Apocalypse Not Yet James K. Galbraith
With the euro touching $1.33 and the pound so high I couldn't bear to look at the rate, my thoughts on a flight home from across the pond turned painfully to the decay of the once-almighty dollar, and to the cries of fear emanating these days from Wall Street.
How We Got Here
The current jitters are no surprise; the few Keynesians left in the economics profession have long thought them overdue. Here are the most important reasons why this is so:
We have, over many years, worn down our trade position in the world economy, from overpowering supremacy 60 years ago, to the point where high employment in the United States generates current account deficits well over half a trillion dollars per year. We have become dependent for our living standard on the willingness of the rest of the world to accept dollar assets-stocks, bonds and cash-in return for real goods and services, the product of hard labor by people much poorer than ourselves in return for chits that require no effort to produce.
For decades, the Western World tolerated the "exorbitant privilege" of a dollar-reserve economy because the United States was the indispensable power, providing reliable security against communism and insurrection without intolerable violence or oppression, thus conditions under which many countries on this side of the Iron Curtain grew and prospered. Those rationales evaporated 15 years ago, and the "Global War on Terror" is not a persuasive replacement. Thus, what was once a grudging bargain with the world's stabilizing hegemon country is now widely seen as a lingering subsidy for a predator state.
In the late 1990s, the United States position was held up by the glamour of the information-technology boom, which brought capital flooding in from more precarious perches in Russia, Asia and other parts of the world. Then, as so often on other occasions in history, America was the wave of the future. But that too has turned to dust and ashes. While major gains from new technology were achieved, few now think that silicon chips are the solution to the world's economic problems, and Silicon Valley has receded to an investment backwater.
Since 1979, China, migrating slowly from the other side of the Iron Curtain, has become one of our largest trading partners, while the relative position of other Third World countries (more wedded to the free market and less effectively managed) has eroded. The concentration of our manufactures trade on China and Japan now means that those two countries now hold preposterous dollar reserves, and their actions substantially determine the dollar's value. However, the actions or potential actions of other players, including Russia, India and the European Central Bank, can also have important effects.
China and Japan are constrained in their behavior by creditor's risk. If they sell dollars aggressively, the value of the remainder of their portfolio plummets and they inflict large losses on themselves. This consideration prompts caution. But everything depends on what everyone else does. The rising unpredictability of U.S. policy-including foreign policy-doesn't help. If one major player gets wind that others may dump, then the urge to join in becomes hard to resist. This is exactly analogous to an old-fashioned stock panic or run on the bank.
Situation Unpredictable, If Not Perverse
The current account is strongly linked in a triangular relationship to the budget deficit and also, critically, to the savings-investment balance of American households, as readers of the invaluable strategic papers by Wynne Godley (see www.levy.org ) will know. In the present environment, with households on average near financial balance, the current account and the budget deficits are nearly equal. But this does not mean-as leading Democrats appear to believe-that reducing the budget deficit will save the dollar. A bank, hit by a panic, cannot save itself by cutting its advertising budget, raising its fees or firing its staff.
And once a rush gets going, jacking up interest rates won't stop it either. Small interest rate hikes do normally affect exchange rates, but only when no player has the kind of extreme market weight now enjoyed by China and Japan. When they do, reactions are unpredictable if not perverse. The Fed's moves earlier this year could well have been aimed, mainly, at deterring the Japanese and Chinese from dumping. Think of them as a petty bribe-a percent or so on a few trillion dollars. Or you might call it a reaction to blackmail, deemed expedient in view of the election. But the election is now past, and that game is up.
Now we hear rumors of Russia trading dollars for euro, of India diversifying its reserves, of China contemplating the same. The reaction on Wall Street has been a trifle unnerved. In comments relayed furiously across the Internet, Morgan Stanley economist Steven Roach apparently told clients to gird for an "economic Armageddon." The dike, once solid, starts to crack; none can say just where or when it will break. But the little Dutch boy, Alan Greenspan, went to Frankfurt a few days back and plainly stated that he did not have enough fingers.
