Will the U.S. Need Help to Recover?
Getting the Context and Diagnosis Right
Martin Wolf and I agreed a few years ago in London that the globalization project might yet prove beyond the capacity of mankind at this stage in human development. We also agreed that would be a grave development. That possibility is now upon us. We have yet to understand the stakes or to muster the political will to address the very real possibility that not only could the systemic global credit crisis and the spreading U.S. balance sheet recession lead to a lost decade or worse for the global economy. It could also lead to the breakdown of the globalization project itself, despite the huge net economic benefits it has brought to virtually every corner of the world. This in turn could threaten social and geopolitical stability. That is the fundamental context for the current financial and economic crisis. This is so big that it demands mobilizing the efforts of all the major economies.
A moment in history
So where are we in March 2009? Above all else, we are at a moment in history, like 1815; 1914; and 1940. The forces that shaped the post-war period have weakened; the counterforces they provoked have strengthened; and we face an increasingly existential level of underlying uncertainty over the future at every level of human affairs. The United States, the world’s largest economy – the one that has lead the world out of all its recessions in the post-war era – is now in a balance sheet recession. Its impact has already spread across the globe. We have lessons on how to get out of a balance sheet recession from Japan in the nineties and the current decade and from Germany and the United States in the thirties. They are not as encouraging as one would hope. The U.S. did not really get out of its thirties recession through policy but by war and the preparation for war. Germany got out of its balance sheet recession by preparations for war. And, it would seem, Japan may not really be out of its balance sheet recession. The end of potentially two lost Japanese economic decades cannot yet be said to be in place.
Achievements remarkable, problems daunting
The post-war achievements of the key countries in the drama that is now playing out are remarkable and the problems they face are daunting. There is both credit and blame for all, so both finger-pointing and self-congratulations are out of place. What all need to focus on now is that we are well along in the end game of the post-war order and what matters are the choices we make about the future.
The U.S. further along
The U.S. under its new President may be further along in facing the scale of the challenges, but it does not yet appear to be where it needs to be. What none of the key countries seem to recognize is that the two model global economy of the last thirty years is dying and will soon be dead. That model had already produced the conditions of the thirties by the early nineties, when Japan was the first to succumb to them. One was the earn-more-than-you-spend Japan, Germany and China model. The other was the spend-more-than-you-earn United States and United Kingdom model. The results of running a rapidly expanding global economy with such contradictory models were the global imbalances and their monetary accommodation, primarily by the Federal Reserve in the United States. The U.S./U.K. model will survive a bit longer as the contractionary forces it has set loose will be blunted by fiscal stimulus that will sustain for a while continuing but declining U. S. current account deficits. This inevitably means that the export-led model of the three big current account surplus countries is also dying. It is pitifully simple. There can be no export-led models by the world’s large economies when there are no spend-more-than-you-earn large economies to take the exports. So there can be no question that the U.S. needs help to recover. The help it needs is to be able to move to a more sustainable balance between what it earns and what it spends within a still growing economy. Only more rapid domestic demand growth in the surplus countries can make this happen. If that help is not forthcoming, the consequences do not bear thinking about. The twin models will still die, but their deaths will be more convulsive and dangerous than should be prudently risked.
Stakes very high
The stakes are very high. Not just economic well-being is at stake. Global social and geo-political stability are also at stake. The challenge is first to find a plan A that saves the globalization project by returning the global economy to growth, and then to muster the needed political will around it. This Conference is about plan A – what it needs to be and its likelihood. But realism requires us to recognize that Plan A – an adequate one needs to emerge soon – may fail and that there is no Plan B. The political will of four countries are key: the U.S., China, Japan and Germany. Right now, only the United States and China seem to have political systems that could muster the needed political will. That means that over the next twelve to twenty-four months – but possibly over an even shorter period – the future of the world will be in the hands of two men – the President of the United States and the Premier of China. Neither country has been in that place before.
