Ten years ago, there was a strange competition in the United States to see who could be more arrogant. Neo-conservatives 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. But equally smug were the neo-liberal economists — liberal in the sense of Adam Smith — who argued that the rest of the world should hurry up and embrace the “Washington Consensus,” or prepare to be sold short. One lot derided the political failure of the Muslim world; the other lot heaped scorn on Asian “crony capitalism,” supposedly the root cause of the 1997–98 Asian financial crisis.
The neo-cons got their comeuppance in Iraq, where American forces were not, after all, greeted as liberators with “sweets and flowers.” The neo-libs got theirs in September, as a Republican Treasury, headed by former Goldman Sachs CEO Henry Paulson, nationalized first the country’s biggest mortgage lenders and then its biggest insurance company. Wall Street’s illustrious investment banks have been bankrupted, swallowed up or transformed into regular banks in the space of less than a year. So close did the U.S. financial system come to complete meltdown in September that Paulson was driven to request emergency powers worthy of wartime: carte blanche to spend around $700 billion on the mother of all bailouts.
The stage seems to be set for the demise of what has been called “market fundamentalism.” But is the same true of the global balance of power? Does Wall Street’s meltdown presage the end of the American century?
The most important thing to understand about the world economy over the last decade has been the relationship between China and America. If you think of it as one economy called “Chimerica,” that relationship accounts for around 13% of the world’s land surface, a quarter of its population, about a third of its gross domestic product, and somewhere over half of economic growth between 2002 and 2007.
For a time, it seemed a marriage made in heaven. One half saved and the other half spent. Comparing net national savings as a proportion of gross national income, American savings declined from above 5% in the mid-1990s to virtually zero by 2005, while Chinese savings surged from below 30% to nearly 45%. This divergence in saving allowed a tremendous explosion of debt in the U.S., because one effect of the Asian “savings glut” was to make it cheaper for American households to borrow money.
How did this operate? The crucial mechanism that bound the halves of Chimerica together was currency intervention. To keep the renminbi (and hence Chinese exports) competitive, the authorities in Beijing consistently intervened to halt its appreciation against the U.S. dollar. The result was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China, which became one of the world’s 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 America’s borrowing habit this way, interest rates in the U.S. would have been substantially higher. Hence the borrowing boom.
To a lesser degree, this pattern repeated around the globe. Across the English-speaking world, household indebtedness increased and conventional forms of saving were abandoned in favour of leveraged plays on real estate markets. Meanwhile, other Asian economies also adopted currency pegs and accumulated international reserves, thereby financing western current account deficits. Middle Eastern and other energy exporters found themselves running surpluses and recycling petrodollars to the Anglosphere and its satellites. But Chimerica was the real engine of the world economy.
Then a wave of defaults in the U.S. sub-prime mortgage market revealed just how unstable Chimerica was. In essence, the rest of the world’s savings helped inflate a U.S. real estate bubble. Easy money was accompanied by lax lending standards and downright fraud. Euphoria eventually gave way to panic. It began in the sub-prime market because that’s where defaults were most likely. But it soon became clear the entire U.S. property market would be affected. For the first time since the Depression, house prices declined at annual rates above 10%. According to Credit Suisse, 6.5 million loans could ultimately fall into foreclosure. That could throw as many as 13% of U.S. homeowners with mortgages out of their homes.
What made the collapse so lethal was that an inverted pyramid of novel financial assets had been erected upon the flimsy base of mortgages. Banks had bundled together loans, sliced and diced them and resold them to investors around the world as “collateralized debt obligations” and the like. Ratings agencies pronounced the top tier of these instruments AAA: the quintessence of financial alchemy. When the supposed gold turned back into lead and then into toxic waste, the consequences were devastating.
