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U.S. Power: Down But Not Out
Niall Ferguson on challenges to American financial dominance.
Wall Street has been as much a part of American power over the past 30 years as the Sixth Fleet. Yet Americas illustrious investment banks have been either bankrupted, swallowed up or transformed into regular banks in the space of little more than six months. So close did the U.S. financial system come to meltdown last month that Treasury Secretary Henry Paulson Jr. was driven to request emergency powers worthy of wartime: carte blanche to spend $700 billion on the mother of all bailouts. For some this crisis was, in economics, what the Iraq War was in foreign policy a damaging if not fatal blow to the credibility of U.S. claims to global primacy.
If the unipolar moment that followed the collapse of the Soviet empire was hubris, then the credit crunch has been a very American nemesis. Ten years ago there was a strange competition in the U.S. 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. Equally smug were the neoliberal economists who argued that the rest of the world should hurry up and embrace the Washington consensus of free trade and open capital flows or prepare to be sold short. One lot derided the political failure of the Muslim world; the other heaped scorn on crony capitalism, supposedly the root cause of the 199798 Asian financial crisis.
The neocons got their comeuppance in Iraq, where American forces were not, after all, greeted as liberators. The neolibs got theirs last month as a Republican Treasury, headed by a former CEO of Goldman, Sachs & Co., nationalized first the countrys biggest mortgage lenders and then its biggest insurance company. As the presidential candidates, in rare unison, heap opprobrium on Wall Street chancers and slumbering regulators, the stage seems set for the demise of what George Soros has called market fundamentalism.
That policy paradigms are shifting is clear. But is the same true of the global balance of power? To answer that question, we need to reflect more deeply on the nature of this crisis.
Over the past decade we have seen the rise of a phenomenon that Moritz Schularick, an economics professor at the Freie Universität Berlin, and I christened Chimerica. In this view, the most important thing to understand about the world economy has been the relationship between China and America. If you think of it as one economy, Chimerica accounts for roughly 13 percent of the worlds land surface, a quarter of its population, about a third of its gross domestic product and more than half of its global economic growth in the past six years. The key question is whether the financial crisis marks the end of this dual engine.
For a time China and America enjoyed a symbiotic relationship that seemed like a marriage made in heaven. To put it simply, one half did the saving and the other half did the spending. U.S. savings as a proportion of gross national income 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 so-called savings glut made it much cheaper for American households to borrow money, fueling a tremendous explosion in U.S. debt. Meanwhile, cheap Chinese labor helped hold down inflation.
The crucial mechanism that bound the two halves of Chimerica together was currency intervention. To keep the yuan and, hence, Chinese exports competitive, the authorities in Beijing consistently intervened to prevent, and then slow, the appreciation of their currency against the dollar. The result was a vast accumulation of dollar-denominated securities in the reserves of the Peoples Bank of China, which became one of the worlds biggest holders of U.S. Treasuries and 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 Americas borrowing habit, interest rates in the U.S. would have been substantially higher.
Needless to say, it was not just the U.S. that was borrowing, and it was not just the Chinese who were lending. All over the English-speaking world, as well as in countries like Spain, household indebtedness increased and conventional forms of saving were abandoned in favor of leveraged plays on real estate. Meanwhile, not only China but other Asian economies adopted currency pegs and accumulated 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 it was Chimerica that was the real engine of the world economy.
As this tremendous expansion in borrowing was taking place, some economists tried to rationalize what was going on. Some argued that this was Bretton Woods II, a system of international exchange rate management akin to the one that linked Western Europe to the U.S. 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. subprime mortgage market revealed just how unstable Chimerica was. In essence, the rest of the worlds savings had helped inflate a U.S. real estate bubble. Easy money was, as is nearly always the case in asset bubbles, accompanied by lax lending standards and downright fraud. Euphoria eventually gave way to distress and then to panic. It began in the subprime market because it was there that defaults were most likely to happen. But it soon became clear that the entire U.S. property market was going to be affected. (According to figures produced earlier this year by Credit Suisse, a total of 6.5 million home loans could ultimately fall into foreclosure. That could throw as many as 13 percent of U.S. homeowners with mortgages out of their homes.) Not since the Great Depression have we seen housing prices declining at annual rates above 10 percent as they have during the past year.
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. The ratings agencies had pronounced the top tier of these instruments to be triple-A-rated. When the supposed gold turned into lead and then into toxic waste, the consequences were devastating. According to some estimates, the total losses on the various kinds of securities affected could amount to more than $1 trillion.
The debt implosion 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. Second, the failure of financial firms has triggered a further crisis in the market for derivatives. Credit default swaps were supposed to be a wonderfully clever form of insurance for bondholders. But it is far from clear how the far-from-transparent derivatives market can cope with defaults on this scale when the notional amount of CDSs is $62 trillion.
But, third and most important, the contraction of bank balance sheets almost certainly condemns the rest of the U.S. economy to a recession. Main Street is only now beginning to feel the pain that will be caused by Wall Streets credit crunch.
