"America Must Correct Course"

The former German Chancellor does his global ciphers.

AI: During a visit to Washington last December, at a dinner at the German Ambassador’s residence, you analyzed the state of the American economy, particularly the size and nature of its financial liabilities, and predicted trouble. That prediction looks increasingly prescient. But what actually troubles you most from a German perspective? The U.S. trade deficit? Its budget deficit? Or its private debt?

Helmut Schmidt: It is the foreign indebtedness of America that concerns me most. The trade deficit has reached 7 percent of GDP. Imports of foreign capital balance out the deficit, particularly capital flows from China, Japan and a number of other countries, including some in western Europe. That might be sustainable as long as America maintains its power and global prestige. Once that changes—and we are already witnessing some such changes due to the policies of the current U.S. President—it gets to be dangerous.

AI: What will happen should the next U.S. president prove unable to help America regain its standing in the world?

Helmut Schmidt: It is hard to conceive of an administration that will do worse on financial governance issues than the current one. An end to the current financial crisis is not in sight yet. Actually, it could get worse still. Even during their last few months, the current Administration is quite capable of committing serious mistakes. In the years following the stock market crash of 1929, virtually all governments committed grave mistakes.

AI: Why should the ordinary U.S. citizen care about debt? Historically speaking, hasn’t debt always been repaid somehow?

Helmut Schmidt: American citizens don’t need to be overly concerned yet, but Chinese, Japanese or German citizens do. Their capital accumulations, their savings, are not being used in their own countries, but in America. It would be much better if that capital were used in their own countries for research, education and other public investments.

AI: What is the relevance of the fact that the U.S. dollar is not the only major reserve currency anymore, with the growth in the prestige and value of the euro?

Helmut Schmidt: That is a healthy development. In twenty or so years we will have three global currencies. In all likelihood the U.S. dollar will remain the most important one, but the euro will be a close second, and the Chinese renminbi will be used as a reserve currency, as well. It seems as if the world is headed for a balance between these three. Not only will this lead to closer cooperation between the three central banks—there are already signs of this type of cooperation today—but it will also hopefully lead to a common approach in the regulation of financial markets.

We need that. Today we have to deal with thousands of financial instruments and derivatives. Not even senior management of corporations like J.P. Morgan, Citigroup or Deutsche Bank can assess the inherent risks of these instruments. A doctor can ordinarily only prescribe a certified drug to a patient. Financial markets used to work the same way. The most important financial instruments were stocks and bonds. In the United States they were licensed by the Securities and Exchange Commission; Germany had a similar institution. Today, however, stocks and bonds play a limited role as certificates, and derivatives have become overwhelmingly important. But nobody certifies them. That is part of the explanation of the current crisis.

AI: What makes you think that a balance among three reserve currencies will create some sort of global financial governance?

Helmut Schmidt: There is historical precedent for this kind of behavior, specifically, in Europe prior to 1914. There were three important currencies at the time: the French franc, the German mark and the English pound. All were accounted for in gold. At times there was devaluation or upward revaluation. The smaller currencies leaned against the larger ones. That’s likely what we are going to see again.

AI: But the Chinese currency does not reflect its true value.

Helmut Schmidt: Neither does the American currency.

AI: In the United States it is not the government that creates this situation, however.

Helmut Schmidt: That is true. In China the Central Bank cannot act independently from the government. Whatever it does must be approved by the Central Committee of the Communist Party. On the other hand, the independence of America’s Federal Reserve is not as absolute as it seems. In the early 1970s, the Fed was still controlled by the Treasury, at least as far as the usage of currency reserves was concerned. The same is still true in China today. Over the course of recent decades the Fed has managed to gain more independence from the Treasury, not least because the government itself abandoned the system of fixed exchange rates.

AI: Don’t artificially rigged exchange rates trouble you? After all, that’s what helps fuel China’s industrialization and helps to increase America’s trade deficit.

Helmut Schmidt: The imbalance is troublesome for the whole world. But it is not the Chinese alone who are responsible. The Americans consume more than they can afford, the Chinese less. Both bear an equal share of the blame for the imbalance.

AI: Americans tend to view it differently—

Helmut Schmidt: —which doesn’t make it right. If the richest nation on the globe finances 7 percent of its daily consumption abroad with other people’s money, that is obviously a burden on the world. Conversely, China is not getting enough value for its exports. All the Chinese get are papers with low interest rates. In the long run, this will be a major disadvantage for China.

AI: What is the reason for the current crisis of the financial markets?

Helmut Schmidt: There are three reasons. First of all, there are these unregulated financial instruments that I have already mentioned. The traders spend hundreds of millions of dollars on products, electronically and without any paper trail, that not even their bosses understand. There are scores of investment bankers out there. They understand their jobs, but not much else. If one sells a product, others will follow suit and start selling off within seconds. That will obviously affect the stock price. That’s how mass hysteria is created within a fairly limited group of people. This type of hysteria, in and of itself, is the second major danger.