Getting the biggest things right
Leaders are usually judged by history not primarily by their mistakes, which are often very large ones, but by whether they get the biggest things right. Both the U.S. and China have daunting internal problems, so their current preoccupation with them should be seen as no surprise or cause for criticism. But it seems likely that for both men, the biggest thing they must get right is how to muster the necessary political will in their respective countries and with each other to bring about the policies that will move the world in a reasonably orderly way from the now unworkable unbalanced two-model global economy to a more balanced unified-model global economy. We do not know whether these two men will prove up to this historic task or even if they yet know that this is their task. If they fail, the export-led model’s death will then come from brute economic, financial and political forces.
Imagine yourself in 1910
Imagine yourself having lunch with friends in your club in Berlin, Paris, London or New York in 1910. You would not have had the smallest clue about what a disastrous thirty-five years lay ahead – two world wars; a global depression and a holocaust, to be followed by another forty-five year Cold War. Or if you were at university after 1945, as I was, you would not have had the smallest clue how good in terms of peace and prosperity in our part of the world the next fifty years would be. In 2009, we still do not have a clear sense of where the years following our present moment in history are headed.
Past moments in history
What should sober us up as we look ahead is that the disastrous global outcome of the 1910-14 moment in history followed the broadly positive-for-Europe outcome of the post-1815 moment in history, which in its turn followed the disastrous-for-Europe Napoleonic Wars period. So the good-for-the-Western-world outcome of the post 1945-50 moment in history was, like the post-1815 moment, preceded by a bad stretch of history. The question is what must be done by us now to ensure that the largely good 1945-50 era is not, like the good post 1815-1910 era, followed by a bad outcome era like the post 1910-1914 era.
Good post-1945 outcomes not inevitable
We should not assume that there was anything inevitable about the good post-World War Two outcomes that everyone in this room has enjoyed. We faced then a deeply and dangerously divided world, with the West on one side, Russia and China on the other, and many countries somewhere in between. We lived for the first time in history with nuclear weapons. We faced the challenge within Western society itself that was presented by the communist promise of a better world, before the genuinely better system that emerged could yet be seen or counted upon. We faced severe class divisions, especially in Western Europe, that were the hangovers of unfinished business from feudalism and the industrial revolution in a world that was still a producer dominant one, unlike today’s increasingly consumer dominant one.
Historic acts of U.S. and European statecraft
Two great historic acts of statesmanship: the establishment of the European Union, and the U.S. led post-war policy of containment and broadening the inclusive order in the world, laid the foundation for the achievements of the era that has now passed. These were achieved by collective action, not unilateral action. The rising dangers of the last decade have come from a reversion in most of the world to unilateral action and to orders based more on exclusion rather than inclusion. This fateful reversion did not only occur over the last few years in the United States, but also in most other major countries as well. The United States, for example, witnessed an incredible shift of wealth and income to the very top percentage of the population, but the loss of internal inclusiveness also occurred in other ways and within other countries.
This “moment’s” essential story
The high stakes Conference flyer headline raises one very simple question. Have we already forgotten the lessons of the last century. The tragedies of the first half came from unilateral action instead of collective action and from exclusion over inclusion. The success of the post-1945 era came from the reverse? Ideology (whether explicit or implicit) and success are a toxic mix? But in the end the fundamental forces always work, as we are now seeing to our great cost. Not all the self-interested or ideological spin or comforting bedtime stories can do more than delay their full force. That is the essential story of the first eight years of the current “moment in history”. When a “moment in history” arrives, it is very difficult for people to understand that the direction and momentum of the previous decades have weakened, while the counterforces provoked have got stronger. They try to deal with the new on the basis of what worked in the old. The unexpected result is a period of uncertain and potentially dangerous transition in which the old models do not predict and do not work. This is where we are now.
Dominant forces have peaked
The key dominant forces over the positive 1945-2000 period were:
- the rise in the role of government;
- the rise in the role of markets;
- the rise in the power of central banks;
- the huge increase in the power of hi-tech military forces at 30,000 feet;
- the drive toward increasing integration and inclusion;
- the availability of affordable oil;
- the Western reliance on collective action in geo-political, economic and financial matters; and
- the dominant political, military, economic and financial role of the United States.
