Henry Farrell: Your new book argues that the most important cause of the recent financial crisis wasn’t financial deregulation but the aftermath of the Iraq war. How could a war create an economic crisis?
Thomas Oatley: I argue that the way the U.S. chose to fund its military buildup for the wars in Iraq and Afghanistan produced an economic boom, out of which emerged a housing bubble. When the bubble deflated, it caused the financial crisis. The basic idea is the following. The U.S. funded the wars in Iraq and Afghanistan by borrowing rather than by raising taxes. The resulting budget deficit had two consequences for the American economy. First, it provided a persistent fiscal stimulus of about 2 percent of GDP that sustained the economic expansion. As a result, unemployment fell from 6.25 percent in 2002 to 4.5 percent on the eve of the crisis. Second, the capital inflows that financed the budget deficit strengthened the dollar, thereby reducing the competitiveness of American manufacturing. As commonly noted, American manufacturing shed 3 million manufacturing jobs during this period.
Now this creates a bit of a puzzle. If the economy is expanding but manufacturing employment is shrinking, then where are these new jobs being created? The simple answer is that growth and job creation occurred in industries sheltered from foreign competition, especially in housing. So as manufacturing employment fell, the American economy added jobs in housing and related activities: 1 million new construction jobs were created, along with another 600,000 new jobs to finance the housing boom. The housing boom pushed home prices up, leading investors to invest even more in housing in the quest for capital gains.
The financial crisis itself was a fairly predictable consequence of these broader economic conditions. Every asset bubble must pop, and when it did the institutions that held the mortgage-backed securities experienced significant weakness in their balance sheets. And while we think of this crisis as a unique event, it isn’t. The Reagan Administration’s deficit-financed military buildup created almost identical economic conditions with almost identical consequences: first a housing bubble and then a banking crisis (the Savings and Loan crisis). And though a bit different, the Johnson Administration’s deficit-financed Vietnam buildup was the central factor driving the collapse of the dollar’s peg to gold. Thus, throughout the postwar period, America’s reliance upon deficit-financed military buildups has generated economic booms and eventually financial instability. The Korean War is the only exception.
H.F.: Why does the U.S. persistently borrow money in order to fund its wars rather than either cutting spending or raising taxes?
T.O.: The U.S. borrows because of three interacting processes. First, the events that trigger large military buildups are unexpected — think here of the 9-11 attack or the 1979 Soviet invasion of Afghanistan. By providing clear and compelling evidence of a threat, these events generate wide consensus among the political elite that the U.S. must increase its military power.
Second, American politics transforms these military buildups into budget deficits. Deficits emerge because the key actors who must approve the required budget adjustments (Congress and the president) typically have very different preferences about how to pay for the additional military power they all agree to be necessary. Some want to cut nonmilitary programs, while others prefer to raise taxes. Thus, political consensus on the need to increase military power allows a large increase in the defense budget while dissensus over how to pay for this larger military prevents post-buildup budget adjustments. Buildups thus yield deficits.
Third, America’s global financial power makes it cheap to finance these deficits. The ability to draw capital from abroad keeps U.S. interest rates low even in the face of increased government borrowing. Moreover, because the U.S. can readily import foreign capital equal to the additional military spending, the budget deficit does not “crowd out” private investment. Politicians thus feel little urgency to bring the budget back into balance.
H.F.: You suggest that another way in which the U.S. tends to deal with its internal problems is by trying to force other states to pay the adjustment costs, through, e.g., the threat of protectionist measures. How does this force us to rethink policy debates about “global imbalances,” and how might it make financial crises more likely?
T.O.: Politicians typically blame America’s trade partners for U.S. trade deficits. For instance, legislators argue that China manipulates its currency to gain an unfair advantage in trade. The former Fed chairman Ben Bernanke attributed the U.S. current account deficit of the 2000s to a “global savings glut” generated by institutional and demographic characteristics of Asian economies. During the 1980s, Congress claimed that Japan used industrial policy to gain an unfair advantage. The Johnson administration targeted Germany with similar measures in the late 1960s.
Blaming foreigners for U.S. deficits is unproductive and potentially dangerous. It is unproductive because the refusal to recognize that American trade deficits are typically homemade makes it harder to negotiate multilateral agreements that might narrow global imbalances. The harder the U.S. pressures its partners to adjust, the more firmly its trade partners dig in their heels. Blaming foreigners is potentially dangerous because it distracts us from addressing the more important cause of the imbalance, American budgetary and broader macroeconomic imbalances. And ignoring these macroeconomic imbalances makes it more likely that asset bubbles and financial weaknesses will develop. As the most recent crisis suggests, when these crises happen in the U.S., the global repercussions are severe and long- lasting.
H.F.: Given the political cycle that you identify, how likely is it that we’ll see similar crises happening in the future?
T.O.: Similar crises are likely because the reforms after the crisis have addressed none of the factors that generated it. The U.S. will experience another national security shock, and, given that American politics remain polarized, the system will transform the buildup into budget deficits. Moreover, policymakers have attributed the financial crisis to regulatory failure and have ignored the importance of macroeconomic imbalances. Obviously, financial regulation is a necessary component of financial system stability, but it is not sufficient on its own. Regulation can be (and often is) overwhelmed and undermined by large and persistent macroeconomic imbalances, much as Hurricane Katrina’s storm surge overwhelmed a levee system that was sufficient to protect New Orleans against smaller storms. Thus, a necessary component to financial stability is global macroeconomic policy coordination. Unfortunately, post-crisis politics, in the U.S. and in Europe, highlight just how unlikely such coordination is.