The U.S. financial system has been as much a part of American power over the past thirty years as the Sixth Fleet. Yet Wall Street’s illustrious investment banks have been either bankrupted, swallowed up or transformed into regular banks in the space of less than a year. So close did the U.S. financial system come to complete meltdown in September that Treasury Secretary Henry Paulson was driven to request emergency powers worthy of wartime: carte blanche to spend around $700 billion on the mother of all bailouts. This is in fact less than half the sum the Federal Reserve has already spent through its various “facilities” to banks.“Why should the rest of the world ever again take seriously the American free market model after this debacle?” a leading British journalist recently asked me. This crisis, he argued, is to economics what the Iraq war has been to foreign policy: a fatal blow to the credibility of U.S. claims to global primacy. “One thing seems probable to me”, declared Peer Steinbrück, German Finance Minister. “The United States will lose its status as the superpower of the global financial system.” The news magazine Der Spiegel called it “The End of Hubris.” To the London Guardian it was “A Shattering Moment in America’s Fall From Power.” Certainly, if the unipolar moment that followed the collapse of the Soviet empire was a very American form of hubris, then the credit crunch has been a very American nemesis. Ten years ago, a strange competition formed in the United States to see who could be more arrogant. Neoconservatives argued that the rest of the world should hurry up and embrace the American political way, or prepare to be bombed into the democratic age. But equally smug were the neo-liberal economists—liberal in the sense of Adam Smith, that is—who argued that the rest of the world should hurry up and embrace the “Washington Consensus”, or prepare to be sold short. One lot derided the political failure of the Muslim world; the other lot heaped scorn on Asian “crony capitalism”, supposedly the root cause of the 1997–98 Asian financial crisis. The neocons got their comeuppance in Iraq, where American forces were not, after all, greeted as liberators with sweets and flowers. The neolibs got theirs in September, as a Republican Treasury, headed by the former CEO of Goldman Sachs, nationalized first the country’s biggest mortgage lenders and then its biggest insurance company, only to let the investment bank Lehman Brothers fail. One of the few things Barack Obama and John McCain could agree on in the final phase of the presidential campaign was that something was rotten on Wall Street. The stage seemed set for the demise of what has been called “market fundamentalism” by George Soros (paradoxically one of its biggest beneficiaries), meaning the belief in the self-regulating nature of what has turned out not to be self-regulating at all. That economic policy paradigms are shifting is clear. But is the same really true of the global balance of power as well? To answer that question we need to reflect more deeply on the true nature of this crisis. We are living through a challenge to a phenomenon Moritz Schularick and I have christened “Chimerica.”11.
“‘Chimerica’ and the Global Asset Market Boom”, International Finance (December 2007). In this view, the most important thing to understand about the world economy over the past decade has been the relationship between China and America. If you think of it as one economy called Chimerica, that relationship accounts for around 13 percent of the world’s land surface, a quarter of its population, about a third of its gross domestic product, and somewhere over half of the global economic growth of the past six years. For a time, it was a symbiotic relationship that seemed like a marriage made in heaven. Put simply, one half did the saving, the other half the spending. Comparing net national savings as a proportion of Gross National Income, American savings declined from above 5 percent in the mid 1990s to virtually zero by 2005, while Chinese savings surged from below 30 percent to nearly 45 percent. This divergence in saving patterns allowed a tremendous explosion of debt in the United States, for one effect of the Asian “savings glut” was to make it much cheaper for households to borrow money than would otherwise have been the case. Meanwhile, low-cost Chinese labor helped hold down inflation. The crucial mechanism that bound the two halves of Chimerica together was currency intervention. To keep the renminbi (and hence Chinese exports) competitive, authorities in Beijing consistently intervened to halt the appreciation of their own currency against the dollar. The result was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China, which became one of the world’s biggest holders of U.S. Treasuries as well as bonds issued by the government-sponsored (now government-owned) agencies Fannie Mae and Freddie Mac. Had it not been for the Chinese willingness to fund America’s borrowing