Reassertion of limits
Limits to all of these have arrived, including to the:
- positive outcomes of the post-war expansion of colonial liberation and of democratic voting;
- rising climate change limits to the use of energy;
- presumed efficiencies achieved at the risk of stable outcomes; and
- the range of effective adjustment capacity of different countries and social groups.
Post-war forces have peaked
The evidence is that every one of these powerful forces has peaked. The initial transition years of the current “moment in history” have been discouraging – 9/11; Iraq; the loss of U.S. focus in Afghanistan; Iran, North Korea; jihad extremism; the mounting global imbalances and internal U.S. imbalances; imbalances in a number of other countries; the greatest credit system crisis in the history of mankind; and a rapidly spreading U.S. balance sheet recession. Moments in history provide a high tension blend of uncertainty and of fateful choices, as the new direction and momentum is not yet set. If over the next few months we do not develop a hopeful confidence in what the direction and nature of the new forces will be, we could be facing a very great “looking into the abyss” crisis.
A moment of fateful choice
So we are at a moment of fateful economic policy choice. The hope must be this. First, the United States and then the other major economic countries – Japan, key Euroland countries, the United Kingdom and China – will join in a collective effort to rebalance the global economic system and to co-ordinate the necessary policy responses aimed at containing the depth and length of the credit system crisis and a deepening and widening global recession. We have seen the huge failures in this century of the excessively unilateral approach of most countries (it was far from only the U.S. that behaved this way). It is now essential that collective action on broadening the inclusive order in the world and containing what cannot yet be included become the basis of the dominant direction and momentum of the new forces that are now gathering. The U.S. for some time now has had no choice but to withdraw to ground it can hold. How other leading countries respond to the resulting vacuums will be central to how stable or unstable the consequences of this withdrawal are. If the U.S. resists that withdrawal, either on its own or because other countries do not step in, it will only weaken itself further.
The positive reshaping of a new inclusive global order depends centrally on avoiding a thirties-like outcome to the current global economic and financial systems crises. Our current crises flowed out of the Munich-like appeasement of the global imbalances. The imbalances reflected a persistent American determination over three decades to consume more than it produces and a persistent determination over many years, first by Japan and Germany, and now by China, to produce more than they consume.
Diagnosis of economic and credit system crises
The failure of the U.S. to confront the imbalances meant that looser monetary policy than otherwise was used to accommodate them. This was the real moral hazard. It began happening with Japan twenty years ago but no one seemed to recognize it. Succumbing to it reflected fear of the economic impact and political implications of non-accommodation. Looser monetary policy combined with weak regulatory understanding and oversight, and classic (not innovative, as the spinners like to suggest) behaviour by the credit grantors. This led to an overall credit system in the U.S. with two thirds of it outside the banking system but dependent on it. By the time of the credit crisis, the overall system had come to have effectively no equity – equity defined as the ability to withstand some real shocks on its own. The result for the United States was not only the greatest credit system crisis in the history of mankind. It also flowed into a severe balance sheet recession, where monetary policy can no longer do much to help the economy recover, because restoring balance sheets, not spending or investing in new plant and equipment, has become the order of the day.
Misguided financial system enthusiasm
The arrival of highly touted “this time it really is different”, “new paradigms” is a classic warning signal. Innovation, at least in the United States, is almost always greeted with a natural enthusiasm that results in something less than a sufficiently critical response. An innovation-based new paradigm is virtually irresistible, especially if it shortens how long it takes to get very rich. A new financial paradigm was believed to have arrived on the heels of central banks whose powers were over-estimated; the glamourized marvels of deregulation, globalization and the expanded overall economic role of financial institutions and financial markets; and the failed wonders of increases in the innovation, complexity and opaqueness of financial products and relationships. The resulting financial world, however, was increasingly disconnected from and damaging to the real economy it exists to serve. It was also increasingly rewarded beyond its real contribution to the economy and in relation to everyone else in the economy. Unfortunately, this new paradigm proved to be the oldest paradigm of all. It was driven by regulation and accounting rules avoidance; too much leverage; too much mismatch of assets and liabilities; too much reliance on unreliable sources of funding; too much mispricing of risk; too much opaqueness and complexity; and too weak (or worse) credit discipline. A lot more was wrong than sub-prime mortgages and greed.
