily. An initial response to the next credit crisis is certain to involve producing yet more money, yet more regulation and yet more state control. Pig on pork. The seventy-three-year post-war drift from well-meaning welfare to a form of communism without the ideological hogwash will be nearing its ultimate conclusion with the next credit crisis. Eventually, the fallacies of state intervention and unsound money will become so obvious, not only to individual governments but also to their electorates, that the tide of government control will begin to recede.
It must do. This was the lesson of the failure of communism in the Soviet Union and the China of Mao. China and Russia now understand this, having experienced it in living memory. These nations have recanted and reformed. But their reformation has been state directed and often flawed. In Russia, an unholy trinity of the Russian leadership, the KGB and organised crime stole ownership of state-owned industries, proving property rights count for little. In China, communist control continued, but under reformed plans, modelled on Hong Kong’s post-war miracle.
Neither of these options are attractive to Western democracies. However, there is nothing like hard cold reality to force people to rethink, and if necessary jettison cherished views. At some point in time, the welfare state model will have to be abandoned, and market-friendly reforms introduced. In this context, the example of Hong Kong’s post-war recovery bears recounting, not only to contrast how an economy can develop with minimal government involvement and a neutral monetary policy, but to illustrate that there can be life after the death of state-managed economies.
The Hong Kong experience is little written about, but it has been truly remarkable. There is no doubt the Chinese leadership compared its sharp contrast with its own failures on the mainland. Same people, different outcome. An attraction was the irrelevance of democracy, which hardly existed in Hong Kong, outside a Legislative Council with limited powers. China, with over forty different ethnic and religious groups, controlled them by not permitting dissent, allowing only communist party representation in Beijing. China doesn’t do proper democracy, and they had that in common.
By emulating the Hong Kong model, China’s economic renaissance has been an incredible repeat performance. The obvious difference between the two is China has a global geopolitical presence, giving it ambitions beyond its territory. Less obviously she differs from Hong Kong in monetary policy, using the expansion of bank credit in her state-owned banks to finance infrastructure improvements at home, in Asia, and elsewhere.
Therefore, could the Hong Kong model offer us a template for economic reconstruction, following the next credit crisis? Or are we condemned to repeat the same mistakes again, until we are the lesser-developed nations, stuck in an Argentinian-style inflationary limbo?
The Hong Kong experience offers us both an alternative and an example of a recovery from Ground Zero. We will recap post-war events in Hong Kong before considering the implications for ourselves.
Hong Kong’s initial recovery
On the same day that her navy attacked Pearl Harbour, Japan mounted a coordinated attack on Hong Kong, the Philippines, Thailand and Malaya. It was 7th December 1941, and Japan declared war on America and the British Empire later that day. Hong Kong’s resident administrators and other British and American nationals were interned as prisoners of war. These included the newly-appointed Colonial Secretary, Franklin Gimson, who had arrived on the island only the day before the invasion to take up his appointment.
The Japanese military confiscated all production and trading facilities, causing great hardship for the general population of about one and a half million. The Hong Kong dollar was replaced by the military yen. During the four years of occupation, the economy was ruined, and the population had more than halved.
On 15th August 1945 the Japanese surrendered, but who to? Hong Kong was arguably Chinese, in the province of General Chiang Kai-shek. Fortunately, Gimson took the initiative and insisted the Japanese surrender to him, which after some hesitation they did. The British navy arrived a fortnight later, and Hong Kong came under British military administration.
After four years of Japanese occupation and the collapse of the military yen, it was a daunting task to get Hong Kong up and running again. Fortuitously, the pre-war civil service was based on an elite of highly trained administrators, the Hong Kong cadets. The cadet system ensured those selected had the qualifications and experience to manage the administration of the colony with minimal input from London. The system had developed before the immediacy of modern communications, so they were trained to take on the spot decisions in remote locations, and answer for them later.
A select team of these cadets had spent the last year of the war planning for the resumption of British control after the Japanese were defeated. They were well prepared and all of the same mind. Consequently, following the surrender, law and order and administrative control were quickly restored. Currency was an obvious issue, given the collapse of the military yen. Initially, the British overprinted yen notes with dollars in a ratio of 100:1. But by 14th September, less than a month after the Japanese surrender, the military yen was formally replaced by the reintroduction of Hong Kong dollars. To ensure their rapid entry into circulation, unskilled labourers were paid to clean up the city and money was distributed to the destitute.
Food supplies needed to be secured. The fact that food distribution had become an inter-governmental function during the war years meant that procurement of the basics, such as rice, flour and butter was initially a government task. And here, one of the cadets, John Cowperthwaite, was instrumental in obtaining the necessary supplies, which he did profitably for the new military government. Included in his department’s tasks was the control of prices, which he carefully set to reflect underlying supply and demand dynamics.