habit this way, interest rates in the United States would have been substantially higher. It was Chimerica that kept the Age of Leverage going in its final phase, as total public and private debt as a percentage of GDP surged from 250 to 350 percent. It was not, of course, just the United States that was borrowing, and not just China that was lending. All over the English-speaking world, as well as in countries like Spain, household indebtedness increased and conventional forms of saving gave way to leveraged plays on real estate markets. Meanwhile, other Asian economies joined China in adopting currency pegs and accumulating international reserves, thereby financing Western current account deficits. Middle Eastern and other energy exporters also found themselves running surpluses and recycling petrodollars to the Anglosphere and its satellites. But Chimerica above all others was the real engine of the world economy. As this tremendous expansion in borrowing proceeded, some economists tried to rationalize what was going on. One school argued that this was “Bretton Woods II”, a system of international exchange rate management akin to the one that linked Western Europe to the United States after World War II. Others called it a “stable disequilibrium”, something that could be counted on to continue for some considerable time. But then a wave of defaults in the U.S. sub-prime mortgage market revealed just how unstable Chimerica was. In essence, the rest of the world’s savings had helped inflate a real estate bubble in the United States. As is nearly always the case in asset bubbles, easy money was accompanied by lax lending standards and outright fraud. Euphoria eventually gave way to distress and then, in a familiar sequence, to panic. It began in the sub-prime market because it was there that defaults were most likely to happen, but it soon became clear that the entire U.S. property market would be affected. Not since the Great Depression have we seen average house prices declining at annual rates above 10 percent. What made the property collapse so lethal was that an entire inverted pyramid of novel financial assets had been erected upon the flimsy base of American mortgages. Banks had bundled together the original loans, sliced and diced them and resold them to investors all around the world as “Collateralized Debt Obligations” and the like. In a quintessential act of financial alchemy, the ratings agencies had pronounced the top tier of these instruments to be AAA-rated. When the supposed gold turned back into lead and then into toxic waste, the consequences were devastating. According to the Bank of England, total losses on the various kinds of securities affected could amount to as much as $2.8 trillion. So far only around $550 billion of write-downs have been acknowledged by banks around the world. Substantial amounts of new capital have been raised from private investors and governments, but there is still a hole—and it is a hole that threatens to get bigger. Dwindling capital at a time when formerly off-balance-sheet liabilities are coming home to roost means exploding leverage: For Bank of America total leverage (on- and off-book assets divided by tangible equity) is now as high as 134:1; for Citigroup the ratio is 88:1. This failure among financial firms has had three distinct consequences. First, it has exposed the weaker banks—particularly the investment banks, which could not fall back on the cushion of savers’ federally insured deposits—to savage and self-perpetuating share price declines (as the underlying equity declines in value, the degree of leverage rises and illiquidity soon morphs into insolvency, killing bondholders as well as shareholders). Second, it has triggered a further crisis in the market for derivatives. Credit default swaps (CDS) were supposed to be a wonderfully clever form of insurance for bondholders. But it is unclear how the far from transparent derivatives market can cope with defaults on this scale when the notional amount of CDS is $58 trillion. But third and most importantly, the efforts of banks to stabilize their balance sheets by reducing credit has driven the U.S. economy into a recession—possibly the most severe economic downturn since the early 1980s, if not the early 1930s. Consumers cut spending by an annualized rate of 3.1 percent in the third quarter of 2008, the biggest drop since 1980. Regional surveys are pointing to an annual contraction in production of about 5 percent. What’s more, as unemployment rises, consumption is bound to fall further. So will house prices. The Fed has cut its effective federal-funds rate to very close to zero. The Federal deficit has already exploded, with the increase in public debt in the past year around $1.5 trillion. But neither monetarist nor Keynesian measures seem able to avert a Big Recession, though they may have staved off a second Great Depression. What are the geopolitical implications of all this? One possibility is that it will speed up the “great