Shadow banking system
A major element that gave new life to that old paradigm was the huge number of credit-granting institutions that had grown up outside the regulated banking sector. This was fueled at base by the decision to accommodate the global imbalances with looser monetary policy in a weakly regulated environment. The central banks were misled because their policies did not fuel goods and services inflation. It did, however, fuel asset inflation and financial institution role inflation, which they either thought they could largely overlook or did not know what to do about. Alan Greenspan said it would be easier to pick up the pieces of a burst bubble than to try to intervene to dampen irrational asset price exuberance! In essence, the global imbalances were sustained by a series of bubbles. In the United States, these accumulated to produce the present balance sheet recession.
Credit system at risk
The result was a credit system that increasingly relied on the capacity of an unreliable shadow banking system. This excess credit expanded the number of sharks in the system and produced a new version of Gresham’s law in the financial system – that bad behaviour drives out good. No new rules for the banking sector can be expected to work that do not include the concept of a “leverage footprint” that recognizes the difference in the scope for leverage pyramiding between banking loans to real economy business and those to financial business borrowers. No amount of regulation will overcome a system that is not tightly disciplined on leverage or by a monetary policy that does not include in its disciplines asset price inflation and keeping the financial system connected to the real economy.
Policy failures aggravated
These central bank and regulatory policy failures were aggravated by an attitude or ideology that financial markets needed little or no oversight or guardianship; that market players owed no obligation to help sustain the fabric of the sytem they profited so greatly from; and that we had become so smart in running the overall system that the previously felt need for a real equity cushion was a high cost anachronism that could be dispensed with.
Important confessional acknowledgement
Before moving on, it is important to acknowledge how almost-beyond-belief-bad the behaviour around the financial system was. If the product innovators; the institutions that bought and sold them; the rating agencies that approved them; the regulators who oversaw them and the central banks that fed them had been in the airline or pharmaceutical business, they would all be in jail for the systemic infection they caused. The idea that the kind of financial and economic outcomes we now have came out of nowhere and were completely unforeseeable does not help us understand what has happened and now needs to happen. Nor does blame help. President Obama was right when he said everyone was complicit.
Where do things sit?
The key failure in the responses of all policy makers in all countries is that they have been very slow to get the diagnosis right. Arguably, while that understanding is now greater and the sense of urgency somewhat higher, most have still not got the diagnosis right. There has been the failure to provide an urgent and aggressive cure of what is belatedly coming to be seen as a very aggressive disease. There are attempts to “blame” one or more countries and sets of economic players – the U.S. for consuming and borrowing too much; China, Japan and Germany for not consuming enough; Wall Street for being too greedy; and so on. There has no doubt been much unaware, inept, unwitting, foolish, corrupt and even criminal behaviour. But none of this would have happened on a dangerous scale if there had not been a failure on the imbalances and in systemic guardianship of the credit system as the circulatory system of the economy.
Family system model
It may now be better to use a family system model for looking at the global economic and financial system. On this basis, the U.S. is the prime symptom-bearer of a dysfunctional global system. Families become dysfunctional when one family member fails to play his proper role and another family member fills the vacuum. Family therapy, not individual therapy, is what is then called for, because even successful individual therapy can still leave in place a dysfunctional family system ready to do its dysfunctional work all over again. Family therapy only works if the parties turn up and agree to try. In today’s circumstances, the dysfunctional behaviour has been both the U.S. taking over too much of the consumption role that properly belongs to the surplus countries, and the failure of those countries to perform their proper consumption role, in each case leaving a role vacuum to be dysfunctionally performed by the wrong countries.
The Bottom Line
The globalization project could for the foreseeable future now be all over. But we dare not stop trying until it is no longer possible to try. The immediate effort must focus on Plan A – global economic recovery as the foundation for the surviving and future thriving of the globalization project. This is the only foundation for the emergence of a stable, peaceful and prosperous global order. Policy decisions and implementation, even more than marketplace dynamics, will determine what policy makers, businessmen and investors face in 2009 and beyond. So (1) getting the context right – which is the moment in history; (2) getting the diagnosis right, which are the global imbalances; their monetary accommodation; and the lack of financial system guardianship and oversight throughout every level; and (3) setting out the fundamental policy steps now required, can together provide a road map on the policy actions now needed and for assessing alternative outcomes, depending on what actions are or are not taken. This means the key countries (above all the U.S. and China) must take seriously whether the U.S. needs help to recover. Their answer will heavily influence economic and market outcomes.
