The Leaderless Economy (part 2)

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My previous post described the Keynesian economic models that Temin and Vines use to explain the relationships between national economies and the global economy. The title of their book represents an overarching theme in their analysis: the need for some strong country to take the lead in fostering international cooperation and global economic growth.

Countries are economic competitors for export markets, but they are also trading partners. Each country benefits by having trading partners that can afford to buy its goods and pay for them with their own exports. Economic collapse in one country hurts other countries, and assistance to a struggling country may be in the long-run best interest of all countries. Such assistance carries risk, however, since it comes with no guarantee of a reciprocal benefit to the country providing the assistance. Temin and Vines believe that the global system works best when it contains one particularly strong country that can afford to take the risk of international leadership. Using the language of world systems theory, they refer to that country as the “hegemonic power.” The authors explain this further using the game-theory concept of the “prisoner’s dilemma,” but I don’t find those details essential.

The United States emerged as the hegemonic power after World War II, providing extensive assistance to Europe with the Marshall Plan and bringing nations together at Bretton Woods, New Hampshire to organize a new monetary system. Many of the ideas of what needed to be done came from John Maynard Keynes, whose thinking developed partly as a reaction against what Britain had failed to do to avoid the Great Depression and the war with Germany. Britain was the world’s strongest economy until the early 20th century, but its competitive position had weakened as the United States and Germany developed new industries like steel and chemicals, and even its established industries like textiles had failed to adopt more advanced methods. Not only did Britain’s weakened economic position undermine its international leadership, but British leaders made several policy blunders that contributed to the Depression, as Keynes saw it. Britain helped cripple the German economy and weaken its democracy by imposing crushing reparations after World War I, and it hurt itself by remaining on the gold standard throughout the 1920s. Fixing the value of the pound at too high a price in gold encouraged people to cash in pounds for gold or other currencies, leading Britain to defend the pound by keeping interest rates too high (trying to reward holders of pounds with a high return). These are contractionary policies that weaken aggregate demand and raise unemployment. (Recall that in the IS/LM model, the higher the interest rate, the lower the level of production at which demand balances supply; and in the IB/EB model, the higher the real exchange rate, the lower the level of domestic demand at which imports will balance exports.) At the onset of the Depression, Herbert Hoover was making the same mistakes in the US, maintaining the gold standard and raising interest rates. By the early 1930s, both countries had ended the gold standard and adopted more expansionary fiscal policies. Temin and Vines consider the Great Depression an “end-of-regime crisis” which brought Britain’s hegemonic power to an end and passed the mantle of leadership to the United States.

By the Bretton Woods meeting in 1944, Keynes had formulated the economic policies he believed necessary for postwar prosperity.

Keynes aimed to establish a policy framework in which individual countries like Britain would be able to promote high levels of employment and output by means of demand-management policies, mainly in the form of fiscal policy. This would, it was hoped, avert slumps in growth and would prevent the reemergence of the kind of global depression that had occurred in the 1930s. Each country would pursue internal balance.

But Keynes saw that such policies would need global support, because they would have to be reconciled with the need for each country to be sufficiently competitive. That is, each country would need to be able to export enough to pay for the imports that would be purchased at full employment.

The specific policies he recommended included management of domestic demand to maintain full employment, pegged but adjustable exchange rates to maintain the balance-of-payments between countries, reductions in tariffs to increase free trade, and international lending to foster economic development. He foresaw international institutions such as the International Monetary Fund, The World Bank and the World Trade Organization. The Bretton Woods agreement set up a system of exchange rates along the lines Keynes recommended:

The IMF oversaw a global system of pegged-but-adjustable exchange rates. A deficit country was declared to be in “fundamental disequilibrium” if it wished to import more at full employment than it was able to cover from its exports. Exchange-rate pegs were not to be adjusted (unless there was a fundamental disequilibrium) to prevent countries from stealing jobs from one another by beggar-thy-neighbor devaluations. But deficit countries in fundamental disequilibria were required to adjust their exchange rates. Lending from the IMF was available to cover liquidity problems during the adjustment period. Surplus countries in fundamental disequilibrium—that is to say, countries exporting more than the amount required to pay for what would be imported at full employment—were also required to adjust.

Under this system, a country whose exports were in much less demand than its imports could restore balance by lowering its exchange rate, making its exports cheaper and its imports more expensive. Anchoring the system of adjustable exchange rates was the stable US dollar, which once again was given a fixed price in gold. This made the dollar the world’s strongest currency, but that was okay as long as the United States was clearly the world’s strongest economy. The system worked well from 1945 until 1971, helping to make that period “the most remarkable period of economic expansion that the world had ever known.”

