Notes on ‘The Economic Crisis and the International Order’ for ISS Conference, Geneva, 14 September 2009 by Robert Skidelsky.
NOT TO BE CITED WITHOUT PERMISSION - www.skidelskyr.com
I.
1. The question of what caused the financial crisis which started in 2007 can be answered on at least three levels. Each cause has to be addressed if we are not to go on repeating the experience.
2. The first-level, or micro-economic, explanation focuses on the failure of the banking system to manage the new ‘risks’ posed by financial innovation. Greenspan’s statement that the cause of the crisis was ‘the underpricing of risk world wide’ was the most succinct expression of this view. Particular attention was paid to the American sub-prime mortgage market as the originator of the ‘toxic assets’ which accumulated in banks’ balance sheets.
3. The second-level answer focuses on the macro-economy. There are two competing views. The ‘money glut’ thesis blames the asset bubbles, especially in housing, on an excessive growth in US credit. This was the result of loose fiscal and monetary policy. The alternative, ‘saving glut’ thesis, blames the crisis on ‘saving running ahead of investment’. The excess saving here was being done by East Asia and the Middle East. Cheap money in the USA was the right response, which for a time averted world-wide deflation. The mistake was the rise in US interest rates in 2005, bringing the housing boom to an end, which caused the American economy to slump. This was a re-run of the debate between conservative and Keynesian economists about the causes of the Great Depression, the only difference being that the source of the excess saving is now external to the US.
4. The ‘saving glut’ theory is the direct link to the third-level explanation which highlights the problem of ‘global imbalances’. The basic idea behind this is the existence of a global monetary and exchange rate system –or ‘non-system’ - which allows all countries, if they so wish, to run permanent current account surpluses, and one country, the United States, to run quasi-permanent current account deficits. The absence or blocking of balance of payments adjustment allowed or forced behaviour on individual countries which while rational for themselves was irrational for the system as a whole. From this system-level perspective, it is the global monetary non-system which needs to be reformed to avert the succession of country, or regional level, crises.F[1]
5. In my presentation this morning, I want to focus on the system-wide explanation of the crisis, not least, because it is the least familiar, and therefore remedies for it languish at the tail end of the reform agenda.
II.
6. Concern about the US current account deficit long preceded the financial crisis; but it was usually accompanied by the attitude ‘let sleeping dogs lie’. By 2005, the deficit had already ballooned to 5% of GDP. In accounting terms this was simply the excess of domestic spending over domestic earnings. How had it happened? The conservative explanation was that the monetary and fiscal authorities had provided Americans with the money to make payments to foreigners for imports far in excess of the payments they received from foreigners for exports. This ‘living beyond your means’ is the classic road to ruin, for households as well as for countries. In the case of households, it is normally brought to an end by the bank manager. In the case of countries, it is normally ended by the refusal of other countries to lend the profligate country the means to continue its spending spree. The puzzle though was why the surplus countries continued to pour their hard-earned savings into the American economy. In a notable lecture in 2005, Ben Bernanke, about to become chairman of the Fed, gave the answer. At first, he says, it was because the US was a highly productive economy. But following the financial crisis of 1997/8, East Asian countries had deliberately started accumulating foreign exchange reserves to guard them against a repetition of the capital flight they had suffered or witnessed. To accumulate reserves they had to run current account surpluses. This tied in with their policy of undervaluing their currencies against the dollar in order to maintain export-led growth. After the collapse of the dot.com boom in 2000, the US also became a much less desirable outlet for direct foreign investment. So East Asian countries, especially China, started to buy US Treasury bills. They intervened massively to buy dollars and resist market pressure for currency appreciation. Investing their dollars in US securities was a way of sterilizing their dollar purchases, thereby preventing domestic price increases that would have eroded their export competitiveness. Like other experts at the time, Bernanke saw considerable merit in the arrangement: it enabled emerging and developing countries to reduce their foreign debts, stabilize their currencies,and reduce the risk of financial crises. Without the US being willing to act as a ‘consumer of last resort’ the global saving glut would exert a huge deflationary pressure on the world economy.