Policy drives outcomes
Policy going ahead is the domain of Richard Koo, Martin Wolf and David Dodge. But I have two broad thoughts:
- first, policy will drive market outcomes for a long time to come; and
- second, while markets are unlikely to be proactive forces for some time, market responses will affect how aggressive the disease becomes and thus how aggressive the cure need be.
Unfortunately, since the credit system crisis began in July 2007, the lack of timely aggressive responses has aggravated the disease. In addition, the two central U.S. bubbles – credit and housing – ensured big time challenges no matter how well and timely the policy responses might have been.
Three fundamentals for policy
No set of policies will succeed if they do not take three things into account:
- No matter what countries think about the U.S. role in its own troubles, there is no economy that can take its place if it remains unhealthy for any extended period.
- The U.S. is in a multiple level balance sheet recession that encompasses:
- the country itself;
- the U.S. federal government;
- its financial institutions; and
- its consumer sector.
- It is mad to expect that the United States political, economic and financial system can sustain a global approach to recovery that requires the U.S. to move to further weaken its country and federal government balance sheets, except as a transition toward balanced growth that no longer needs further U.S. balance sheet deterioration to sustain it.
Do not bet against the United States
Fifteen years ago I told a Tokyo business audience it was almost impossible to overestimate the lack of collective foresight by Americans but that once they got it, you could not overstate what they can bring to bear. I believe that still applies. The United States learned one crucial lesson after coming to Europe’s rescue from its self-inflicted wounds – that it could be in their vital interest to help other countries recover. Other countries now need to learn that lesson. If they do not the U.S. may then unlearn the lesson it learned from two world wars.
Policy not a simple process
We will need to recognize through all this that choosing and implementing the right policy is not quite as simple as the single word policy may suggest. Indeed, policy process may sometimes be a more useful concept than policy. I see seven main elements in what will be an essentially ongoing dynamic policy process. Whether one is a policymaker or a private sector player, one needs to have a view on how each one of these elements is going in order to assess how policy overall is going and the likely credit flows; consumer demand; and asset prices marketplace responses.
- First, recognition that one is seriously sick. This is pretty well recognized everywhere but it has taken precious months to get virtually everyone there.
- Second, the right diagnosis of the disease. We have come a long way, but we still have a way to go to achieve a full understanding of the nature and implications of the U.S. balance sheet recession; of the unresolved imbalances; and of how hard it is to exit a balance sheet recession. Indeed, the only sure and reasonably quick exit will be if those who are not in a balance sheet recession, but are suffering from the U.S. one, are the primary countries to stimulate and incur the necessary debt to do so. By contrast, the understanding of the credit system insolvency and the shrunk credit capacity from the collapse of the shadow banking system seems fairly well along but the cure is affected by public revulsion and sticker shock.
- Third, looking into the abyss. Some fifty years ago, shortly after he won his Nobel Prize for the Suez ceasefire, Mike Pearson told me something which I believe is of central relevance today. He said that when a country desperately does not want to do what it must do, there is only one thing you can do: walk them slowly to the edge of the abyss, stand patiently with them as they look in, and gradually they will realize that much as they desperately do not want to do what they must do, it is better than what they see in store for themselves if they do not do it. There were some post-Lehman Brothers abyss moments for the Administration, Congress, the American people and even the G-7. We almost certainly have new abyss moments ahead.
- Fourth, political will. Political will in all countries, and most especially in the U.S. and China, depend on an abyss they have yet to look into. We cannot say when the next abyss moment will come, but it will come, and the response of the key countries will be fateful for our world. Looking into the abyss is not always enough. Too often in human affairs, one chooses to live through the abyss. Europe deserves special attention. It was twice rescued from itself by the United States and given forty-five years Cold War protection. Right now, it seems not to see it is time to give something back and that it could be a very big mistake for itself, not just the U.S. and the world, not to do so. Germany seems central and unready.