Industry grew quickly from the outset, because of the availability of labour, the hands-off attitude of the administration, and the rapid resumption of entrepôt activities. It was upon this, the China trade, that Hong Kong was built in the eighty years before the war by the British hongs (the trading houses) acting as intermediaries between China and the rest of the world.
The United Kingdom had its own post-war problems, so it was unable to distribute largesse to previously enemy-occupied colonies to assist in their recovery. The Labour government was inward-looking rather than interested in the colonies to boot. Consequently, the administration in Hong Kong had limited help from London, and if it had turned to London for money after the period of military administration, it would then be in the emasculating hands of the Treasury. If it was to have a high degree of operational autonomy, the new government would have to fund itself, a fact which undoubtedly concentrated minds.
This led to a policy of ensuring as far as possible that there was a surplus on the government’s accounts, sufficient to accumulate a contingency fund over time with an objective of covering one year’s revenue. It was quickly decided that this could only be achieved through a policy of encouraging business development and entrepôt trading through low taxes, and by restricting government spending to the bare necessities. It was also understood that businesses should be free to decide their own direction, rather than the government trying to give it a steer. In short, the administration could not afford any flights of fancy.
The first post-war Financial Secretary was Geoffrey Follows. More than anyone else, Follows set the administration’s economic policy in stone. He introduced a permanent income tax on profits and earnings at 10%, which only rose to 12 ½% in the 1950s. This tax, which was the only general tax, was justified as necessary for rebuilding the colony’s infrastructure and to ensure financial independence from Britain and was accepted by the population as being a necessary evil. Under his stewardship, Follows’ first post-war fiscal year of 1946/47 was the only year with a deficit (of $3.5 million in expenditures of $82 million).
The other years up to Follow’s last budget in 1951/52 showed healthy surpluses totalling $178 million. He inherited from the military administration a debt of $26 million, which including spending of $200 million on rehabilitating the economy, left public debt at $65 million and unallocated cash reserves of $180 million.[iii]
The strength of the Colony’s laissez-faire foundations was tested by the defeat of the Chinese Nationalists in 1949, followed by UN and American sanctions imposed against Communist China as part of the Korean War effort in late-1950. Exports to China from Hong Kong had grown to $1.6 billion in the year before the sanctions and collapsed by two-thirds the year following.
It was the private sector that came to the rescue. Refugees began flooding into Hong Kong from communist China, and Chinese entrepreneurs moved their operations from mainland centres, such as Shanghai, to Hong Kong. In fact, forward-thinking businessmen started making enquiries about moving to the island as early as 1947. The entrepôt trade was seamlessly replaced by manufacturing. The hongs in the entrepôt trade, Jardines, Swires, Inchcape and their ilk, refocused their business activities to Australasia, the Pacific and Europe. These British-owned businesses were replaced by Chinese textile manufacturers and other Chinese-owned enterprises.
The challenges for the government’s stewardship were momentous, and there can be little doubt that only an unfettered, low taxed private sector could have responded with the rapid redirections of capital required. Imagine, for a moment how a typical British post-war response would turn out. At that time, the Atlee government in London was busy nationalising industries and taking control of land for housing development. The basic rate of income tax for fiscal 1947-48 was 45%, with the top effective rate including surtax and tax on investment income taking the highest rate to 147.5%, as stated earlier. Tax was a discouragement to business innovation. Food rationing continued on meat and other foods until July 1954, while in Hong Kong fish and fresh vegetables were never rationed. The Hong Kong government continued to handle importation of rice, meat, flour, sugar and butter, but all rationing effectively ceased in 1948 and these activities tailed off in 1949.
A short history of Hong Kong’s monetary affairs
The post-war development of the Hong Kong economy concentrated on implementing a basic economic approach designed to ensure the most rapid reconstruction possible and to weather the instabilities of being an entrepôt for the Chinese trade. That was successful, as we have seen. But the question over monetary stability had been effectively set to one side. Notwithstanding the currency being termed dollars, Hong Kong was in the sterling area and had its currency reserves in sterling to which the currency was tied through a currency board. This was a common arrangement throughout the Empire, dating from gold-standard days. However, after the war when sterling was fiat and Britain was nationalising businesses, there was a fundamental mismatch between currency valuation factors in the UK and those that pertained in the far more successful economy of Hong Kong.