The third factor is what Alan Greenspan once termed “infectious greed.” The bonus system invites greed. New York investment banks alone have showered their employees with yearly bonus payments worth about $38 billion. It was nothing but coincidence that the current crisis was triggered by a system that handed out mortgages to people not all of whom could be expected to pay them back. It might just as well have been the collapse of a major investment fund or a hedge fund or a private equity fund.

AI: What type of medicine do you suggest for the ailing markets?

Helmut Schmidt: There is no drug that will help immediately. In the long run, however, financial instruments will have to be regulated as if they were drugs. For immediate relief the Federal Reserve is creating liquidity of a magnitude that we have never seen before in world history.

AI: The European Central Bank and some European countries have been doing the same.

Helmut Schmidt: Not quite. They are more hesitant, but they tend to follow the American example in the end. If they didn’t do so, the euro would appreciate even more and further harm the European export position.

Beyond that, it is important to recognize that the infusion of liquidity into the markets is a short-term expedient that will have long-term consequences. First of all, it creates the potential for inflation. We will see it later in 2008 and the following year. The other risk is what Americans call “moral hazard”: Traders and bankers will start counting on government action to bail them out when they act imprudently. We would have a similar problem in Europe if the European Central Bank were to adopt the American approach completely.

AI: Analysts in the United States tend to criticize the European Central Bank for not doing enough.

Helmut Schmidt: Americans love it when others bail them out, as Europeans did, you may remember, in the late 1970s.

AI: Europe’s inflation rate is lower than America’s, and yet the European Central Bank had not lowered interest rates. The critics contend that Europe is not pulling its weight and is avoiding its new global responsibility.

Helmut Schmidt: Such allegations against the European Central Bank are not justified. The rest of the world does not necessarily have to operate the way America would like it to. I experienced the same pressure myself when the Carter Administration thought that the Germans and the Japanese ought to go into debt and spend public money to fuel the world economy. We rejected that analysis at the time, and today we are seeing the same kind of thing again, only now the Americans are pressuring the European Central Bank instead of those of individual governments.

AI: What is the reason for the weak dollar? How important is the difference in interest rates between the United States and Europe?

Helmut Schmidt: As to the different interest rates, it is not very important because the economies operate in different contexts. Only a small portion of the American economy is truly globalized. Currently, the German export rate is at approximately 47 percent of GDP. The American export rate is much lower. The United States has the largest domestic market in the world, so that it is really only marginally interconnected with the rest of the world. Japan is different, Germany is different, so are France and Great Britain. That’s why non-American publics tend to be more sensitive to phenomena such as external deficits, and that’s why the American public is just not used to looking at its own balance sheet. It does not seem to care, except when the dollar’s value changes sharply.

AI: So the weak dollar is a consequence of the trade deficit?

Helmut Schmidt: Yes, of course.

AI: What is the relevance of sovereign wealth funds?

Helmut Schmidt: For the time being they are insignificant. But they could grow quickly.

AI: Why are they insignificant for the time being? Aren’t the amounts enormous, even today?

Helmut Schmidt: No, not really—at least not when you compare them with other relevant funds.

AI: There are two different theories about sovereign wealth funds. One theory contends that the funds could easily become instruments of political pressure. The other theory says that these funds are playing an important role in global economic integration.

Helmut Schmidt: These funds may well become dangerous in the future. The capital in these funds will grow. Look at the enormous Chinese currency reserves: Only a small portion is invested in sovereign funds. It is easy to envision a situation in which political influence will be the real target to be bought.

AI: But it is Russia, not just China, that people worry about.

Helmut Schmidt: In Russia, the currency reserves are currently relatively small compared to Japan or China.

AI: But the willingness there to use economic instruments to gain political influence is high, is it not?

Helmut Schmidt: No, it is higher in China for now, and even the funds in Dubai are more relevant today than the Russian ones. But that may change.

AI: What is your long-term worry about these funds?

Helmut Schmidt: The Americans will have to worry about them. They have to deal with their trade deficit. They have to balance their budget. They should return to the reasoned monetary and financial policies of Bill Clinton. He left office with America in decent shape. The current Administration has created the current troubles, just as Reagan earlier left the country in similar shape.

AI: The American public perceives Reagan’s heritage as admirable, which, for many, leads to conclusions about the current situation. Many Americans think going into debt is not so bad when the broader reasons for doing it are compelling.