What are the geopolitical implications of all this? One possibility is that the great convergence between East and West will speed up. Back in 2003 in one of its first BRIC reports forecasting the prospects of Brazil, Russia, India and China, Goldman Sachs projected that China would overtake the U.S. in terms of gross domestic product in 2041. More recently, the firm has brought that date forward to 2027. Maybe it will be even sooner than that. For one inevitable consequence of the credit crunch is that the U.S. will grow more slowly for the foreseeable future: at closer to 1 or 2 percent per annum, rather than the 3 or 4 percent we have become used to. By contrast, Chinas semiplanned economy can comfortably maintain growth of 8 percent a year, propelled by state-led investment in infrastructure and growing consumer demand. Because net exports are no longer the key driver of Chinas growth, an American sneeze does not necessarily cause an Asian cold.
A second possible implication of the current crisis is that the days when the dollar was the dominant 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 worlds No. 1 currency, the unit of account in which most financial transactions were done. It died a long, lingering death, sliding from $4.86 in 1930 to near-parity with the dollar at the nadir in the early 1980s. The principal reason for that was the huge debts that the U.K. had run up to fight the world wars. The second reason was lower growth. Britains economy was the underperformer of the developed world in the postwar decades, right up 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 American International Group the U.S. could find itself in a similar situation. With debt spiraling upwards, the dollar could follow the pound into the category of former reserve currencies. And the U.S. 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., caring less about its currencys peg to the dollar the end of Chimerica would have arrived. And with the end of Chimerica, the balance of global power would be bound to shift. No longer so committed to the Sino-American relationship 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 nascent empire in commodity-rich Africa.
Yet commentators should always hesitate before they prophesy the decline and fall of the U.S. The country 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 is that the U.S. has long offered the worlds most benign environment for technological innovation and entrepreneurship. The Depression saw a 26 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), Procter & Gamble (soap powder), Revlon (cosmetics), RCA (radio) and IBM (accounting machines). In the same way, the double-digit inflation of the 1970s didnt deter Bill Gates from founding Microsoft in 1975, or Steve Jobs from starting 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 Americas 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 the same role in the cold war.
The other reason the U.S. bounces back from even the worst financial crises is that, bad as they feel at home, they always seem to have worse effects on Americas rivals.
Think of the Great Depression. Though its macroeconomic effects were roughly equal in the U.S. and Germany, the political consequence in the U.S. was the New Deal; in Germany it was the Third Reich. Germany ended up starting the worlds worst war; the U.S. ended up winning it.
In a similar way, the credit crunch is already having worse effects abroad than at home. Both the euro zone and Japan are closer to being in recession than the U.S. According to the MSCI indices, the U.S. stock market was down 19 percent for the year as of the start of this month. The equivalent figure for China was 46 percent, and for Russia, 49 percent. These figures are scarcely good advertisements for the more regulated, state-led economic models favored in Beijing and Moscow.
In any case, are these rival empires really credible alternatives to the U.S.? Though it is growing rapidly, China is bedeviled by three serious ailments: demographic imbalance, environmental degradation and political corruption. It is far from clear that the countrys manufacturers are ready to decouple from the U.S. market, any more than the Peoples Bank of China is able to kick its habit of accumulating dollar reserves. Nor, for that matter, is Chinas military remotely ready to mount a serious challenge to American dominance of the Pacific. Economically as well as strategically, Chimerica is far from dead.
Russia, meanwhile, is closer than ever to resembling its cold war caricature: Upper Volta with missiles, in the phrase of former German chancellor Helmut Schmidt. Reliant primarily on its abundant energy rather than its declining population to generate wealth, the government in Moscow has become a version of what Marxist-Leninists used to call state monopoly capitalism, with Prime Minister Vladimir Putin as the CEO-cum-Duce. Putins 1930s-style invasion of Georgia was a fresh reminder that political risk remains substantial in Eastern Europe.
Moreover, the U.S. governments debt continues to be regarded by investors as a safe haven in uncertain times; hence the periodic dollar rallies in the latest phase of the financial crisis. Huge though the costs of the current crisis may prove to be, there is a way of presenting them that may suffice to reassure the rest of the world. After all, the federal debt in public hands remains equivalent to less than 40 percent of U.S. GDP, a significantly lower figure than in many European economies or Japan.
Of course, this crisis could yet prove to be the safe havens last gasp, especially if the authorities are unable to avert a fresh wave of bank failures.
Nevertheless, the caveat is clear. The hubris of recent years has certainly been followed by a terrible financial nemesis. But it is much too early to conclude that the American century is over, or that China is about to take over from Chimerica. Like so much else made in the U.S., this nemesis is proving an all-too-successful export.
Niall Ferguson is Laurence A. Tisch Professor at Harvard University. His new book, The Ascent of Money: A Financial History of the World, will be published in November.