Left Flank

John B. Judis' «Debt Man Walking» is one reason I keep subscribing to TNR. If you don't subscribe, you might want to read Judis' article on the newsstand. Even deeper than the current credit crisis which has spread to world currencies, Judis identifies a breakdown in the entire Bretton Woods II system.

Bretton Woods II took shape during Ronald Reagan's first term. To combat inflation, Paul Volcker, the chairman of the Federal Reserve, jacked interest rates above 20 percent. That precipitated a steep recession--unemployment exceeded 10 percent in the fall of 1982--and large budget deficits as government expenditures grew faster than tax revenues. The value of the dollar also rose as other countries took advantage of high U.S. interest rates. That jeopardized U.S. exports, and the U.S. trade deficit grew even larger, as Americans began importing underpriced goods from abroad while foreigners shied away from newly expensive U.S. products. The Reagan administration faced a no- win situation: Try reducing the trade deficit by reducing the budget deficit, and you'd stifle growth; but try stimulating the economy by increasing the deficit, and you'd have to keep interest rates high in order to sell an adequate amount of Treasury debt, which would also stifle growth. At that point, Japan, along with Saudi Arabia and other opec nations, came to the rescue.

At the end of World War II, Japan had adopted a strategy of economic growth that sacrificed domestic consumption in order to accumulate surpluses that it could invest in export industries--initially labor-intensive industries like textiles, but later capital-intensive industries like automobiles and steel. This export-led approach was helped in the 1960s by an undervalued yen, but, after the collapse of Bretton Woods, Japan was threatened by a cheaper dollar. To keep exports high, Japan intentionally held down the yen's value by carefully controlling the disposition of the dollars it reaped from its trade surplus with the United States. Instead of using these to purchase goods or to invest in the Japanese economy or to exchange for yen, it began to recycle them back to the United States by purchasing companies, real estate, and, above all, Treasury debt.

That investment in Treasury bills, bonds, and notes--coupled with similar purchases by the Saudis and other oil producers, who needed to park their petrodollars somewhere--freed the United States from its economic quandary. With Japan's purchases, the United States would not have to keep interest rates high in order to attract buyers to Treasury securities, and it wouldn't have to raise taxes in order to reduce the deficit. As far as historians know, Japanese and American leaders never explicitly agreed that Tokyo would finance the U.S. deficit or that Washington would allow Japan to maintain an undervalued yen and a large trade surplus. But the informal bargain--described brilliantly in R. Taggart Murphy's The Weight of the Yen--became the cornerstone of a new international economic arrangement.

Over the last 20 years, the basic structure of Bretton Woods II has endured, but new players have entered the game. As Financial Times columnist Martin Wolf recounts in his new book, Fixing Global Finance, Asian countries, led by China, adopted a version of Japan's strategy for export-led growth in the mid-'90s after the financial crises that wracked the continent. They maintained trade surpluses with the United States; and, instead of exchanging their dollars for their own currencies or investing them internally, they, like the Japanese, recycled them into T-bills and other dollar-denominated assets. This kept the value of their currencies low in relation to the dollar and perpetuated the trade surplus by which they acquired the dollars in the first place. By June 2008, China held more than $500 billion in U.S. Treasury debt, second only to Japan. East Asia's central banks had become the post-Bretton Woods equivalent of Fort Knox.

Judis identifies drawbacks to this arrangement.
there have been downsides to Bretton Woods II. Often noted was how the accumulation of dollars in foreign hands--particularly those of a potential adversary like China--threatens America's freedom of action. A hostile nation could blackmail the United States by threatening to cash in its dollars. Of course, if a nation like China actually began to unload its dollars, it would jeopardize its own financial standing as much as it would jeopardize America's. But economists Brad Setser and Nouriel Roubini argue that even the implicit threat of dumping dollars--or of ceasing to purchase them--could limit U.S. maneuverability abroad. «The ability to send a 'sell' order that roils markets may not give China a veto over U.S. foreign policy, but it surely does increase the cost of any U.S. policy that China opposes,» they write.

