Economic indicators across the board are falling rapidly. The fundamental problem here is that the global economy has developed in such a way that the US economy - and to a lesser extent, the developed economies of Europe - have become the engine of consumption. Entire economies in Asia, encompassing billions of people, have developed under the "export-oriented industrialization" model used successfully by Japan after World War II. Under this paradigm, central banks and governments suppress the value of their currencies using policies which, in effect, mean that workers and consumers in Asia are being forced to save a large portion of their income, making the goods they produce artificially cheap. To understand how this works - and why it’s no longer working - you need to understand the economic history of the world over the last 6-7 decades.
Bretton Woods
The story begins in 1944. After World War II, the United States was the only industrial power left standing. Germany, Japan, France, and other European economies were decimated; their factories destroyed, their people impoverished. Britain, long the world’s dominant economic power and the issuer of the world’s reserve currency, was in similar shape. The pound, backed by the rubble that once comprised the world’s mightiest industrial economy, had been made worthless by the costs of war and could no longer function as currency by which international accounts were settled. The world’s leading economists met at Bretton Woods, NH before the war’s end in 1944 to devise a new system of international payments and exchange rates; what emerged came to be known by the name of the conference’s location - the Bretton Woods System.
In this system, all countries would peg the value of their currencies to the US Dollar, while the dollar was pegged to gold at $35 per ounce. In this way, the exchange rates of foreign currencies were determined in relation to the dollar, while governments were able to exchange their currencies for gold, effectively making the US Dollar "as good as gold." If another country got into trouble and saw the value of their currency decline sharply, the International Monetary Fund (IMF), was able to make adjustments to the exchange rate regime and/or issue loans to mitigate short-run balance-of-payment imbalances and stabilize foreign currencies. Thus, member countries would not have to induce a severe recession or depression in order to cut imports and national income to a level that was within their means to fund. The IMF was able to use this leverage to prevent the adoption of policies which would have caused a nation to default on its outstanding debt, and to reduce the temptation of poor countries to embark on policies of economic nationalism - restricting imports and capital outflows - much to the chagrin of populist demagogues in many third-world nations.
This system worked exceptionally well for thirty years; the post-war economic boom was one of the longest periods of increasing prosperity in world history. The United States benefited greatly from its position as the issuer of the world’s reserve currency. Since other governments had to hold dollars to participate in the system, the US was able to run persistent budget deficits and finance ever-increasing consumer spending and private investment without raising interest rates. While other nations had to either raise taxes or cut growth by raising interests rates in order to meet their obligations, the US was able to have it all - low unemployment, high domestic consumption and investment, low interest rates, low taxes, and high government spending. In effect, the rest of the world was doing a lot of the USA’s saving, but the US trade deficit encouraged exports from developing countries and spurred economic growth. However, it began to show signs of strain in the late 1950s. The system from whence the USA enjoyed unimaginable benefits was reliant upon very good behavior to maintain the dollar’s prestigious position. The American public ultimately rejected the hard decisions necessary to do so.
Beginning with tax cuts and increased domestic spending in the 1960s, the US trade deficit began to increase rapidly. The Vietnam War placed an even more enormous strain the federal budget and thus the Bretton Woods system, as the US borrowed heavily from abroad to finance prosperity at home while it was undergoing enormous outflows of human and economic capital in fighting the war. When Nixon assumed office in 1969, the situation continued to deteriorate. The central banks of France and Germany were piling up huge amounts of US Treasuries, and economists began to question how long they would be willing to pay our bills. The Fed induced a recession in 1969, but inflation stayed elevated due to pressures on the dollar. 1969 also proved to be the peak of US oil production, and America was soon forced to begin importing oil more and more oil from overseas, greatly excacerbating the balance-of-payments problem. Nixon, always the cynic, was advised that the Bretton Woods was facing collapse, but decided that keeping unemployment low for short-term political gain was more important than the long-run health of the economy. "We’ll take inflation if we have to" he said, "but we can’t have unemployment. Nobody ever lost an election because of inflation."
And yet, the only trade-off was in the short run. By 1970, the crisis had become acute. US gold coverage - the amount of gold held in reserve to back the outstanding fiat (paper) currency - declined from 55% to 22% as more and more dollars were being printed to finance the fiscal and balance-of-payment deficits. Foreign central banks began losing faith in the ability of the Treasury to redeem dollars for gold, and began demanding their gold at $35 per ounce, a huge discount to the value of gold on open markets. Faced with a run on gold reserves, spiraling inflation, and an impending election, Nixon unilaterally closed the "gold window" - suspended the exchange of dollars for gold - implemented trade protections, wage freezes, and price controls. The Bretton Woods system collapsed.
A successive series of attempted devaluations of the dollar were unsuccessful in imposing discipline on the the US, and countries began abandoning their dollar pegs. By early 1973, the last Bretton Woods exchange markets were closed, and thus began the "Great Inflation" of the 1970s. Without the discipline of the gold-exchange system, other countries began attempting to print their way out of trouble as well, and inflation rates in countries around the world spiked. We in the US could no longer rely on other countries to do our saving for us, and the choice was either to tighten our belts, or find a new source of saving to bankroll our consumption. Enter Nixon’s visit to China.