reconvergence” between East and West. If you go back to the very first “BRICs” report that Jim O’Neill and his colleagues at Goldman Sachs produced about the prospects for Brazil, Russia, India and China, China was projected to overtake the United States in terms of gross domestic product in 2040. But in more recent reports, that has been brought forward to 2027. Maybe it will be even sooner than that, for one inevitable consequence of the credit crunch is that the United States will not only suffer negative growth for at least two quarters (and perhaps a whole year), but will also grow quite slowly for the foreseeable future. By contrast, China’s semi-planned economy can probably maintain growth of above 6 percent a year, propelled forward by half a trillion dollars of new state spending on infrastructure and social services. Because, according to the “decoupling” thesis, net exports are no longer the key driver of China’s growth, an American sneeze need not necessarily cause an Asian cold. A second possible implication of the current crisis is that the days when the dollar was the sole international reserve currency may be coming to an end. Reserve currencies do not last forever, as the case of the British pound makes clear. Once upon a time, sterling was the world’s number one currency, the unit of account in which most financial transactions were done. It died a slow, lingering death, sliding from $4.86 in 1930 to very near parity with the dollar at the nadir in the early 1980s. The principal reason for that was debt: the huge debts that Britain had run up to fight the world wars. The second reason was lower growth: Britain’s economy was the underperformer of the developed world in the postwar decades, right down to the early 1980s. If, as seems inevitable, the main fiscal consequence of the credit crunch is a huge increase in the liabilities of the Federal government—already substantially increased by the nationalization of Fannie Mae, Freddie Mac and AIG even before the $700 billion Troubled Asset Relief Program—the United States could find itself in a similar situation. With debt spiraling upwards, the dollar could follow the pound into the category of former reserve currencies. If so, the United States would lose that convenient facility, which it has exploited since the 1960s, of being able to borrow from foreigners at low interest rates in its own currency. With China decoupled from America—relying less on exports to the U.S. market, caring less about its currency’s peg to the dollar—the end of Chimerica would have arrived, and with it the balance of global power would be bound to shift. No longer so committed to the Sino-American friendship established back in 1972, China would be free to explore other spheres of global influence, from the Shanghai Cooperation Organization, of which Russia is also a member, to its own informal nascent empire in commodity-rich Africa. Yet commentators should hesitate before prophesying the decline and fall of the United States. It has come through disastrous financial crises before—not just the Great Depression, but also the Great Stagflation of the 1970s—and emerged with its geopolitical position enhanced. That happened in the 1940s and again in the 1980s. Part of the reason it happened is that the United States has long offered the world’s most benign environment for technological innovation and entrepreneurship. The Depression saw a 30 percent contraction in economic output and 25 percent unemployment. But throughout the 1930s American companies continued to pioneer new ways of making and doing things: think of DuPont (nylon), Proctor & Gamble (soap powder), Revlon (cosmetics), RCA (radio) and IBM (accounting machines). In the same way, the double-digit inflation of the 1970s didn’t deter Bill Gates from founding Microsoft in 1975, or Steve Jobs from founding Apple a year later. Moreover, the American political system has repeatedly proved itself capable of producing leadership in a crisis—leadership not just for itself but for the world. Both Franklin Roosevelt and Ronald Reagan came to power focused on solving America’s economic problems. But by the end of their presidencies they dominated the world stage, FDR as the architect of victory in World War II, Reagan performing a similar role in the Cold War. It remains to be seen whether Barack Obama will be a game-changing president in the same mold. But Americans voted for him in the hope that he is. Would Obama have won without the credit crunch, which destroyed what little remained of the Republican reputation for economic competence? But the most important reason why the United States bounces back from even the worst financial crises is that these crises, bad as they seem at home, always have worse effects on America’s rivals. Think of the Great Depression. Though its macroeconomic effects were roughly equal in the United States and Germany, the political consequence in the United States was the New Deal; in Germany it was the Third