CHARLIE ROSE: Stephen Roach is here. He is chairman of Morgan Stanley Asia. For much of his career, he served as the firm’s chief economist, heading up a team of economists around the world. His new book is called "The Next Asia: Opportunities and Challenges for a New Globalization." I am pleased to have him back at this table. Welcome. STEPHEN ROACH: Good to see you, Charlie. CHARLIE ROSE: You left Wall Street to go live in China. STEPHEN ROACH: I did. About three years ago, your friend and mine, John Mack, called me up and said, 25 years as an economist, a long time, good job. How would you like to do something different and be the chairman of Morgan Stanley’s business activities in Asia? And I told John I thought he was nuts. I had the best job. I wasn’t going to leave it. He said, "Think about it." And, you know, John, when he says, "Think about it," there’s a fair amount of emphasis there. I did think about it. And I’d built fabulous relationships in Asia over the years, Charlie. I was passionate about the region. I thought I knew it well, but I knew in my gut that it would be a lot different from the inside than from the outside, and I said, yeah, I’m going to go for it. And I’ve been out there now about two and a half years. And I have no regrets. I love it. I have learned an awful lot about Asia, and I thought it was time to put it down in a book and get it out there when the world is very focused on Asia, its own challenges and its role in the global economy. CHARLIE ROSE: What do you love and what have you learned? STEPHEN ROACH: What I am most passionate about in terms of Asia is what they’ve done, especially in China, over the last 30 years. You know, big celebration, 60th anniversary of the People’s Republic of China. But the first 30 years were pretty awful and the next 30 years have been spectacular. And the difference is they have really put huge focus on transitioning this economy from one that was owned by the state to one that is more of a market-based economy. They’ve taken huge risks in terms of reforms, layoffs, building market structures, building companies that we’ve never seen before. And to be on the inside and watching, watching that risk taking up close is a pretty fascinating experience for anyone. And I love every bit of it. CHARLIE ROSE: Do you have access there, the kind that you might have here? STEPHEN ROACH: I have -- I’ve been really blessed and fortunate. When I first started writing about China in depth, probably about a dozen years ago, I wrote a piece in the "Financial Times" called "This China is Different," right after the financial crisis in ‘97-98. The finance minister of China at the time read it, gentleman by name of Shien Wang Chien (ph), and summoned me to meet with him -- believe it or not, in a boat in the back harbors of Seattle on a Saturday in mid-1999. We hit it off. He opened one door after another for me in China, including introducing me to then the premiere, Zhu Rongji, and it’s really been nonstop ever since. You know, it helps to be in the right place at the right time and be lucky. CHARLIE ROSE: And so, how do they see their future? There was that famous speech that Wen Jiabao made, in which he said, to the alarm of some China watchers and to the alarm of some people in China, which was-- surprise, surprise, this economy may not be sustainable, this economy may not be as good as you think it is. You remember the quote. STEPHEN ROACH: Look, I was there. This was back in March of 2007, the end of the big congress they have in Beijing, the National People’s Congress. He said the economy, while it appears to be strong on the surface, beneath the surface is unstable, unbalanced, uncoordinated, and ultimately, unsustainable. And we have got to address these issues before it’s too late. And it was really -- it was a quote that I used as a setup for much of this book, the four "un’s," as they then became known. And interestingly enough, in mid-September, there was a big conference again in Dalian, China, that I attended, and you would expect the premiere to come out and say, "We’re recovering. We’re leading the world. We’re proud of what we’ve done." He said, "No, this recovery is fragile. It’s tentative, and it continues to reflect an economy that’s unstable, unbalanced, uncoordinated and unsustainable." And this is -- this is the issue in China right now. The path they’re on, as spectacular as it’s been, it’s dominated by exports. It’s dominated by investment. They’re under-consumers, they’re over-savers. It’s very destabilizing, and they’ve got to address it. And this crisis