Helmut Schmidt: Yes, but the current situation is much more dangerous. Only a few years after the Reagan Administration ended, the Soviet Union collapsed. America’s prestige grew tremendously during the Administration of George H.W. Bush. His son has to cope with the fact that America’s prestige and reputation are quite a bit lower now than when he was inaugurated. That creates a big, even a fundamental difference. Clinton was able to come in, and after eight years, left the country in decent economic shape. Whether he had good people at Treasury or whether he followed his instincts or whether it was all coincidence—I cannot possibly judge that from afar. But no one can seriously dispute the facts. And no one can dispute the fact that today—again, whatever the reasons—things are a mess.

AI: Let me ask now about trade. The Doha Round is stalled and some believe it has already failed. The United States and Europe have both become obstacles to success because of their agricultural subsidies. Many bilateral trade agreements they have negotiated also undermine the multilateral system. Is the world headed toward a new protectionist era?

Helmut Schmidt: I am not too sure about that.

AI: Protectionist tendencies are strong in Europe and strong in the United States.

Helmut Schmidt: These tendencies exist in every democratic society. Whenever economic difficulties become apparent, foreign countries are blamed and asked to pay the price. This attitude is common among trade unionists on both side of the Atlantic. That does not mean, however, that we will dive into a protectionist era. We have seen the expansion of free trade since World War II. Colbertism has been in decline. I don’t envision that this trend is going to change. Of course, there are challenges. Americans always pay lip service to free trade but, in reality, they tend to be more protectionist than their rhetoric suggests. The same is true for the French; a little less so for the Germans.

AI: You mentioned that you see a connection between America’s economic and its political difficulties, especially with regard to the fact that America is losing its moral authority. Are you really saying that trust is in the end indivisible?

Helmut Schmidt: Yes, but America has not lost its moral authority yet. It has not vanished; it is just reduced. If America lost its moral authority completely, very bad things could happen.

AI: Like what? Please give us a forecast.

Helmut Schmidt: I am not a weatherman.

AI: But you could provide the next administration with some advice.

Helmut Schmidt: America needs to correct course in some areas. One is the budget deficit, which is connected to its trade deficits. Another one is regulation of financial markets, as I have already discussed. My third piece of advice is that Americans be more realistic about their own limits. The American economy can’t afford the wars the country is now fighting, yet the speeches of the presidential candidates don’t give any indication that they have understood that there is a connection between America’s wars and its economic woes.

AI: Some analysts warn against wars over natural resources, especially over oil. What should the big industrial nations do in order to prevent energy wars?

Helmut Schmidt: It is just normal that scarce resources become more expensive. We see this process with oil and natural gas. To assume that price increases are a reason to go to war is rubbish. After all, prices will not decline after a war, because a war won’t change the basic relationship between global supply and demand. In the long term, all societies have to reduce their dependency on oil and natural gas. We need to use new technology and we need investments so that a larger portion of our energy demand is satisfied by renewable energy like wind, water and nuclear. There are no limits. There is a lot of energy inside our planet. We must get it out with research, followed by tremendous investments.

AI: Such high-tech scenarios cannot please developing countries. They fear falling behind again. There are those who claim that poverty is a consequence of the lack of development aid and that the industrial nations do not help enough. Others think that development aid is counterproductive because it distorts the markets. In their view it is more important to liberalize trade, improve education and fight corruption. Where do you stand in this debate?

Helmut Schmidt: I have never shared the idea that it is possible to help 150 developing nations through development aid alone. So far, development aid has fueled the extraordinary growth of world population through better hygiene and improved medical care. In the early 20th century, about 1.6 billion people inhabited our world. Today there are almost 7 billion—after only a little more than one century. And the population explosion continues, but only in developing countries.

From a moral standpoint it was perfectly legitimate to bring hygiene and medicine to developing countries. The consequences were huge, and of course positive. In the future, however, it will be much more important to help women and girls to obtain equal rights and an education. Then they can decide for themselves whether they want children or not. That’s much more important than development aid in the ultimate economic circumstances of poorer countries.

AI: You have followed decades of world politics, and you have studied other decades from before you were born. How do the late 20th and early 21st centuries look compared to others in terms of the relevance that politicians attribute to world economic and financial governance?

Helmut Schmidt: The economic interactions between the big national economies are not taken seriously enough. All the major economic theories—Marxism, Keynesianism, neo-liberalism and monetarism—have always claimed that it is sufficient to talk about national economies. Nobody talks about world economics. The consciousness of being inextricably connected to the economies of others is not very well developed. It has not really sunk into the brains of the political class, either in the United States or in Europe. So far, most of our leaders are thinking in ways that lag behind fast-moving economic realities. In my experience, this has always caused trouble.

Appeared in: Volume 03, Number 6 | Published on: July 1, 2008
Thomas Kleine-Brockhoff, a fellow of the German Marshall Fund of the United States, recently met with former German Finance Minister and Chancellor Helmut Schmidt in his Hamburg office on behalf of The American Interest to discuss the United States and the world economy.
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