Who Wins? Bush's Base
The most stunning aspect of these events has been the insouciance of the Bush administration. Neither the president, nor Secretary of the Treasury John Snow, nor anyone else has troubled even to emit the usual platitudes about the greenback-not, at least with the slightest conviction. It's almost as if they've figured it out. It's almost as if they realize the awful truth. Which is that the dollar's decline is mainly good for their friends, and bad mainly for those about whom they couldn't care less.
Yet that is the truth. The dollar's decline immediately boosts the stock market, for a simple reason. Multinationals have earnings in the United States and in Europe. When the dollar falls, U.S. earnings stay the same but the European earnings go up when measured in dollars. Oil prices in dollars will stay up-at least enough to prevent the price in euro from falling. This too helps U.S. oil company profits, measured in dollars. Meanwhile, China will keep its renminbi tied to the dollar, and prices of Chinese imports won't rise much, so Wal-Mart isn't badly hurt. The American consumer will get hit, but mainly on the oil price rather than on the rest of the consumption basket. Many will grumble, but few will recognize the political roots of their problem.
Since the U.S. owes its debts in dollars, the financial blow will fall first on China and Japan, in the form of a depreciation of their holdings. Tough luck. Latin American debtor countries will get hit on their exports, but helped on their debt service. Those (like Mexico) who export almost exclusively to the U.S. will get squeezed; others (like Argentina) who market to Europe but pay interest in dollars will be hurt less. An unequivocal loser is Europe, which has been hoping for an export-led fix to their own, largely self-inflicted, mass unemployment. The Europeans can forget about that.
If Bush's insouciance works, the dollar could decline smoothly for a while and then, simply, stop declining. U.S. exports might recover somewhat, helping manufacturing, though there's no chance exports and imports will balance. But even so, the dollar system could stay intact, so long as China and Japan remain willing to add new dollars to their depreciated hoard. Given that their interests lie in maintaining export activity and the jobs it creates, they may very well make that choice. Large-scale dollar purchases by the European Central Bank are also a remote possibility (the option has been mentioned on the periphery of the ECB). The problems would return later on, but meanwhile, such an action would prove that God really does look after children, small dogs and the United States.
Apocalypse Considered
What could up-end the apple cart? An unstoppable panic is probably not yet the largest risk. There are simply too many dollars in the theater of the world economy, too few exits and only a few elephantine players. The latter would soon be discouraged from selling by the soaring price of the available alternative assets, and the run would fizzle out. Thus the final dollar crisis will probably wait until a political crisis-say, someday with China-sets it off.
Some fear rising long-term interest rates-and a recession-simply on account of the sliding dollar and price inflation. But this also won't necessarily happen. For an inflation premium to be built into the long-term interest rate, there needs to be higher expected inflation on a continuing basis. Notwithstanding the cheap psychology of "rational expectations," beloved of economists, actual inflation can rise for a long time before expectations do. And the inflation adjustment, coming (let us say) primarily through a rising dollar oil price, could come and go rather quickly. It need not get built into a spiral of wages and prices. So far, despite the substantial dollar decline that has already occurred, long-term interest rates have hardly budged. They have generally risen no more, and in some cases less, than the short-term rates Greenspan started pushing up last spring.
A change in European policy-toward a high-growth, full employment Keynesianism-could bring a decisive shift in the world balance of economic power. Such a shift would create profits in Europe (where there presently are few), attracting capital. It would open up a European current account deficit, where there is presently a surplus. Soon the euro would not be a scarce currency any longer, and the reduction of the dollar's reserve status could truly get underway. Unfortunately for Europeans, European policymakers don't see-and won't seize-this opportunity. Frankly, they are too reactionary and too stupid. That's a tragedy for Europe, though in some ways it's undeserved good luck for the United States.
And the fourth possibility is that Alan Greenspan could change his mind, raise interest rates and inflict on us all a monumental "defense of the dollar." Morgan's Roach worries about this with some good reason; I've worried about it too. While sharply rising interest rates could cure both inflation and the weak dollar-as they did in the early 1980s-the resulting slump would be even more disastrous than it was then, because debt levels are higher now than they were. Just as the slump then destroyed Latin America and Africa, a new one could bring China, Japan, India and others into worldwide recession. There would be no easy way out.
