Four questions with China skeptic George Magnus

December 3, 2010, 4:36 PM UTC

When George Magnus talks, you’d do well to listen.

Magnus, a senior economic adviser for the UBS Investment Bank, was among the few high-profile economists to foresee the global financial crisis. As it unfolded in 2007 he was warning that the world economy faced a “Minsky moment” – the point, named after the writings of the late economist Hyman Minsky, at which massive leverage crumbles under its own weight. As the unrest in the euro zone attests, we are still reeling from that shock.

A euro skeptic too

Magnus has since moved on, even if the world economy hasn’t. He has written two books – 2008’s “The Age of Aging,” warning of the troubling demographics facing rich economies, and this year’s “Uprising,” which weighs how seriously we should take the rise of China and other developing economies. “Uprising” has just been released and Magnus is making the media circuit to discuss the book, which argues China isn’t quite the economic juggernaut we seem to imagine.

I spoke with Magnus this week about the euro crisis, America ’s response to its economic problems (including growing older) and the nature of the troubles facing China, which he says are widely underestimated. Here are some excerpts.

Fortune: What do you make of the euro crisis?

Magnus: It’s a right old mess. The problems really start with the banking sector, and they’re the same problems as we had in 2008. But the way we dealt with that crisis simply put it on slow burn. Banking liabilities became contingent liabilities of the sovereign, and now there is no investor confidence that the sovereigns will be able to pay up. It’s extremely messy and is starting to look quite dangerous.

It exposes one of the critical weaknesses of Europe, which is the institutional setup. We know what kinds of things need to be done, but you need political will to do those things and no one ever bothered to think about institutions when they were setting up the euro. Now they’re doing it on the hoof and mostly in a reactive way.

You need a holistic solution to contain the cancer of banking system contagion. You need to decide on a euro-wide policy and adopt it – maybe take a weekend to look at the banking sector and come out on a Monday morning and say, we’re doing this. It might not be pleasant but the contagion could be contained.

As bad as the euro mess looks, you made the case in the aging book that the demographic crisis is less easy to deal with.

The financial crisis is forcing us to address problems under duress. The government debt crisis in Europe is an immediate manifestation of the banking crisis, and that is forcing people to look at future liabilities like pensions and healthcare. So we’re beginning to think about cost implications but not because we’ve been enlightened.

The thing that’s worrisome is I see no evidence anyone is taking a comprehensive strategic view of the problem. We’ll always be chasing our tail if we don’t start to see it as an economic problem that we’re not replacing workers as the current ones retire.

The risk is that the scale of this problem could make the banking crisis look like an hors d’oeuvre for a much bigger crisis.

You mentioned the institutional failures in Europe. Are weak institutions at the core of the problems facing China ?

Institutions are the soft underbelly of the Chinese success story. No one is doubting the progress they have made over the past 30 years – it has been unprecedented and China has a large population with great power, rising status and strong decision making. We sometimes admire that sort of decision making in the West where it is all messier.

Maybe not such an uprising after all

But I think the story with China is sort of “back to the future.” You have to consider China dominated the global system until 1800 – and yet the Industrial Revolution happened in a hick town in northern England. Why is that?

I’d say it is because the bureaucracy there was unwilling and unable to accept the sort of disruptive technological and social change that was necessary then, and I see the same sort of situation now.

After all the success from the 1978 reforms, China must do another reboot, to become less capital intensive and less mercantilist and rebalance the economy.

But that is a very difficult task for the Communist Party. They have been willing to be radical about economic rights and property rights, but they have not been willing to make big changes along the lines of Western legal and political rights.

Take the debate about universal rights. Recently Wen Jiabao has been going quiet on that – which suggests perhaps the debate is being shut down. That is worrisome in two ways: If China can’t make big changes, the world and especially the West won’t be pleased; and does it show China is going its own way down the Japanese path, with an undervalued exchange rate and an overreliance on trading?

There will be issues like inflation that will test the leadership there on their willingness to change. I am not holding my breath for any big gestures or radical economic changes.

What do you make of the criticism from China and others of QE2?

Look, there is no certainty printing money will do anything like ensure a recovery. I don’t think it will be especially successful in restoring job growth. But no matter what they say around the world, the reality is the United States has to do what it has to do to look after its own interests.