that the world is in right now I think is their wake-up call that they have no choice but to get on with the heavy lifting of addressing these issues. CHARLIE ROSE: And they are? STEPHEN ROACH: They’re dragging their heels. They’ve got to do more. They did a stimulus package that gave them a lot of growth in the first half of 2009, but 88 percent of that growth, Charlie, came in one sector, investment, which is already very top-heavy, and they funded it with just a bonanza of bank lending, which if this type of approach continues, will compromise loan quality and cause problems for the banks. The thing is . CHARLIE ROSE: And what did they do with it, they built investment? I mean, they built infrastructure? STEPHEN ROACH: Infrastructure was most of it. And, you know, developing countries need infrastructure. You want infrastructure, state- of-the-art infrastructure go to China. There’s nothing like it. Especially if you know, if you get stuck on the Van Wyck here (ph), I would think of what it’s like to drive to the airport in Beijing. CHARLIE ROSE: And what’s it like? STEPHEN ROACH: Well, Beijing, there’s a lot of cars, but, you know, these roads are smooth, there are no bumps. And you go to the airport, it is spectacular. CHARLIE ROSE: And how fast can you drive? STEPHEN ROACH: Well, you know, it depends on the time of the day you pick. You pick a day when there’s no traffic, there’s no telling how fast you can drive. The problem with driving in China is most of the drivers don’t have a lot of driving experience. CHARLIE ROSE: OK. So, what China has to do, first of all, is to create more consumer spending, so there will be a demand for the products it makes. STEPHEN ROACH: Absolutely. I mean -- and here’s the issue in China. Chinese households save to excess. Their savings rate for the household sector in the year 2000 was about 27 percent. In the year 2008, it was 37 percent. So the more income they get, the more they save, and the reason they save is because they have no social safety net. Their national social security fund, the pillar of the retirement system, has about $82 billion U.S. dollars of assets under management. That’s $90 a worker of lifetime social security benefits. They did a medical care plan earlier this year, $30 a person for three years. So when you don’t have any security for the future, when you -- when your medical benefits don’t cover your average expenses, you’ve got to save, and that inhibits the growth of a broadly based consumer culture. They’ve got to invest in their safety net and they’ve got to do it now. CHARLIE ROSE: Uncoordinated means what? STEPHEN ROACH: Uncoordinated talks about fragmented aspects of China. There’s an old Chinese proverb -- the mountains are high and the emperor is so far away. And that says, you know, the guys in Beijing, you know, they may give an order, but, you know, beyond -- beyond Beijing, people do whatever the heck they want, and I think that’s very, very true. Very fragmented banking system, system of regional governance, and they’re trying to pull that together, and they’re actually making some progress. CHARLIE ROSE: Yeah, what’s happening out there in the regions? I mean, are we seeing any local democracy? STEPHEN ROACH: In some pockets of China, especially a place like Xinjin (ph), located very close to Hong Kong, there have been some experiments in freely held elections and in political reform. But these are the exceptions, not the rule. And the fascinating thing about transitioning to a consumer-based society, you will raise the whole aspirational level of this massive population. It’s going to be very hard to do that ultimately without a more free choice of political leadership. CHARLIE ROSE: But they see economic growth as their only salvation. STEPHEN ROACH: The two biggest -- well, the two words that always shape my assessment of risk in China are social stability. And they have made the determination they need rapid growth to absorb surplus labor and maintain social stability. Without that rapid growth, they do worry about destabilizing events in their population. They’ve had plenty of them recently. They’ve had ethnic violence in Xinjiang province, they had it in Tibet. They had massive layoffs in Guangdong province because of the export collapse. So growth is the antidote right now for everything. But the key for China, I think, is to move away from this fixation on the quantity of growth and now start to think much more about the quality of growth, and that’s a better mix of the GDP; it’s environmental issues; it’s resource consumption. They’ve done