7. But Bernanke pointed out three snags in the situation. First, for developing countries to be lending large net sums to mature industrial countries was undesirable: the flow should be going the other way to countries with a capital shortage not capital abundance. Second, much of the capital inflow into the US went not into improving productivity, but into the residential sector and consumption. Third, the arrangement depressed US exports, encouraging instead the sectors producing non-traded goods and services. But to repay its foreign creditors, the US needed healthy export industries. A fall in the dollar was, therefore, needed to shrink the non-tradable relative to the export sector. But ‘fundamentally, I see no reason why the whole process [of rebalancing] should not proceed smoothly’.[2] The FT columnist Martin Wolf said the same thing. ‘The pattern of surpluses and deficits will create difficulties only to the extent that the intermediation of the flows from the savings-surplus to the savings-deficit countries does not work smoothly…But no insuperable difficulty should arise. If some people (Asians) wish to spend less than they earn today, then others need to be encouraged to spend more’.[3] As late as mid-2007, he thought that the chance of the ‘financal brain’ generating a ‘huge calamity’ ‘looks remote’.[4] His tune today is very different. ‘Today’s crisis’, he announces squarely ‘is…a symptom of an unbalanced world economy. [5] Wolf now argued that reserve accumulation by the exchange-rate targeting countries of East Asia explains the low long-term interest rates and monetary easing of the US in the 2000s. Cheap money had ‘encouraged an orgy of financial innovation, borrowing and spending’ which created housing bubbles. ‘High income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the household bubble was the vehicle through which it worked’.[6] In Wolf’s view, it was the large macroeconomic effects of the East Asian financial of 1997-8 which enabled America to become the ‘borrower and spender of last resort’
8. Let’s recap on the ‘money glut’-‘saving glut’ debate. The official Fed view was that the existence of a “global saving glut” required the US to step forward as the super borrower to rescue the world from a recession. The Fed also pointed out that there was no danger of inflation in the cheap money period. The “money glut” view holds that the direction of causality was quite the opposite: US monetary excess brought about low interest rates which sparked a rapid growth in credit while undermining household savings. This then resulted in trade deficits which weakened the dollar and thereby forced floating currencies up to uncompetitive levels and governments of pegged currencies to embark upon open-ended foreign-currency intervention. Thus, in the money-glut view it was excessive US spending which led to excessive emerging-market saving and not the other way around.
9. One needs to be clear about the causal mechanisms by which ‘surplus Chinese saving’ became ‘excessive American spending’. Evidently, the Americans didn’t directly spend Chinese savings. The US dollars earned by Chinese exporters weren’t being borrowed by American firms and households: they were being borrowed by China’s central bank, which then hoarded or sterilized them to keep the exchange rate low. The story goes somewhat like this. Instead of having to borrow from the American public to finance its fiscal deficit, the US government could borrow Chinese savings by issuing Treasury bills. Therefore federal deficits did not raise the cost of domestic borrowing, which they would have done had the government had to borrow American savings. If the economy is working to capacity, the more governments borrow, the less private investors borrow. This is called ‘crowding out’. With Chinese savings available, the government could run a deficit without crowding out private spending. This allowed the Fed to establish a much lower funds rate –the rate at which banks borrow from the Fed and each other –than it would otherwise have been able to do. This, in turn, enabled banks to expand their deposits (loans) to customers more than they could otherwise have done. In short it was via their impact on the financing of the federal deficit, that Chinese savings made it possible for the US consumer to go on a spending spree. This explanation brings out the role of the US fiscal deficit in precipitating the financial meltdown. Conservative critics of Greenspan’s monetary policy, have ignored the fiscal side of the equation, no doubt because they believed the deficits were incurred in the worthy cause of the ‘war against terror’.
10. Why was the ‘double deficit’ unsustainable? The basic reason was that the borrowing went into consumption –both private and public –and also speculation rather than into investment. Wolf remarks that the savings glut might be better thought of as an ‘investment dearth’.[7] This echoes Greenspan’s finding that cheap money hardly raised the level of US investment. A key indicator of this was ‘the dramatic swing in corporations’ use of their internal cash flow…from fixed investment to buy back of company stock and cash disbursed to shareholders’.[8] The lack of opportunities for profitable investment determined the pattern of American spending. Americans borrowed not to invest in new machines but to speculate in houses and mergers and acquisitions. The resulting growth in paper wealth triggered off a consumption boom. The situation was unsustainable because no new resources were being created with which to pay back either domestic or foreign borrowing.
11. The present financial meltdown is producing the market-led adjustment which eluded policy makers. Willy-nilly Americans are having to spend less and save more; the decline of their export-markets forces the Chinese to shift their growth emphasis to domestic development; the weakening of the American economy has produced an automatic decline in the relative value of the dollar against other currencies. But unless these market-led adjustments to acute crisis become conscious policy choices in both China and the US, the global imbalances will recreate themselves and we will limp out of this crisis into the next.
