The Long View 2008-11-22: Debt and the End of the Age

John J. Reilly links here to an excellent article in The New Republic, “Debt Man Walking”.

Even though the 2008 Housing Bubble has passed, we still live in the financial world that TNR article describes. If you want to understand the slightly insane sounding but remarkably stable practice known as Modern Monetary Theory, or MMT, you should start with this article.

John referred to MMT as quantum finance, which is a good appellation for something that makes no sense at all to normal people, but Very Serious Economists have spent a lot of time thinking about, and so far the world does actually work reasonably well with this arrangement.

MMT, like Bretton Woods before it, is designed to keep the US on top of the global system. However the economic returns have been distributed very differently. In the post-WWII settlement, the US profited handsomely, and the inchoate Communist movements in the US of the 1920s and 1930s were destroyed by raising the standard of living of most Americans. A flaw in this system was the racial apartheid that American Blacks experienced, but the rising Black middle class that was created by the economic growth was able to protest more successfully than in the past.

However, the original system started to break down by the end of the Vietnam War, and the solution that was devised came from the economic school of neoliberalism, which despite its name was a very bipartisan thing in the 1970s and 1980s. What is sometimes called Bretton Woods II also allowed for significant economic growth, but the new system allowed things previously considered unproductive to be counted as such in official statistics, leading to the FIRE economy. Finance, insurance, and real estate became bigger and bigger parts of the economy, and this was aided and abetted by the Bretton Woods II system which allowed companies to mine their industrial base for short term profit, destroying American manufacturing.

Very Serious Economists will sometimes justify this because this policy has been associated with economic growth in the rest of the world, explicitly trading off the American working class for workers abroad. It may be true, although I have some doubts about the causality. Nonetheless, you can see how the vital spirits of the age have waned since none of the men who make this argument have been hanged from lampposts by angry Rust Belt workers.

In what is absolutely not a coincidence, the purported interest in the well-being of workers outside the US handsomely profits some at the top of the economic order, with some of that largess being redistributed to economic think tanks. It is also worth point out that China roughly mirrors the US in this way, with a vast impoverished hinterland and glittering coastal cities.

As the TNR article points out, this whole arrangement is built on a system that has a seemingly endless demand for US Treasuries, making it unnecessary for the United States to balance the Federal budget. That’s the part that sounds crazy, but seems to work.

Debt and the End of the Age

I have been brooding about John B. Judis's piece in The New Republic, Debt Man Walking, since I read it earlier this week. It perfectly expresses what has been wrong with American fiscal policy for the past 35 years:

The original Bretton Woods system dates from a conference at a New Hampshire resort hotel in July 1944....

The dollar became the accepted medium of international exchange and a universal reserve currency. If countries accumulated more dollars than they could possibly use, they could always exchange them with the United States for gold. But, with the United States consistently running a large trade surplus [so this was not a problem].

[In the 1970s, under the pressure of American trade and federal fiscal deficits] a new monetary arrangement began to emerge. Economists often refer to it as "Bretton Woods II"....Bretton Woods II took shape during Ronald Reagan's first term....[The paradigm case was Japan. Japan's] export-led approach was helped in the 1960s by an undervalued yen, but, after the collapse of Bretton Woods, Japan was threatened by a cheaper dollar. To keep exports high, Japan intentionally held down the yen's value by carefully controlling the disposition of the dollars it reaped from its trade surplus with the United States. Instead of using these to purchase goods or to invest in the Japanese economy or to exchange for yen, it began to recycle them back to the United States by purchasing companies, real estate, and, above all, Treasury debt....With Japan's purchases, the United States would not have to keep interest rates high in order to attract buyers to Treasury securities, and it wouldn't have to raise taxes in order to reduce the deficit....[The petro states participated eagerly. China has recently become America's largest counterparty in the system] The more tangible drawbacks of Bretton Woods II have been social and economic. Bretton Woods II has perpetuated the U.S. trade deficit, particularly in manufactured goods. Forced to compete against foreign products kept cheap not only by low wages abroad but by the dollar's high value, U.S. manufacturers have had little incentive to expand or even retain their operations in the United States.

It may take a few moments for the reader to appreciate the full import of this analysis. American governments for the past generation have been content to allow foreign competitors to hollow out the American manufacturing sector because the process has obviated the need to raise taxes. Not raising taxes created "growth," in the sense of financial speculation and an expanding low-wage service sector. The industrial sector was mined to facilitate this process.