so well that they really need to rethink this growth paradigm. CHARLIE ROSE: But I talk to a lot of people who are engaged in the work of looking at climate change, say, notwithstanding their refusal to accept established emission standards, you know, they are very committed to solar, they’re very committed to electric cars, they’re very committed to a range of things that suggest their awareness that growth has the peril of a kind of environmental damage. STEPHEN ROACH: Well, I think -- there is a growing consciousness inside of China that open-ended growth has a lot of negative side effects or what economists call externalities. And excess resource consumption, oil consumption, and pollution are clearly the most obvious of these negative externalities. But the question is, are they really doing something about it? And there certainly is a lot of advance going on in alternative energy technologies in China. And because of the nature of their system of governance, they can do nuclear in a way that, you know, a society like the U.S. could not even. CHARLIE ROSE: Just order it be done. STEPHEN ROACH: Yes, exactly. So they can move very aggressively in these areas. But the bottom line is, as long as they have this growth model that’s fixated on exports, fixated on investment, it’s dominated by the industrial production, smokestack-type industries, which are very, very biased toward pollution and excess energy consumption. They’ve got to get out of that model. CHARLIE ROSE: What’s their commitment to some kind of removing American -- the dollar as a reserve currency in the world? STEPHEN ROACH: I think it’s all talk right now. I think the end game is, of course, that, you know, the dollar will not be the preeminent anchor of the world financial system at some point in the distance future. CHARLIE ROSE: Are they right? What does "distant" mean? STEPHEN ROACH: Probably 50, 60, 70 years out. But look at China. They’re an export-led economy. They need a competitive currency to support their export business. If they were to sell their dollars right now, their currency, the renminbi, would go up, but would undermine their export competitiveness, they’d lose jobs and they’d run a risk of social instability. They’re not going to do that. So. CHARLIE ROSE: It’s not in their interest to get rid of the dollar. STEPHEN ROACH: Not at all, until they change their economic structure that makes them less dependent on the currency support to their main engine of growth, which is exports. CHARLIE ROSE: Is China different than the rest of Asia? STEPHEN ROACH: Absolutely. The piece I told you about earlier that the finance minister read a dozen years ago, the title of it was this sort of trivial title called, "This China is Different." And I wrote that because in the Asian crisis, all these, you know, economies that we were so envious of were falling by the wayside. They were devaluing their currencies. They had massive current account deficits. They had run out of reserves. They had to run to the IMF. China, huge saver, they were building currency reserves, they had a current accounts surplus. They did not go to the IMF. They did not devalue their currency. And they were very, very focused on building the greatest export machine the world had ever seen and executing that construction project by transitioning from a system of state ownership to a system of market-based private ownership. CHARLIE ROSE: Is it a joint venture between government and private? STEPHEN ROACH: Absolutely. The government still has huge stakes in all of. CHARLIE ROSE: Huge stakes meaning majority? STEPHEN ROACH: Yeah, in many cases, 50 to 60 percent are still owned by the government. CHARLIE ROSE: What’s the possibility of a trade war with China? STEPHEN ROACH: That’s sort of up to us, I think. In the years 2005 to 2007, the U.S. Congress, in its infinite wisdom, introduced 45 separate pieces of anti-China trade legislation. Not one of them passed. Reason? Unemployment rate was four percent. Today, we’ve got a little bit more than four percent unemployment in the U.S. We have a president who in September imposed sanctions on 35 percent -- big sanctions -- on the exports of tires coming out of China in the United States. Small potatoes. Tiny piece of the overall trade between the two countries, but emblematic of a big issue that’s looming in 2010. Midterm elections coming for a very popular president. The unemployment rate’s going to be, you know, nine percent-plus, maybe higher. And the Congress is itchy to push the blame on to somebody else, and that somebody else always seems to