Inevitably, Hong Kong’s industrial success had the effect of increasing demand for commercial property, which was financed to a significant degree by the expansion of bank credit. It resulted in a property and banking crisis in 1961. This turned out to be a warm-up for a larger crisis in 1965, when Hong Kong’s credit cycle expanded ahead of a growing inflation problem in the UK, leading to a sharp increase in sterling interest rates. Inevitably Hong Kong’s rates rose with them, and a number of major banks faced difficulties and very public runs.
When sterling devalued in 1967, the Hong Kong dollar was revalued to offset most of the devaluation. By then, Britain had given the majority of her colonies independence, and shortly afterwards announced a policy of withdrawing her forces from east of Suez. It was clear that the ties with Britain were loosening, and in 1972 the currency peg was switched to the US dollar from sterling, where it remains to this day.
While economic policy had been an obvious success, monetary policy was exposed to two problems. First, there are the variations of outstanding bank credit, exposing the economy to a boom and bust credit cycle. Second, by firmly tying the currency to a foreign currency, domestic interest rates became bound to those of the currency to which it is tied as well, otherwise an unwelcome arbitrage takes place. The effect, as we have noted, is that the boom-bust cycle of the currency parent is adopted by the currency child.
At least the currency board system removed the temptation of inflationary financing of government spending, giving the dollar relative stability compared with other currencies in the region.
The lessons for us all
Hong Kong’s post-war experience shows that a rapid recovery from an economic and monetary crisis is eminently possible. Hong Kong’s economy had been destroyed by the Japanese occupation. Yet, within a month a new currency had been issued, and by the end of the British military occupation eight months later, the economy was on its way to a sustained recovery. Remarkably, the only government deficit incurred after the cost of the initial naval occupation was $3.5 million in the first budget year.
The contrast with the post-war experience of the developed nations is clear. Hong Kong’s policy had been guided by the classical economics of laissez-faire. At the same time, central planning and Keynesian-inspired monetary management were fashionable in the economies of the victorious allies and the newly liberated European states. Many of these collapsed when the Iron Curtain fell, by which time Hong Kong was a thriving financial and economic centre with a population that had increased eight-fold since the war.
An important factor in Hong Kong’s success was lean, responsible government from the outset. While other nations were pursuing a policy of suppressing free markets by maximising planning and control and the imposition of punitive taxes, Hong Kong encouraged entrepreneurial development. It was conscious of being competitive through low taxes and light regulation. It was a theme from Follows’ early budgets and carried on by his successors as Financial Secretary.
There follows a list of points and issues that cannot be ducked, if our future leaders in the welfare states are to emulate the successful policies of Hong Kong’s cadets. It is assumed that the next credit crisis will be greater than the last, and that initial statist solutions to it will eventually fail. It is likely that the purchasing power of fiat currencies will suffer from the central banks’ proclivity to extend infinite quantities of money to halt widespread banking and commercial failures. It is also assumed that government borrowing requirements will rise on the back of the economic consequences of the credit crisis, despite the rise in interest rates, springing a debt trap firmly shut.
To prevent a descent into a full-blooded collapse, governments will have to urgently adjust their behaviour and address economic and monetary issues in accordance with the following seven principles.
It is a difficult list, and we can be sure that future governments will think it is impossible to implement. Getting there is bound to give all reforming governments much trouble, but it is the minimum required, and carefully executed, it can be done.
- Tomorrow’s leaders do not have the luxury of progressing their economies despite public opinion. They will therefore have to carry public opinion with them in order to retain public support through a difficult reformation. Given this involves cutting public spending as much as possible, the more the better, it will be an extremely difficult task. However, at the depths of crisis, public opinion is always amenable to radical solutions so long as they are persuaded of the reality.
- Tomorrow’s leaders will be badly advised by establishment economists and other experts schooled in the failed statist traditions. They lack the benefit of the constructive planning of the Hong Kong cadets for a post-war economic renaissance based on free markets. They will have to plan their approach carefully, respecting the solid lessons learned from working with markets, while arguing against establishment economists.
- Tomorrow’s leaders must discourage and ignore lobbying by vested interests. Government’s role must be redefined as working in the interests of the electorate as a whole, without having any responsibility for individuals and businesses.
- Future governments must understand that they have been the source of economic instability; it is not the actions of the private sector. They must abandon all attempts at economic planning.
- Accordingly, they must not try to coordinate economic policies with other nations. G7, G8 and G20 talking shops should be shut down.
- The error made by Hong Kong over monetary policy, by linking its currency to first sterling and then the dollar, can be avoided by the reintroduction of a rigid gold standard, coupled with strict limitations on the creation of bank credit. A currency board tied directly to gold is the only answer.
- Bank credit can be effectively controlled by requiring the shareholders of licensed banks to accept unlimited liability. It is the best regulator possible for containing lending risk.
[iii] Budget statement, 1951.
Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.