To date, however, that strategic impact has been chiefly theoretical. The more tangible drawbacks of

Bretton Woods II have been social and economic. Bretton Woods II has perpetuated the U.S. trade deficit, particularly in manufactured goods. Forced to compete against foreign products kept cheap not only by low wages abroad but by the dollar's high value, U.S. manufacturers have had little incentive to expand or even retain their operations in the United States. Since the early '80s, the United States has lost about five million manufacturing jobs. True, the United States has gained some highly skilled manufacturing jobs, but most of the lost jobs have been replaced by low- wage service sector employment. This has been a factor in creating a U.S. workforce with an overpaid financial sector at one extreme and a sprawling low- wage service sector at the other.

In Japan, China, and other Asian countries, there has been a similar downside to the grand bargain. The surplus dollars gained from trade with the United States have not been used to raise the standard of living, but rather have been squirreled away in Treasury securities--«sterilized» is the technical term. Writes Wolf, «China has about 800 million poor people, yet the country now consumes less than half of GDP and exports capital to the rest of the world. » In an odd way, the contrast between the concentration of new wealth in China's coastal cities and the grating poverty of its countryside has mirrored the contrast between the lavish lifestyle of the Wall Street wizard and the plight of immigrant and illegal-immigrant workers in America's barrios.

Of more immediate concern, Bretton Woods II contributed to the current financial crisis by facilitating the low interest rates that fueled the housing bubble. Here's how it happened: In 2001, the United States suffered a mild recession largely as a result of overcapacity in the telecom and computer industries. The recession would have been much more severe, but, because foreigners were willing to buy Treasury debt, the Bush administration was able to cut taxes and increase spending even as the Federal Reserve lowered interest rates to 1 percent. The economy barely recovered over the next four years. Businesses, still worried about overcapacity, remained reluctant to invest. Instead, they paid down debt, purchased their own stock, and held cash. Banks and other financial institutions, wary of the stock market since the dot-com bubble burst, invested in mortgage-backed securities and other derivatives.

The anemic economic recovery was driven by growth in consumer spending. Real wages actually fell, but consumers increasingly went into debt, spending more than they earned. Encouraged by low interest rates--along with the new subprime deals--consumers bought houses, driving up their prices. The «wealth effect» created by these housing purchases further sustained consumer demand and led to a housing bubble. When housing prices began to fall, the bubble burst, and consumer demand and corporate investment ground to a halt. The financial panic quickly spread not only from mortgage-backed securities to other kinds of derivatives but also from the United States to other countries, chiefly in Europe, that had purchased these American financial products.

And that's not all. As American demand for Chinese exports has stopped growing, China's economy has begun to suffer. Roubini has argued that, if China's export-dependent growth drops from 12 percent to 5 or 6 percent per year, China will be unable to provide jobs to the 24 million new workers that join the labor force each year. China would experience the equivalent of a recession, with repercussions throughout Asia. More importantly for the United States, China would no longer have the surplus dollars to prop up the market for U.S. Treasury bills. The Obama administration could, of course, reduce its dependence on China by reducing the budget deficit, but doing that now would deepen the recession, as well as preventing the new president from pursuing many of his domestic initiatives.

The consequences could be even more dire. In the past, countries in recession could count on countries with growing economies to provide outlets for their exports and investments. The hope this time is that economic growth in Asia and particularly China can backstop a U.S. and European recession. But, as a result of Bretton Woods II, prosperity in the United States is intertwined with prosperity in Asia. China depends on exports to the United States, and the United States depends on capital from China. If that special economic relationship breaks down, as it seems to be doing, it could lead to a global recession that could morph into the first depression since the 1930s.

The solution?

Some of the policies that Obama championed during the presidential campaign can help move us to a new system--as long as they are not seen merely as temporary palliatives to get the United States out of a recession. These steps include public investments that would make U.S. industries more competitive; subsidies under strict conditions to U.S. automobile manufacturers; and the encouragement of new «green» industries. (By contrast, Obama's principal proposal--a tax cut for the middle class--would not necessarily improve America's economic standing.)

But China, Japan, and other Asian countries--either on their own or with prodding from the new administration--will also have to play a part. Indeed, China may have already begun to do so by announcing a $586 billion stimulus plan of public investment in housing, transportation, and infrastructure. If China plows its trade surplus back into its domestic economy, it will increase demand for imports and put upward pressure on the yuan, reducing China's trade surplus with the West.