be China. So if a bilateral trade bill goes through the Congress, I think President Obama is going to have a heck of a time vetoing it, and that’s a big issue, and. CHARLIE ROSE: And if he does? I mean, if he doesn’t veto it? STEPHEN ROACH: If he doesn’t. CHARLIE ROSE: And if it goes through, what will the Chinese do and where does it take us? STEPHEN ROACH: Well, you can’t forget one critical thing. We don’t save a nickel in America, and courtesy of trillion-dollar budget deficits, our savings position is going to get worse. And so our biggest lender, our biggest provider of surplus savings from overseas are the Chinese. We put trade sanctions on them, they will not show up at a treasury auction. The dollar will crash. Long-term real interest rates will shoot up, and we’ll be back in the soup again. So, you know, I appear in front of the Congress, you know, several times a year. I’ve done it for the last five or six years. I talk about this. It goes in one ear and out the other. They don’t seem to care. They want a scapegoat for the pressures, the very legitimate and palpable pressures that are bearing down on middle-class American workers. China is the enemy. CHARLIE ROSE: You supported President Obama. STEPHEN ROACH: I did, I voted for him. CHARLIE ROSE: And what do you think of his stewardship of the economy? STEPHEN ROACH: Look, he inherited a total mess. This crisis had been building for a long, long time, an outgrowth of reckless behavior from Main Street to Wall Street to Washington. But, you know, like all these messes, he can blame it on the other guy, but it’s now his recovery, whether he likes it or not. And so the challenge will be for him in the next few years to put in place policies that really give us a better process of economic organization, a sustainable healing. CHARLIE ROSE: They say they’ve turned the economy around. In your judgment, have they? STEPHEN ROACH: I think they put a huge hole -- they plugged a huge hole in the financial system. They seem to have, because of that, instilled better sense of confidence amongst businesspeople and consumers. So the freefall has stopped. The recovery, though, I think is still a ways out, very tentative, very fragile, and ultimately very anemic and vulnerable. CHARLIE ROSE: Do the Chinese see the global economic issues different than the Americans do, beyond this sort of consumption-spending issue that’s been there before and which you used to sort of provide for many years as a warning? STEPHEN ROACH: Well, I think that the Chinese are using this crisis - - their word for crisis, Charlie is an interesting word, weiji (ph), which means both danger and opportunity. And I think . CHARLIE ROSE: It sounds like Rahm Emanuel. STEPHEN ROACH: Yeah, exactly. Maybe he was Chinese, I don’t know. But -- but they’re -- they’re -- they’re looking at this as a time to rethink this global strategy. They’ve been hugely dependent, and successfully so, on the U.S. as a main engine driving the external demand that supports their export machine. And so now they -- they’re beginning to sense that they -- that they need a broader platform to support their globalization reach. They need to be able to sell those exports into Europe, into Latin America and to Africa. They’re thinking a lot about resource acquisition strategy in places like Australia and South America. CHARLIE ROSE: But they’re doing a lot of resource acquisition strategy all over the world, aren’t they, in terms of energy. STEPHEN ROACH: They -- they’re. CHARLIE ROSE: Africa especially. STEPHEN ROACH: They’re an energy-short nation, and they absolutely need to do this. CHARLIE ROSE: How do they view the United States? I mean, I realize there’s no monolithic view. STEPHEN ROACH: They have extraordinary admiration for the United States. They truly do. You know, when I go to China, which is every other week, they continue to talk a lot about our resilience, our flexibility, how they would give anything to have a Silicon Valley. CHARLIE ROSE: But aren’t they trying to develop a Silicon Valley? STEPHEN ROACH: Well, they’ve got -- they’ve got a few. CHARLIE ROSE: I’m asking whether there’s a commitment to do it, not whether they’ve been able to do it. STEPHEN ROACH: They’d like to, but the true Silicon Valley spirit, the interplay between entrepreneurs and major universities and the creative genius that comes out of that interplay, that takes a long time to build. They don’t have that yet. CHARLIE ROSE: But they recognize that. STEPHEN ROACH: They would love to have that. They really would. They’ve got a few good technology companies, but