A Strange New World
Such folly is possible, but now I don't expect it. I rather think Greenspan will take a pass on all the past decades of Federal Reserve myth-making. That means that he will actually sit on his hands while oil and some other import prices drive upward. Given the alternatives, it's probably the right course of action. But let no one say, afterward and with a straight face, that our Central Bank takes all that seriously the bunkum it spreads, about fighting inflation.
For this reason, we're more likely to enter a strange new world, where Republicans in office behave like 1970s Democrats on meth. In a stagflation economy, budget deficits are inevitable and there is no strategy that will end them. It's obvious that adding large near-term tax increases to the mix would merely slow growth further, while there isn't enough federal public non-defense spending left to cut. So the Republicans will make excuses, and let the deficits run on, and incur the scolding of the IMF and the OECD. If we're lucky. It's far from the worst thing the Republicans could do.
Sadly, the Democrats will respond as badly as possible, like 1930s Republicans on downers. In a touching devotion to dogma, they will call for fiscal discipline to close the budget deficit. This will undermine the case for relief to working families, for aid to state and local government, and the defense of Social Security benefits that they might otherwise make. Our jobless compatriots won't find this endearing. Faced with higher inflation, Democrats may demand to know why Greenspan has done nothing. Households struggling to manage their debts will not be greatly amused. Then Democrats will say that things were better under Clinton. That's thin gruel; in the 1930s you could have said the same of Coolidge.
What Should Be Done?
The reality is that budget deficits cannot be controlled until the trade problem is fixed. So what should be done? It's a long-term project, but it's not difficult to assemble the start of a real program. Oil companies are likely to earn high profits in the turbulence ahead. Let's tax them (and other windfalls), perhaps with a variable import fee. Let's plough the proceeds back to state and local governments, so they can maintain services and vital investments. Let's cut payroll taxes for now, to help working people cope. And let's start our next technology boom, focused on new energy and reduction in per-unit GDP consumption of oil. These would be useful beginnings on the home front.
The big action, however, must come on the international side. My supply-side friends pine for the gold standard, and they make a serious point. The experiment of worldwide floating exchange rates, inaugurated by global monetarists in 1971, has failed disastrously. The world was better off when we had fixed exchange rates. Indeed, in the most successful arena of global trade and finance we have fixed exchange rates right now, thanks to the unappreciated but sensible dollar-pegging of the Chinese. Fixing exchange rates in Europe (through the extreme measure of creating a single currency) also proved a boon for the poorer countries of Europe, eliminating speculative currency risk. Even though, overall, European policy remains terrible, unemployment has dropped sharply in Spain and Greece since the euro came in.
Global fixed exchange rates would help developing countries, by sharply curtailing the destabilizing role of private currency markets. They would therefore also help us, by creating stronger and more stable markets for our exports. But there is no simple return to global fixed exchange rates. It would be a terrible mistake to create a system that imposed deflationary pressure on us and through us on the world as a whole-the problem of the classical gold standard. To get where we need to go, we must also recreate a global financial network oriented toward the support of development and growth. When we have that, growth policies around the world will help rather than hurt each other. At that point, we could profitably put real effort into reintroducing full employment economics to Europe and Japan.
For such a policy to succeed, America must also change. Specifically, we must turn away from our present over-reliance on armed forces and private bankers, far away from the fantasy of self-serving dominance for which, the markets are clearly telling us, the world will not agree to pay. We need instead an industrial strategy based on technological leadership, collective security, and smart use of the world's resources. The financial counterpart must be a new source of liquidity for many developing countries, permitting them to step up their imports, and correspondingly our exports and employment. This will probably require a new network of regional regulatory agents, empowered to enforce capital control and to take responsibility for successful development strategies among their members.
No Viable Alternative
The point is not that any of this would be easy. Nor can it be done in the lifetime of this administration or of the political dominance that Bush now seeks to achieve. The point is, rather, that there is no viable alternative, so far as I know. Absent a fully articulated strategy, the attempt to pretend otherwise with a few slogans is an economic and also a political dead end.
Two steps are thus required. The first is thought, and the second, when the opportunity arises, will be action. The scope of action cannot be small, for the problem now exceeds six hundred billion dollars every year. But only by dealing with it, over time, can we hope to regain full employment without witnessing, sooner or later, the final run on the dollar.