Reich. Germany ended up starting the world’s worst war; the United States ended up winning it. The American credit crunch is already having much worse economic effects abroad than at home. It will be no surprise if it is also more politically disruptive to America’s rivals. Among the other developed economies, both the Eurozone and Japan are already officially in recession, ahead of the United States. The European situation is especially precarious because, contrary to popular belief, European banks are in worse shape than their American counterparts. Average bank leverage in the United States is around 12:1. In Germany the figure is 52:1. Short-term bank liabilities are equivalent to 15 percent of U.S. GDP; the British figure is 156 percent. Indeed, the United Kingdom runs a real risk of being Greater Iceland—an economy crushed by a super-sized financial sector. Moreover, unlike the United States, there is no single European Treasury that can implement multibillion-dollar fiscal stimulus. Monetary policy may be uniform throughout the Eurozone, but fiscal policy is still a case of every man for himself. Emerging markets, too, have been hammered harder by the crisis than the “decoupling” thesis promised. In the year to the end of October 2008, the U.S. stock market declined by 34 percent. But Brazil’s was down 54 percent, China’s 58 percent, India’s 64 percent and Russia’s 66 percent. When Goldman Sachs christened these four countries the BRICs, they little realized that their equity markets would one day be dropping like bricks. These figures are scarcely good advertisements for the more regulated, state-led economic models favored in Beijing and Moscow. The financial crisis is especially bad news for energy exporters: not only belligerent Russia, whose leaders yearn for a reconstituted Soviet empire, but also those other thorns in the side of the United States, Iran and Venezuela. Any oil price below $94 a barrel is bad news for Venezuela’s fragile finances; any price below $55 spells trouble for Iran. In any case, is even the fastest growing of America’s rivals really a credible alternative to the United States? Rapidly though it is growing, China is bedeviled by three serious ailments: demographic imbalance, environmental degradation and political corruption. China’s military is not remotely ready to mount a serious challenge to American dominance in the Pacific. And, crucially, it is far from clear that China is ready to wean its manufacturing sector completely off the U.S. export market. After three years of very mild renminbi appreciation, the People’s Bank of China seems to be contemplating renewed intervention to keep the currency weak relative to the dollar. That means China will continue to sell renminbi for dollars, further enlarging its already large portfolio of U.S. bonds. There is a paradox at the heart of this crisis. In many ways it is a crisis that has “Made in America” stamped all over it. Yet in the very worst moments of panic this fall, investors made it clear that they continue to regard U.S. government debt as a “safe haven” in uncertain times; hence the recent dollar rally. Huge though the costs of the current crisis may prove to be, there is a way of presenting them that may yet suffice to reassure the rest of the world that America can afford it. After all, the Federal debt in public hands remains equivalent to below 40 percent of U.S. GDP, a significantly lower figure than in many European economies or Japan. (The vastly larger unfunded liabilities of the Medicare and Social Security systems remain, fortunately, off balance sheet.) Of course, this crisis could yet prove to be the safe haven’s last gasp, especially if Congress runs amok with supplementary bailouts and stimulus packages, and the international bond market finally writes the United States off as just another Latin American economy. There seemed very little awareness at the mid-November G-20 summit in Washington that uncoordinated interest rate cuts and stimulus packages could unleash a fresh bout of volatility in international currency and bond markets. The possibility remains, too, that the coming explosion of U.S. Federal debt could finally trigger the dreaded dollar rout, especially if the Chinese decide that the export game is up and their only hope is a policy of “market socialism in one country.” Yet this still seems a less likely scenario than a continuation of Chimerica. True, the financial hubris of recent years has been followed by a terrible nemesis. The age of leverage has ended not with a whimper but a deafening bang. Nonetheless, it is much too early to conclude that in geopolitical terms the American century is over, or that China solo is about to take over from Chimerica. Power is always relative, and a crisis that hits the periphery of the global economy harder than the core must logically increase the power of the core. Nemesis, too, can be exported. 1.
“‘Chimerica’ and the Global Asset Market Boom”, International Finance (December 2007).