Reform or Bubble? Choose one

Why is it very important to prevent the banks from speculative trading? Let's consider these facts that are relevant today:

1. America has injected enormous amount of liquidity into the financial system and the interest rates in US are near zero.
2. Asia, especially China and India, seem to be in a comfortable zone (relatively) out of the recession and have started monetary-tightening.

Is there a relationship between American financial system and Asia? Yes there is. With the US interest rates at an all time low near zero and expected to remain low throughout this year, there are huge amounts of capital outflows from US into emerging markets. This capital-outflow is supported by the speculation that emerging markets will do better than the US, atleast in the shorter term. There are good reasons to believe this - economies like China and India have had tremendous growth in recent years, have financially sound banks, have huge foreign reserves and high savings rate. And all these are currently being deployed and will be deployed in their respective economies to promote and support growth.

In both China and India, I expect strong government spending during the coming years. China, I would expect, to spend on factors that would drive consumer-spending. China is already embarking on a $150 billion nation-wide health-care package.

India has plans to spend heavily on its broken infrastructure like roads, ports, bridges, public-transportation etc. India is expected to need $500 billion in the next five years to meet the growing infrastructure demand (and the govt. acknowledges this).

Both China and India have huge savings rate and large amount of foreign reserves that should see the planned investments get implemented. United States is also expected to invest on a large scale in infrastructure related projects to push the economy higher. So all this should ensure a considerable amount of global capital-sector spending.

But the recovery from this recession is very different from the earlier ones. In this recession, the US consumers are hit hard and they are likely to spend less in the coming years. Can this decrease in US private consumption be compensated by an increase in private consumption from Asian economies like China and India? I very much doubt it. In 2007, US consumed $9.7 trillion worth of goods and services which is six times more than the combined consumption of China and India in the same year (source: "The Next Asia" book by Stephen Roach, Morgan Stanley Asia Chairman).

And this time, Asia leads the recovery and US will follow, which means exports are going to be a key for growth in the US in the coming years. Will this mean that America will need a weaker dollar? Well, I am not in favor of this idea. With enormous capital spending expected in the coming years in the world's two most populous nations and other developing countries, a weaker dollar will shoot up the commodity prices to unsustainable levels and that combined with the large liquidity in the US financial system and with low interest rates will make a good recipe for inflation in US.

Now there are two questions that we have to answer here:

1. How are we going to make American exports more competitive?
2. But even before answering the first question, how can we be sure that Asian economies don't get into any kind of economic trouble, which if they, will bring down the world again into recession?

One of the solutions to the second question, which will be a very good first step towards a stable global economy, will be to bring about financial and banking reforms in the US. If the commercial banks are allowed again to get involved in proprietary trading, which is done using the abstract concept called "speculation", then there is high-risk of asset-bubbles forming in Asian economies due to cross-border capital flows. Many Asian economies, especially China and India have some sort of capital-controls but this will not be sufficient to stop the speculative inflows. And this may cause unsustainable shoot-up in real estate and stock prices. At the same time, allowing banks to do proprietary trading will seriously reduce bank-lending in US. This is especially true after the credit-bubble burst. Bank-lending is very much needed now for small businesses and to an extent to consumers in the US. By preventing banks to speculate using depositors' money, we can bring a balance between exports and domestic consumption in US and this will also help reduce the currently unsustainable current account deficit.

Now coming back to question number 1 - how can we make American exports more competitive? The answer to this does not lie in a weaker dollar but instead in increasing productivity. For this to be achieved, US must direct the cheap money available into education, investments to achieve higher energy-efficiency, investments in people, scientific-research and other areas of technology. What the US does NOT want now is the government and Federal Reserve trying to increase the retail-spending of American consumers through cheap money to pre-crisis levels that were already unsustainable, to prop up the economy. Trying to do this may look right now but going back to the old-ways will likely make our economy present us something in the future, which has been presented to us again and again - a "bubble"