III.
12. In the last part of these remarks, I want to turn to the reform agenda. In Lenin’s words ‘What is to be done? The standard view of those who discuss such matters is that the Chinese and other East Asian countries should take steps to eliminate the saving glut which they have created. This, it is claimed, is in their own self-interest. The Chinese save and invest almost 50% of their GDP. One can argue that they get very poor return for their frugality. Chinese employment has hardly grown, because investment in export-led growth is highly capital intensive. Moreover, there are political risks in channelling current account surpluses into foreign reserves instead of greater consumption, improved health care and infrastructure. This is particularly the case when the nominal returns on dollar debt are as low as they have been in the last few years. Emerging market governments should pursue expansionary fiscal policies to stir more private demand since, if public-goods provision improves, private actors will have less of an incentive to keep up current rates of precautionary savings. Emerging market governments should also undertake financial reforms to enable them to raise funds in their own currencies – the only way to avoid the currency mismatches that frequently caused crises in the past. The best way to achieve this is to develop local-currency bond markets. Unless these domestic credit markets are deepened emerging market governments will be unwilling to run deficits since the only funding available exposes them to currency risks.
13. The East Asian countries are also urged to more flexible exchange rates, even though it is conceded that this might make it more difficult for them to secure net capital inflows. The IMF must be better at delivering technical assistance, surveillance, coordination of macroeconomic policies and exchange rates and crisis management. It must reform its system of representation and resume its role as credible crisis lender. The decision of the G-20 meeting of 2 April to expand the IMF’s special drawing rights (SDRs) available to its members by $250bn is an important step in this direction. If, as Fred Bengtsen, director of Washington’s Peterson Institute for International Economics, argues this opens the door to China’s proposal to create a global reserve currency to replace the dollar, a major step would have been taking to eliminate the ‘global imbalances’ between China and the United States which, lies at the heart of the economic slump.[9] But the questions of how much international reserves are needed, and how they are to be distributed, their are unanswered.
14. The trouble with this set of reform proposals is that it puts all the onus of reform on China and East Asia, and none on the United States. It ignores the fact that the global imbalances have suited the United States –specifically the power holders in the United States - just as much as it has those in China. The summary ‘it has enabled the Americans to live beyond their means’ is too vague to be useful. One needs to ask: which Americans? Certainly many middle and low income American households have been given access to credit beyond their means. But secondly, the American-Chinese symbiosis has been excellent for US business profits. American businessmen have been complicit in Chinese ‘super-competitiveness’ by offshoring well-paid manufacturing jobs to China in order to cut costs. The decline in US manufacturing and growth in non-tradable services, and the financial operations which secured this re-structuring, have enabled financiers and businessmen to earn huge profits which should have been shared with their workers. Morally, the financial community has been living well beyond its means. But, perhaps above all the American current account deficit has enabled the US government to live beyond its means, by getting other countries to finance its imperial pretensions. In 1968 De Gaulle talked about ‘the exorbitant privilege’ of the US dollar. This is the heart of the matter: until it is ended, no fundamental reform of the global imbalances is possible.
15. To understand how the dollar came to be thus privileged, we need historical perspective. Under the pre-1914 gold standard regime, no global imbalances could emerge. Independent countries held their reserves in gold. Current account imbalances led to inflows and outflows of gold from the reserves of central banks. These triggered off domestic interest rate, prices, and income movements which restored balance, often at considerable cost in terms of output and employment for the gold losing countries. Before 1914 even the main capital exporting countries, Britain and France, ran current account surpluses, though both the sterling and francs were ‘privileged’ currencies within the British and French empires.
16. The rot, as the French would see it, started with acceptance of the ‘gold exchange standard’ at the Genoa conference of 1922. This allowed independent countries to hold part of their reserves in a leading currency like pounds or dollars. Keynes had championed the idea in his first book, Indian Currency and Finance (1913),arguing that it would avoid deflation by economising on the use of gold. The French regarding it as a plot by the British Treasury to prop up Britain’s fading world position by printing pounds to cover its overseas costs. The Bretton Wood treaty of 1944 extended the principle of the gold-exchange standard. De Gaulle’s favourite economic adviser, Jacques Rueff, claimed not only that it was inherently inflationary, but that it gave ‘seigniorial’ rights to the US dollar, ie., the right to print dollars to pay for American overseas spending. De Gaulle’s policy of swapping dollars for gold in the late 1960s played a key part in destroying the Bretton Woods system in 1971.