there are few. CHARLIE ROSE: Does that cause you to say, look, notwithstanding everything that’s said about the economic growth level in comparison between the United States and China and India, do not count America out because it has this entrepreneurial, creative, risk-taking instinct? STEPHEN ROACH: Absolutely. I mean, that’s our strength. You know, when -- when we’re faced with a problem that forces us to look inside of ourselves, we can be a very resilient, tough place. But, you know, when we pretend that these problems that we have are not important, we can get ourselves in a real mess. CHARLIE ROSE: What’s our biggest problem? STEPHEN ROACH: I think our biggest problem was we spent 12 years growing well beyond our means, funding those -- that growth by borrowing against asset bubbles. And that was phony growth, Charlie. CHARLIE ROSE: And now we look at a deficit like we’ve never seen before. STEPHEN ROACH: And because of that, then we built up excesses in the financial system, excesses in the real economy. That’s the key to this crisis. This was not just a financial problem, a Wall Street problem. This is a problem that had a horrible interplay between the real economy and the financial economy. So it all has become. CHARLIE ROSE: But what does that mean, a horrible. STEPHEN ROACH: Interplay? CHARLIE ROSE: Interplay. STEPHEN ROACH: Consumers. The American consumer moved up to 71 -- 71.5 percent of overall GDP in the United States, is still there today. The savings rate went to zero for the first time since the 1930s. A lot of people say, "Well, Americans are saving again." The savings rate numbers just came out for the month of August. Three percent. That’s not much. We’ve got to take that savings rate -- given the retirement that’s looming for 77 million baby boomers, that saving rate’s got to go back up to 7, 8, 9, 10 percent. CHARLIE ROSE: You’re more optimistic for China’s future than the United States? STEPHEN ROACH: I think right now, the path that China is on is much more impressive. They’re running their financial system much more prudently. And I think the balance sheet for the private economy is in better shape. They do have a lot of issues, though. I don’t want to just, you know, paint a rosy picture. CHARLIE ROSE: What are those issues, beyond what you’ve already talked about, in terms of . STEPHEN ROACH: Well, again, I just go back to, you know, the Premiere Wen’s own diagnosis. This is -- this is probably the most unbalanced economy of any of the big economies in the world today. And they’re compounding the imbalances as we speak. And this crisis to me is all about the unsustainability of imbalances. CHARLIE ROSE: And what is their geopolitical ambition? STEPHEN ROACH: I think we make too much out of it. They have a big standing army. The army, I think, mainly is an army that is focused on defense, as opposed to offense. The one issue that has always been a big risk factor for China has been Taiwan. There’s been big political change in Taiwan with the change in leaderships. I think that issue has been defused. I’m not -- I’m not worried about China as a military threat. And I realize that there are experts at the Pentagon who say that, you know, next to the U.S., China is investing more in I.T.-enabled military capabilities and we should worry about this. I don’t see that. CHARLIE ROSE: You have said that the Wall Street you know is not the Wall Street that the president seems to speak about. STEPHEN ROACH: I did say that, because I think the president has gone too far in making this executive compensation issue, the bonus issue, the lynchpin of his critique against Wall Street. He describes people getting bonuses, taking risks, and being reckless, insensitive and irresponsible for the implications of their actions, that have major impacts on the broad society. And it’s a culture of -- as he describes it -- one of self- centered insensitivity, motivated by a desire for material acquisitions. There’s a lot of money that’s been made on Wall Street. I don’t deny that. But I do not see that -- those values in the company that I’ve been in for 27 years, and every company has some, you know. CHARLIE ROSE: But didn’t your company get in trouble because it took too many risks and got too much engaged in trading and certain support of certain kind of securitization. STEPHEN ROACH: We made major mistakes in risk management. But was that because of our bonus system or because we simply did not appreciate the risks that were embedded in the assets? CHARLIE ROSE: Would that be -- clearly, it was the latter. Nobody