This crisis has exposed weaker banks — particularly investment banks, which could not fall back on the cushion of savers’ federally insured deposits — to savage and self-perpetuating share price declines. (As the underlying equity declines in value, the degree of leverage rises, and illiquidity soon morphs into insolvency, killing bondholders as well as shareholders.) The contraction of bank balance sheets condemned the rest of the U.S. economy to a recession. Main Street is only now beginning to feel the pain.
What are the geopolitical implications of all this? One possibility is that the “great reconvergence” between East and West will speed up. The U.S. will grow more slowly for the foreseeable future: closer to 1–2% per annum, rather than the 3–4% we have grown used to. By contrast, China’s semi-planned economy can comfortably maintain growth of 8% a year, propelled by state-led investment in infrastructure and growing consumer demand. China may overtake the U.S. as the world’s largest economy far earlier than previously anticipated.
A second possible implication is that the U.S. dollar’s status as the dominant international reserve currency may end. Once upon a time, the British pound was the world’s No. 1 currency, the unit of account in which most financial transactions were done. It died a slow, long, lingering death, sliding from US$4.86 in 1930 to very nearly parity with the dollar at the nadir in the early 1980s. The principal cause was the huge debt Britain ran up to fight the world wars. The second reason was lower growth: Britain’s economy was the underperformer of the developed world in the postwar decades, right down to the early 1980s.
If, as seems inevitable, the U.S. government faces huge expansion in its liabilities — already substantially increased by the nationalization of Fannie Mae, Freddie Mac and AIG — the U.S. dollar would face the same cocktail that dethroned the British pound. 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 currency’s peg to the U.S. dollar — the end of Chimerica would have arrived. That would cause the balance of global power to shift. No longer so committed to the Sino-American friendship, China would be free to explore other spheres of influence, from the Shanghai Cooperation Organisation to its own nascent empire in commodity-rich Africa, not to mention the newly influential G20, which seems set to displace the G8.
Yet commentators should hesitate before they prophesy America’s decline and fall. It has come through 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 in the 1980s.
Part of the reason is that the U.S. has long offered the world’s most benign environment for technological innovation and entrepreneurship. The Depression saw a 30% contraction in economic output and 30% unemployment. But throughout the 1930s, U.S. companies continued to pioneer new ways of making and doing things: think of DuPont (nylon), Procter & Gamble (soap powder), RCA (radio) and IBM (accounting machines). In the same way, the double-digit inflation of the 1970s didn’t deter Bill Gates from founding Microsoft in 1975, or Steve Jobs from founding Apple a year later.
Moreover, the American political system has repeatedly proved itself capable of producing leadership in a crisis. Both Franklin Roosevelt and Ronald Reagan came to power focused on solving America’s economic problems. But by the end of their presidencies they dominated the world stage, FDR as the architect of victory in the Second World War, Reagan performing the same role in the Cold War.
And consider this: even the worst financial crises that have plagued America, bad as they seem at home, seem to have worse effects on America’s rivals. Think of the 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 world’s worst war; the U.S. ended up winning it.
Something similar may be happening today. At press time, the U.S. stock market was down about 39% during 2008. The equivalent figure for China is 49% and for Russia — the worst affected of the world’s emerging markets — 72%. These figures are scarcely good advertisements for the more regulated, stateled economic models favoured in Beijing and Moscow.
In any case, are these rival empires credible alternatives? China is bedeviled by three serious ailments: demographic imbalance, environmental degradation and political corruption. It is far from clear that China’s manufacturers are ready to decouple from the U.S. market, any more than the People’s Bank of China is able to kick its habit of accumulating dollar reserves. Nor, for that matter, is China’s military remotely ready to mount a serious challenge to U.S. dominance of the Pacific. Economically and 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 Vladimir Putin as the CEO-cum-Duce. Putin’s 1930s-style invasion of Georgia was a fresh reminder that political risk remains substantial in eastern Europe.
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 solo is about to take over from Chimerica. Nemesis, too, can be exported.
Niall Ferguson is a historian and professor at Harvard University. His new book, The Ascent of Money: A Financial History of the World, was published in Novemember 2008.