- Fifth, policy choice. Policy choice depends on understanding the context and getting the diagnosis right. So far, we can say nobody seems to grasp the moment in history, high stakes, context within which the global financial system and economic crisis are occurring. As for getting the diagnosis right, no one seems fully there yet. But even when one gets there, is the policy on offer well-targeted enough; big enough; soon enough; for long enough; clear enough; and well enough and promptly enough implemented? So far, U.S. policy is seen by most as probably falling short on each of these tests. But most of the rest of the world falls even further short.
- Sixth, market response. At every stage of policy implementation, from announcement to on-the-ground impact, there will be market response feedback that will be positive or negative: on the jobs front; consumer demand; credit flows; and asset prices. So far there has been some positive response to policy, but it is not yet apparent how strong traction these policies will prove to have. If the market comes to disbelieve that there is strong enough traction to do the job, we will almost certainly have another Lehman Brothers-style abyss on our hands on a global economic scale.
- Seventh, new shocks. The world will not stand still as policy is administered, and there will be new shocks. We will know we are beginning to get out of the woods when the effects of those shocks clearly become more moderate.
Three front policy war
Policy is thus needed now on three fronts; stronger demand in the real economy; much improved credit flows; and getting on the path to righting the imbalances. There is a natural tendency to say one front is more important than the other. At any one moment, there may be more urgency in one than the other. But all are urgent. And progress on every one is necessary for progress on the others. And delay on any further delays recovery, raises the risks and increases the costs.
China’s help will transform the world
The fact the United States needs help on all three fronts does not mean it is in decline. It means that the success of globalization has produced a new global economy math and that the dysfunctional two-model form of that globalization will be replaced. There will be no happy countries if the U.S. recovery falters. But if it succeeds, it will mean that China has helped make that happen. This would be a transformational moment for the world that would likely set the stage for an outcome closer to post-1945 that post-1914, and without the deep divisions of that period. It will be an even better outcome if all the current account surplus countries understand and act on the need for collective action.
What is needed
What will not be needed is for every country to sign onto the same way of running their domestic affairs. What will be needed is for every major country to understand that they cannot adopt a domestic macro policy model that is unbalanced and thus destabilizing of the global economic order. But equally, different domestic micro models will need to be accommodated within a broadly free trade order. There will be no single way of doing things on the economic front any time soon, if ever. If the U.S. recession persists or worsens, there will be no single plan B to go to. Each country will then be forced into decisions that will likely mean a world of blocs and rising protectionism – the very conditions of the Great Depression.
A very large warning sign
There was a very large warning sign last week in the United States on what can happen if the rest of the world does not get it on the U.S. need for help to recover and thereby help the global economy to recover. The existential level of anxiety among the American public about the future fastened last week on the AIG bonuses. It resulted in an American populist outrage and a Congressional response that will do more harm than good. But both the outrage and the response can be useful as a warning that everyone is going to have to change and get into the boat with everyone else to ensure a stronger and earlier recovery than now looks likely.
If I were to sum up where we are today, it would be this. We are in a blend of an economic summer equivalent of the fateful Battle of Britain summer of 1940 and of the phony war that preceded it. We must now fight a fateful economic war from the greatly weakened position which the long appeasement of the imbalances brought. It will be a long and costly struggle. It will take longer than one would wish to mobilize the resources at the command of the Western world and emerging Asia. But as in 1940, there is no doubt they can be mobilized and win out. To do so will require the political will and wisdom to make hard choices that are more than rhetoric. There will be more casualties. And the world that emerges will be as much different from the pre-July 2007 world as the post-1945 world was from the pre-World War Two world. My answer to the Conference question is that the U.S. will need help to recover; that only a sustainable U.S. recovery can provide the foundation we need for global economic growth and the shaping of a more hopeful global order; and that this historic struggle can only be won through collective action in which two countries, China and the United States, and two men, the President of the United States and the Premier of China, play their necessary leadership roles.