Waiting for Godot

That is apparently the script for our current macroeconomic worries.  Having lived last year's absurdity at close range, we wake up midway through 2009 only to find ourselves in the same bizarre situation.  Waiting for the collapse of American empire and the US dollar is like waiting for Godot.  We perpetually have assurances that it will arrive sometime soon.  And yet, nothing seems to be able to permanently break down this system, no one can think of a way to leave it behind, and we all return to the squalid, crisis-prone arrangements that brought us here.  Nothing to be done.

I've already talked about how this applies to banking reform.  Today, I am reflecting on the renewed weakness of the dollar, the rising commodities prices, and the continued dollar reserve accumulation of China and others.  Consider the way and even less stable version of Bretton Woods 2 has been so quickly reinstated, even when we know that original was a flop.

Actions, I believe, speak louder than words. No doubt the world's emerging markets aren't pleased with their exposure to the dollar, but for now they seem to have no good alternative to accumulations of large dollar reserves. The simple reason? Structural imbalances are very difficult to unwind. Nations heavily dependent on exports can't afford to go playing around with exchange rate values in ways that reduce their competitiveness in key markets. The question is, how long will this last?

Well, in one sense, the system is still pretty stable. America currently has a much smaller current account deficit to finance, and while much hay has been raised over government borrowing, that borrowing has largely offset the massive fall in private American borrowing, leading to no net change. On the other hand, as Brad Setser points out, Bretton Woods 2 was based on a very simple quid pro quo—America got the cheap borrowing and BRICs got a plum market for exports. These days, America is still getting the cheap borrowing, but the exporters aren't seeing much of a return for their efforts; support for the dollar may have prevented a larger collapse in exports (to the extent that's possible), but it hasn't reinvigorated export-dependent economies.

With the basis of Bretton Woods 2 no longer in place, there is a greater incentive for emerging markets to move to a new system, presumably one in which domestic demand plays a stronger role. But as the latest data indicates, the transition is unlikely to involve a sudden move away from dollars. These things take time.

Somehow the world seems unable to make any substantive course correction, a fact which I would chalk up to politics. The instability of this system is essentially held together by politics.  Without the centralization of currency manipulation and reserve investment decisions in places like China, it is unlikely that their private sector would have made the same huge bet on the dollar and on export driven growth.  Without the phony regulation of the US financial system to guarantee an air of respectability, we would also not have been able to absorb so much surplus capital in the US without more of it passing into real investment either domestically or abroad, or without it at least spreading into equities.  As it was, politics was what held this stable disequilibrium together to begin with -- Chinese politics, led by exports and with its debilitated domestic financial system, and American politics, with its hyperactive financial system that enabled it to find some place to gamble away Chinese savings. 

So I think you can see the macroeconomic patterns of the last decade (in retrospect we can see that this cycle really began with the Asian crisis of 98) as the system's response to the political bottlenecks that constrained it -- the capture of the US government by financial services, and the capture of the Chinese government by its rapidly growing exporters.  Because the real driving economic force through all of this has been the same force that has driven rising standards of living (on and off) for the last 500 years -- 2 billion newly productive workers entered the market economy.  Normally this type of productivity increase would have been highly deflationary, and would have dramatically raised standards of living in the emerging world.  Unfortunately, finance and deflation go together like oil and water, and China at least wasn't ready to see too fast a rise of a new and more independent middle class making financial decisions on its own.  The productivity boom of China's rapid industrialization was thus channeled in a particular direction because it fit with the political constraints on both sides of the globe.  I think this goes a long way to explaining all of the relevant factors that Martin Wolf discusses in his new column.

The paper points to four salient features of the world economy during this decade: a huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in emerging economies); a global decline in nominal and real yields on all forms of debt; an increase in global returns on physical capital; and an increase in the "equity risk premium" – the gap between the earnings yield on equities and the real yield on bonds. I would add to this list the strong downward pressure on the dollar prices of many manufactured goods.

In a certain sense, this is a relatively comforting conclusion -- the current crisis is, from the perspective of the globe as a whole, a rich man's problem.  Globalization was too successful and too productive, or at least too rapid relative to the global financial system's ability to absorb the benefits.  All one has to do to fix this is slow down consumption in the US and stimulate consumption in China, and voilà, we can gradually go back about our business. 

The dominant feature of today's economy is that erstwhile private borrowers are, to put it bluntly, bust. To sustain spending, central banks are being driven towards the monetary emissions of which Ms Merkel is suspicious and governments are driven towards massive dis-saving, to offset higher desired private saving.

Today, Germany wants to preserve the value of its money, while China is desperate to preserve the value of its external assets. These are understandable aims. Yet, if this is to happen, debtor countries have to stabilise their economies without another round of profligate private borrowing or an indefinite rise in government debt. Both paths will ultimately lead to defaults, inflation, or both and so to losses for creditors. The only alternative is for debtors to earn their way out. At the level of an entire country that means a big rise in net exports. But if indebted countries are to achieve this aim, in a vigorous world economy, the surplus countries must expand demand strongly, relative to supply.

China's decision to accumulate roughly $2,000bn in foreign currency reserves was, in my view, a blunder. Now it has a choice. If it wants its claims on the US to be safe, it must facilitate an adjustment in the global balance of payments. If it and other surplus countries wish to run huge surpluses and accumulate vast financial claims, they should expect defaults. They cannot have both safe foreign assets and huge surpluses. They must choose between them. It may seem unfair. But whoever said life is fair?

While macro-economically straightforward, this solution runs counter to the interests of the political constraints that sponsored the meltdown.  On top of the difficulty of either side slipping those constraints, you have to establish some trust between the two new political establishments that would replace the current ones.  So to get to there from here, you not only have to change US politics, but you have to simultaneously change Chinese politics in a complementary fashion.  We still sink or swim together.