The baleful effects of Bretton Woods II have been by no means limited to the United States, as we see in another New Republic piece, this one by by Joshua Kurlantzick, Crash and Burn. The author argues that the current situation is serious for the US, but potentially catastrophic for China as we have known it since Deng Xiaoping's reforms.

Pearl River cities like Guangzhou, nouveau riche businesspeople cut deals at swank hotels...But in recent months, the Delta has started to seem more like Allentown, circa 1980s...Since the 1989 Tiananmen crackdown, China's urban middle classes have bought into [the post-Deng boom]--and the regime. In one Pew poll, over 80 percent of Chinese said they were satisfied with conditions in their country...Now, that bargain is breaking down. Exports constitute nearly 40 percent of China's GDP--far too high a figure. (By comparison, in the U.S., exports account for about 10 percent of GDP most years.) And the global financial slowdown is already taking a terrible toll...

You must read that whole article to see just how much is going wrong all at once. We may note that the statement that 40% of GDP for exports is too high may be true, but it needs explanation: some countries' economies have a sustainable export sector far larger in percentage terms than that of the United States. In any case, the author makes pretty much the argument that Gordon Chang made in The Coming Collapse of China: that China is hilariously overleveraged, and that the bursting of the bubble will threaten the regime. Indeed, the article quotes Chang himself, who recently said in this Forbes piece:

To prevent [a collapse] from happening, Beijing this week unveiled measures to help industry, such as a new value-added tax rebate, but the program will undoubtedly prove ineffective. The issue is not that Chinese goods are too expensive; the problem is that foreign consumers are not consuming.

And neither are China's. ...

The coming slowdown looks like it will hit China especially hard. The country's exuberant growth has created dislocations, such as questionable bank loans, unfunded social welfare obligations, a degraded environment and rampant corruption. These problems have not posed serious threats up to now, because continual increases in economic output have tended to mask them.

Yet, as China turns from boom to bust, they will inevitably emerge. When that happens, much of what we think we know about the Chinese economy--and China itself--could become obsolete.

We may note Chang has changed his tune slightly since The Coming Collapse of China appeared. In that book, he argued that the collapse would be triggered in part by China's inability to adapt to international financial standards. Now he seems to be saying that it is participation in world trade itself that is the problem.

Be that as it may, it is news like this that should leave us skeptical of this kind of prognostication:

U.S. economic and political clout will decline over the next two decades and the world will be more dangerous, with food and water scarce and advanced weapons plentiful, U.S. spy agencies projected on Thursday.

The National Intelligence Council analysis "Global Trends 2025" also said the current financial crisis on Wall Street is just the first phase of a global economic reordering... China and India, following a "state capitalism" economic model, were likely to join the United States atop a multipolar world and compete for influence, the report said.

Russia's potential was less certain, depending on its energy wealth and internal investment. But Iran, Turkey and Indonesia were also seen gaining power.

Again, this is not so different from the arguments that Fareed Zakaria made in The Post-American World, and they are not wholly without merit. Certainly the post-World War II world is unraveling, and to the extent that world was an American enterprise, America can be said to be in decline. However, it is not at all clear that this implies a relative decline. America's counterparties in that system prospered in the niches the system afforded. As we have seen above, one could even argue that the system has been debilitating for the United States itself. The implosion of the system would damage America, but not so much as the other participants.

As we have discussed in this space previously, it is not inconceivable that the 21st century could see areas of the world relapse into barbarism. As Mark Steyn noted about the recent uptick in piracy:

In America Alone, I quote Robert D Kaplan referring to the lawless fringes of the map as "Indian Territory". It's a droll jest but a misleading one, since the very phrase presumes that the badlands will one day be brought within the bounds of the ordered world. In fact, a lot of today's badlands were relatively ordered a couple of generations back, and many of them are getting badder and badder

A world with an increasingly ill-defended frontier might actually tend toward unipolarity, in the sense that a secure citadel is a pole. However, we should not expect to see this trend toward barbarism extend too far. It is centuries too early for a Mad Max world. These disorders will be put to rights in due course. We may, however, reasonably entertain pessimism about the ability of the current machinery of international governance to do it.

Copyright © 2008 by John J. Reilly

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