Brace Yourselves

By Bill Emmott
Sunday, October 19, 2008

Historians identify changes in eras in terms of decades, even centuries. Commentators are a much more impatient bunch: A few weeks of turmoil on Wall Street, a year of the credit crunch, and they've formed an instant consensus that a new era has begun, that points have turned or tipped or gushed over a watershed.

This consensus, on both sides of the Atlantic, has formed around four themes. One is the idea that the dividing line between the market and the state, between conservative economic thinking and progressive intervention, will now shift decisively away from the market. A second is that America's status as a free-market beacon and provider of the dollar standard will decline sharply. A third idea is that this Western economic crisis is going to confirm, and probably accelerate, the shift in economic power to Asia, and in particular to China. And when you put those three themes together, you get a fourth: that authoritarian nations, where the state runs the economy and where the political leaders are instinctively hostile to America, are going to become stronger, both internally and as role models.

The haste with which this agreement has been reached should make us suspicious. It's time to wonder whether all four of these themes may be wrong. In fact, it's time to wonder whether the ultimate consequence of this economic turmoil could be the precise opposite of what's expected.

Consider each of the agreed-upon themes in turn. The last big financial crisis -- in fact the biggest stock and real estate collapse -- to have occurred in any large industrial economy since 1929 was the one that began in Japan in 1990-91. Did that lead to a decisive shift in the balance between the state and the market? Yes, it did: It pushed Japan far more toward the market and away from state intervention and regulation.

The reason, in part, was that the collapse destroyed the Japanese bureaucracy's reputation. (In the United States, it is bankers' reputations that have suffered, along with Alan Greenspan's.) But the biggest reason was pragmatic: The cost of rescuing the financial system and supporting the economy was so high that it left the annual budget deeply in deficit. With gross government debt at 180 percent of GDP (Washington's is now about 90 percent) there was little choice but to cut the state back.

In the United States, the cost so far of recapitalizing the banks, taking control of Fannie Mae and Freddie Mac and so on has been smaller than the Japanese expenditure: 5 percent or so of GDP here vs. 20 to 24 percent in Japan. That extra debt and a higher deficit will extend government, but it will also constrain other spending by the new administration and Congress. There will almost certainly be a fresh fiscal stimulus package after Jan. 20, perhaps focusing on rebuilding infrastructure. But other projects will have to be put on hold. In the medium term, the net effect on the government's financial role may turn out to be neutral, unless a potential President Obama succeeds in persuading Congress to finance his scheme for universal health care.

In Europe, however, the extra debts and deficits being taken on in Britain, France, Germany and elsewhere are already larger than those in the United States and are being piled onto already overloaded public finances. There, the Japanese outcome is a real possibility: Rather than extend the state, these extra burdens could in fact give a powerful push to pro-market, state-trimming reform. Europe had already been moving in that direction under leaders such as Nicolas Sarkozy in France and Angela Merkel in Germany; this crisis may well accelerate that process considerably.

Yes, regulation of banking and other financial firms is likely to increase, as it has in Japan. But that is quite a technical matter of capital-adequacy rules and the treatment of derivative securities, not the stuff of new eras and paradigm shifts.

What of the second theme, of a post-American world with a shrinking role for the dollar, analogous to the demise of sterling and of Britain's economic and financial status after 1945? The first point to be made is that the dollar's role in global foreign-exchange reserves was much smaller in 1990 (50 percent of global reserves) than it is today (about 63 percent), so even a fresh decline in its use would not be path-breaking. The second is to ask what the alternative is: the euro, the currency of a region that has gone into recession more quickly than the United States, and whose banks are just as troubled? And not, certainly, China's yuan, unless that country's leaders are poised to surprise us all by making it convertible and reducing controls on capital flows, both of which are necessary before a currency can take on reserve status. By default, the dollar is likely to keep its leading role. Whether the United States will again be a beacon of economic policy and performance depends on how bad its recession proves to be and on how well it adjusts to a new period of higher household savings and lower consumption and debt. It depends, too, on how American politics respond to rising unemployment and whether Congress tries to move sharply away from fairly open trade and toward protectionism. That's what happened in the recession of the 1980s. Membership in the new World Trade Organization will make that much harder, however, as will either a President Obama or a President McCain, both of whom profess to be multilateralists.

China will certainly be an issue for the new Congress and administration: Its extraordinary current-account surplus of 10 percent of GDP, its slowing but still rapid growth (down to "just" 10 percent a year from 12.9 percent), its accumulation of capital in its sovereign investment funds could all provoke resentment, envy and fear. But will its global status and role really, as the third theme claims, be strengthened by this Western economic crisis?

It could be: If China's leaders were to abide by Western recommendations and revalue the yuan while also increasing public spending to stimulate the domestic economy, the country could become a crucial source of import demand for the world. That, however, requires China's domestic interests to become neatly aligned with global interests, for it is those internal interests with which its leadership is principally concerned. And even reflation and revaluation would not make China an American-style buyer of last resort, because its economy is German-size, not American-size -- $3.2 trillion as opposed to $13.8 trillion for the United States.

Moreover, China's leadership has other preoccupations besides seeking loftier global status. Thanks to its capital controls, its savings surplus and its state-controlled banking system, China is well insulated from the Western financial crisis (unlike India, where companies' foreign debts are high and private banks are getting squeezed). Its low-end exporters, however -- cheap labor and high-volume industries such as toys and textiles -- are already in trouble due to both rising wages and a higher valuation for the yuan since 2005. Other export industries now look set to lose business as Western markets shrink. Meanwhile, public concern about pollution, combined with political fears about dependency on imported resources, is bringing about a new emphasis on efficiency and, to some extent, tighter environmental controls.

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