understood the risk embedded in the assets very well. I mean, there were a few that did, but not many. Did you? Did you? STEPHEN ROACH: Look, I. CHARLIE ROSE: I mean, did you? STEPHEN ROACH: I -- as the firm’s chief economist, I was out there. CHARLIE ROSE: Out there doing what? STEPHEN ROACH: Certainly warning about a very serious buildup of excess in our economy and in our financial system, and very reckless policies that were supporting that. Did I think that this was going to blow up in the way that it did, with the demise of so many of these once- proud firms that the investment banking business would be turned inside out? No way. CHARLIE ROSE: But the conventional wisdom is the following -- and you tell me whether you believe it or not -- one is that, you’re sitting there and you’re making risk decisions, and you’re leveraging like crazy, and sometimes 40:1 -- whatever it might be. And -- and you’re looking across the street and somebody else is doing that and seeming to be successful, and you say to yourself, I have got the demands of people looking at my stock, I have got to make sure that I have the same kind of earnings performance, and therefore we take risks. Is that a simplification that you can’t accept, or is it at the core of what went wrong? STEPHEN ROACH: I think it’s an oversimplification, Charlie. I really do. I mean, I think, you know, we’re all -- we’re a very competitive industry. So when we see, you know, one company doing well, you know, we - - we look at it, but we’re all different companies. CHARLIE ROSE: And you take more risk than you might, because you realize you would be able -- more valuable . STEPHEN ROACH: No, I don’t think it’s that automatic. I mean, we look carefully at what the competition does, but our DNA is different than theirs. We have strengths that other companies don’t have, and they have strengths that we don’t have, and we try to find what we do best and stay with it. But we are not perfect. We made big mistakes, and we certainly regret those, and our share price reflects that. CHARLIE ROSE: Paul Volcker said he is in favor of commercial banks and hedge funds and certain other kinds of trading companies being distinct from commercial banks. Commercial banks should have a "too big to fail" provision to them, but certainly not investment banks and in terms of doing trading activities and hedge funds and all that. You buy that? STEPHEN ROACH: Look, Paul Volcker is my hero. You know, as an economist, you don’t get a chance to have too many heroes. He truly -- and I can’t be critical of anything that the guy says. But he -- what he’s saying is the infrastructure of the financial system needs to be viewed as a public utility, where, you know, deposits are secure, transactions are secure. And then there’s this risk-taking activity, and, you know. CHARLIE ROSE: Let them go, whatever they do. STEPHEN ROACH: Well, whatever. (CROSSTALK) CHARLIE ROSE: . live by their own. STEPHEN ROACH: Well, let them go. CHARLIE ROSE: Yes. Live by their own. (CROSSTALK) STEPHEN ROACH: And, you know, there is some truth to that. But. CHARLIE ROSE: What -- some truth to it, or he’s right and, therefore, the administration is wrong because they’re not going as far as he’s willing to go? STEPHEN ROACH: Well, look, I think it’s a complex problem. And what’s missing in the debate that drives me nuts is going back to the very function of central banking that’s at the core of our financial system. Do we have the right model for the Fed to go forward? And, you know, I think we’ve minimized the role that the custodians, the stewards of our financial system, the Federal Reserve, played in leading to this crisis and in making sure that we will never have this again. I think we’ve had horrible central banking in the United States for the past dozen of years. I mean, we elevate our central bankers, we probably . CHARLIE ROSE: From Greenspan to Bernanke. STEPHEN ROACH: Yeah. CHARLIE ROSE: Both. STEPHEN ROACH: We call them maestro, and, you know, we make them sound larger than life. And, you know, and the fact is, they condoned policies that took us from one bubble to another. They failed to live up to their regulatory responsibility granted them by law. They concocted new theories to explain why these things could go on forever, and they harbored the belief, mistakenly in my view, that monetary policy is too big and blunt an instrument, and so you just bring it in to clean up the mess afterwards rather than prevent a mess ahead of time. Well, look at the mess we’re in right now. We need a different approach here. We really do.