In the late 20th century, it was the United States that became the faltering hegemonic power. The story is in some ways similar to Britain’s earlier story, involving a combination of declining global competitiveness and domestic policy blunders. The country’s competitive position after World War II was exceptionally strong, since it was producing over one-fourth of all the goods and services in the world. Challenges were inevitable sooner or later, especially from European recovery and Asian development. The transition to a less dominant economic position was complicated by the expansionary fiscal policies of the Johnson administration, especially the failure to raise taxes to pay for the unpopular Vietnam War. With the economy already operating at high capacity, the additional fiscal stimulus pumped up consumer demand, generating both inflation and an excess of imports over exports. The combination of the dollar’s fixed price in gold but declining buying power threatened a run on the dollar, which the Nixon administration avoided by taking the US off the gold standard and letting the dollar float like other currencies. “The resulting devaluation corrected the external imbalance, but it made the internal balance worse by intensifying American inflation.” “Supply shocks” such as the higher price of oil contributed as well. President Carter’s new Federal Reserve Chairman, Paul Volcker, adopted a monetary policy so strict that it not only brought down inflation, but threw the economy into recession. When it recovered in the 1980s and after, it seemed for a time that internal equilibrium had been re-established, and by 2000 economists were speaking favorably of the “Great Moderation.” What was overlooked by many was that a worsening external imbalance was enabling the internal balance. Americans were increasingly living beyond their means, exporting too little, importing too much, and sustaining domestic consumption by accumulating government and household debt.

Why wasn’t the US trade deficit mitigated by a decline in the value of the dollar, which is what’s supposed to happen in a system of floating exchange rates? The main reason is that other countries, especially China and other East Asian countries, prevented that in order to protect their export-led economies. Instead of letting their currencies float upward, they pegged exchange rates at a level that kept their currencies cheap and the dollar strong. Then they took many of the dollars they earned with their exports and lent them back to the US, making us the world’s biggest debtor.  This arrangement made imports to the US cheap and exports more expensive, hurting US manufacturing on world markets. It also encouraged borrowing and spending by Americans enabled by saving and lending by foreigners. Our economy could remain strong only if government and consumer spending were high enough to compensate for the lack of foreign demand for our products. The Reagan-Bush reductions in taxes and increases in military spending helped fuel domestic demand, as did looser monetary policy by the Federal Reserve under Alan Greenspan, especially after 2001. Remarkably, foreign countries continued to finance our deficits even as lower interest rates diminished their returns.

At the same time, the distribution of American income was changing, with more going to the richest 1% and less to the bottom 80%.  (This is partly a result of globalization too, because of the loss or outsourcing of good manufacturing jobs.) After-tax income was becoming even more skewed, since the Reagan and Bush tax cuts were directed especially at the wealthy. The wealthy had more money to lend, while the less wealthy had more reason to borrow in order to achieve their financial goals, such as home ownership. With interest rates low, investors had an incentive to seek higher returns in riskier investments, such as sub-prime loans and the even riskier derivative securities based on those loans. While the manufacturing sector declined, the financial sector boomed, and financial institutions created new instruments like collateralized mortgage obligations, pools of mortgages that offered high returns while disguising risks. Rating agencies overrated these instruments by assuming that they were diversified enough to minimize risk, overlooking the possibility that a general decline in home prices or incomes would cause many borrowers to default simultaneously. Under-regulation of the financial industry, including a refusal to regulate derivative securities at all, made it even easier to engage in risky behavior.

In short, the choices the United States made in the face of its declining international strength were crucial. The tax cuts, financial deregulation, and choice of a low level of interest rates— instead of ensuring that the dollar devalued— are fundamental to our story. They left the United States in internal balance but with an external imbalance. The United States encouraged expenditure through financial deregulation and a low level of interest rates. This unhappy combination caused the financial bubble, which led in turn to the crash.

The internal balance in which demand absorbed productive capacity turned out to be unsustainable, since it depended ultimately on spending in excess of income by government, by consumers, and by the country as a whole. The bubble had to burst when prices fell in the overheated housing market, borrowers began defaulting on loans that were larger than their homes were worth, investors began panic-selling the overvalued mortgage-backed securities, and large investment banks failed when they were caught holding too many toxic assets themselves.

Temin and Vines regard the recent global financial crisis as another “end-of-regime crisis,” this time marking the end of American hegemonic power and global leadership.

How do we know that this is the end? We know because of the lack of leadership from the United States to revolve the crisis. The United States turned belligerent after the suicide attacks on September 11, 2001, echoing the frustrated policies of Germany between the world wars and leaving the world economy leaderless. The United States set the example for bank bail-outs during the crisis itself, but then vanished as a world leader….The country has become part of the problem rather than a leader orchestrating the search for a solution to it.


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