17. Although the French tended to regard the Bretton Woods system as an international version of Keynes’s inflationary ideas, in fact it marked a failure of Keynes own plan for an International Clearing Union. Admittedly, the Keynes plan was addressed to the problem of deflation. It was specifically designed to prevent creditor countries from hoarding reserves by trading at undervalued currencies. If they ran persistent current account surpluses, the surpluses would be confiscated and redistributed among deficit countries. Deficit countries were also penalised (though to a lesser extent) if they ran persistent current account deficits. In this way a global balance between saving and investment would be secured through a balanced trade position, which would in turn allow fixed, but adjustable, exchange rates.
18. The Bretton Wood agreement of 1944 adopted the proposal for fixed but adjustable rates, but failed to provide a remedy against surplus countries accumulating, or hoarding, reserves. In practice, the problem was solved by the United States taking the place of 19th century Britain as the chief supplier of foreign investment funds. The outflow of American saving helped reconstruct Europe after the war, and kept global demand buoyant throughout the Bretton Woods era. The dollar replaced gold as the world’s chief reserve currency. This allowed the US to print dollars to cover its growing trade deficit. (Though it never ran a current account deficit in the Bretton Woods era.) The arrangement suited both the Europeans and the United States, because it not only enabled the Europeans to export to America at undervalued exchange rates, but it also covered the cost of America defending Western Europe,and non-Chinese East Asia, against communism. In other words, the ‘exorbitant privilege’ allowed the US to pursue an imperial mission which, in the era of the Cold War, was greatly to the satisfaction of its partners and allies.
19. The privileged position of the dollar survived the collapse of the fixed-exchange rate regime in 1971. In theory, floating exchange rates remove the need for any reserves at all, since adjustment of current-account imbalances was supposed to be automatic. But the need for reserves unexpectedly survived, mainly to guard against speculative movements of hot money which could drive exchange rates away from their equilibrium values. Starting in the 1990s, East Asian governments unilaterally erected a ‘Bretton Woods II’, linking their currencies to the dollar, and holding their reserves in dollars. This reproduced both the benefits and faults of Bretton Wood I: it avoided global deflation, but undermined the long-run credibility of the reserve currency.
20. The new construction allowed the United States to continue to enjoy the political benefits of ‘seigniorage’ – the right to acquire real resources through the printing of money. The real resources the USA acquired were not just free consumer goods, but the ability to deploy large military forces overseas without having to tax its own citizens to do so. Every historian knows that a hegemonic currency is part of an imperial system of political relations. The Americans acquiesced in the unbalanced economic relations initiated by East Asian currency under-valuation because they ensured the persistence of unbalanced political relations. US acceptance of a reform package aimed at ending global macro-economic imbalances thus depends on its willingness to accept a much more plural world –one in which other centres of power in Europe, China, Japan, Latin America, and the Middle East assume responsibility for their own security, and in which the rules of the game for a world order which can preserve the peace while effectively tackling the challenges posed by terrorism, climate change, and abuse of human rights, are negotiated, and not imposed.
21. The British prime minister, Gordon Brown, has suggested that there should out ‘trigger points’ for action to tackle current account surpluses and deficits. This is in the spirit of Keynes’s Clearing Union, but it is as yet hardly a plan. To discover whether and how it might be made to work should be the urgent task of the IMF, and a worthy topic for a new Bretton Woods conference. But whether, even under Obama, the US would willing to accept the political rebalancing of the world it would entail is far from obvious. It will require a huge mental realignment in the United States. The financial crash has disclosed the need for an economic realignment. But it will not happen until the US renounces its imperial mission.
[1]This three-level approach to explaining the current economic crisis is indebted to Kenneth Waltz. Man, the State and War (1959) and Theory of International Politics (1979).
[2]Ben Bernanke, Ben Bernanke, ‘The Global Saving Glut and the US Current Account Deficit, March 10 2005. www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm
3 Wolf, Why Globalization Works., p.184
[4] Financial Times, 26 June 2007
[5] Financial Times, ‘Why the Federal Reserve has to keep the party going’, 21 August 2007
[6]Ibid. ‘Asia’s Revenge’, 8 October 2008
[7] Fixing Global Finance, p.65
[8] Greenspan, The Age of Turbulence: Adventures in a New World, pp.471-2
[9]Fred Bengsten, Financial Times, 9 April 2009, ‘Beijing’s Currency Idea needs to be taken seriously’.