Not only is the US making history with its first mixed-race president, but the world is moving from one economic era into another.

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Fundamentally, I'm skeptical about what the US Congress, Hank Paulson, and Ben Bernanke think they're doing (actually, for the same public choice reasons Will Wilkinson offers in his diavlog) with the compromise legislation awaiting floor votes in both chambers. I also resent the Bush administration's apocalyptic pronouncements as a tired reprise of post-September 11 doom and gloom. I continue to look for any expert who can reasonably explain the fiasco and give me a decent recommendation.

Cue Arnold Kling as he «blasts the Paulson plan as essentially corrupt». This just one small segment of a longer primer on this road to financial perdition. The advantage of Kling's plan is, that the government will have pennies to spare on relief, and not on pumping up stock prices. I'm also trying to avoid that huddling predisposition victims get when the tiger approaches, when a minute before each person knew the bad guy was luring the beast to them. I don't want just to trust Congress because I'm momentarily scared I have no other choice.

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About Republican presidential candidate, and former fighter jock, John McCain's decision not to campaign while Wall Street suffers, here's a shorter version of the longer version I think John McCain should not be president.

I, for one, think Congress has been handling this pretty well so far. The Bush Administration came to them with an obviously flawed package. They responded with appropriate skepticism and are busy coming up with what look like sensible alternatives.

Implicit in McCain's appeal is that the presidential campaign was politicizing this issue, in ways that have made crafting a response more difficult. It's not clear to me that's actually been happening--or that politicizing the issue is such a bad thing. Coming up with the right response requires making choices about political values. Is it important to help homeowners? Is it ok for the government to own part of the investment business?

What does seem apparent, though, is that putting the two candidates in the negotiating room is far more likely to distract--and derail--negotiations than having them out on the hustings. Besides, it's not as if McCain has any great expertise he can bring to this subject. Or does he plan to bring Senator Phil Gramm, Mr. Deregulator himself, along?

One other concern: McCain just made it clear he expects a negotiated solution by Monday. In other words, he's just set a deadline. But, like many commentators and experts, I'm increasingly convinced that haste is bad idea here. If it takes a few extra days--or even a few extra weeks--to craft legislation, that might not be such a bad idea, as long as Congress makes clear that it will, eventually, do something.

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Roger Lowenstein explains why Ben Bernanke and Henry Paulson are saving America from The Wrong Emergency

In 1932, at the height of the Great Depression, the government created the Reconstruction Finance Corp. to make loans to banks, railroads and others. President Hoover asked for $2 billion--equivalent in today's money to $30 billion--and spent just under that amount in the RFC's first year. The country then was in the midst of an economic catastrophe. Economic output had dropped 45 percent. Production of steel and autos were each down by three-quarters. Unemployment was 24 percent, and so on.

The allocation sought by Paulson is 23 times bigger. And it is in addition to the tens of billions pledged to back loans to Bear Stearns, Fannie, Freddie and A.I.G.

America's economy does not face an emergency--only its financial system does. This is a distinction lost on the bankers in Washington, but it is one worth remembering. On Main Street, unemployment is 6.1 percent. Home prices are down close to 20 percent and presumably headed lower. These numbers are not pretty, but they do not add up to an economic Pearl Harbor or even close.

Of course, potentially several million Americans face home foreclosure. That is a crisis, but it is a slow-developing one, for which the normal legislative process--as distinct from a shotgun corralling of Congress--will suffice. And the Paulson plan does not help homeowners.

The only emergency is on Wall Street, and that is entirely of Wall Street's making. It was the banks that made the loans, the banks that bought the paper, the banks that dumbly believed the models that said that housing prices wouldn't collapse. The pinstriped bankers who leveraged their institutions' capital thirty-to-one so as to inflate their profits (and their personal take) now complain they were done in by those nasty short-sellers. How touching to see executives from the likes of Lehman Brothers, not normally an institution associated with widows and orphans, squawk about cutthroat tactics. Regardless, had they not borrowed so much, they would not have been vulnerable.

Ultimately, the issue of blame is less important than is the question of whether markets will eventually right without a federalization of losses.

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