Bretton Woods II
Far from being an altruistic visit to advance world peace, Nixon’s normalizing of relations with China had a very specific purpose - leverage the Chinese supply of cheap labor to enable the US to continue living beyond its means. However, it was Japan that played the most important role in the creation of Bretton Woods II. While Japan is often thought of as a capitalist society, the reality is much murkier. Socialism of the mild sort, as was the consensus in the UK during this time, generally meant government control over and central planning of the "commanding heights" of the economy - utilities and heavy industries - while leaving market forces to determine the production of higher value-added products. The problem with this idea is that the "commanding heights" don’t actually command anything; the true commanding heights of a market economy are not the heavy industries, but the financial markets.
The Japanese economy, while reliant upon market forces to do the heavy lifting, is controlled by high-level technocrats at the Ministry of Finance. In contrast to the import substitution models popular at the time, the MoF set about developing a policy of strategic development through export-oriented industrialization. They wanted cheap capital for their exporters, which was funded by forced savings through MoF purchases of US public debt. Rather than invest their export earnings to build up domestic industries, the Japanese plowed them back into purchases of Treasuries, thereby keeping the value of their currency suppressed and their exports artificially cheap.
Thus, a new Bretton Woods began to emerge. During the 1980s, the US again slashed taxes and ramped up spending, yet this time we were able to do so without causing inflation or sky-high interest rates because the Japanese MoF bought up our debt at huge premiums. On the back of the US fiscal and balance of payments deficits, the export-oriented Japanese economy boomed. But when the US economy slowed, imports did too. The "Japanese miracle" was revealed to be a massive bubble, and rather than let the export-oriented economy readjust to a more domestically-oriented one, the MoF propped up the existing economic structures.
With the election of Bill Clinton and the return of fiscal restraint, the dollar surged, but as the US ran fiscal surpluses, the supply Treasuries available for purchase by the MoF shrank. The MoF could no longer boost exports by financing the non-existent US budget deficit, the Yen appreciated, and rather than allowing domestic demand to increase, Japan entered a decade of stagnation. Yet, even though the US government was now living within its means, the American public was not. America still posted trade deficits year after year, and while Japan still held vast numbers of US assets, China was on the rise. China’s domestic economy posted solid gains throughout the 1980s and 1990s, yet their currency was still at artificially strong levels, making exports uneconomical. But following the Japanese model, the Chinese government itself began a weak-currency policy.
The Collapse of the .com Bubble and the Bush Era
The budget surpluses of the 1990s freed up an enormous amount of capital for private investment in the US, much of which went to hyped-up .com firms with no assets, no revenues, no earnings - but extraordinary share prices. Wall Street argued, as in asset bubbles past, that the old rules no longer applied. Consumers took out loans and bought huge amounts of these absurdly-inflated stocks on margin. They increasingly financed current consumption against the value of speculative stock picks. However, reality eventually reasserted itself, and when the bubble burst (expedited by 9/11), many consumers’ paper wealth evaporated, and they were stuck with the enormous debt they had incurred during the boom.
But rather than ensure an orderly deflation and market correction, the Fed slashed (real) interest rates to negative territory, while Bush and the Republican Congress pushed through massive tax cuts - even with the expected return to deficits during the downturn. While .com stocks plunged, the Fed and the new administration worked to ensure that the consumption-fueled economy that grew up around effortless wealth was maintained. But investors were soured by the collapse of the stock market; real estate was the new must-own asset. Consumers, encouraged by their elected leaders, once again borrowed heavily to finance speculative asset purchases. Wall Street, now freed from the constraints of much of the regulation put in place during the 1930s, created numerous securities and instruments that enabled banks to expand lending to un-creditworthy buyers.
Bush and the neo-cons launched headlong into a war in Iraq and, like LBJ and Nixon, pursued a guns-and-butter policy of further tax cuts, massive defense expenditures, and huge increases in entitlement spending. The budget deficit ballooned, but like Japan, China stepped in to purchase the new debt at huge premiums. Interest rates in the US stayed absurdly low. Despite massive government and consumer spending, and the trade deficits those necessitate, the US was spared inflation, unemployment, and the loss of its reserve currency status.
Yet, once again, economic reality reasserted itself. The real estate bubble collapsed, leaving many US households with negative net worth. The falling dollar, demand from developing energy markets, massive domestic consumption, and instability in the Middle East caused energy prices to spike, further squeezing consumers. Unable to pay the bills on their massive debt, American households began defaulting on their mortgages and credit cards. The financial system, an elaborate house of cards dependent upon increasing levels of consumer indebtedness, began imploding. And, like Japan in the 1990s, rather than ensure an orderly transition to more rational economic structure, the US government continues to try to prop up the debt-fueled "consumer economy," oblivious to the fact that selling debt-backed securities in exchange for the fruits of world’s labor is totally unsustainable and unrealistic.
And once again, we still we have no policies to move the United States towards a production-oriented economy. Rather than embark on the spending necessary to make this transition, they instead continue to exchange noncollectable consumer debt on the balance sheets of banks for US Treasuries in a futile attempt to bring back the good ole days of unsustainable consumer spending. Just as how they’re unable to grasp that the sky-high gasoline prices were the result of inadequate supply and unabated demand, policymakers seem unable to grasp the reality that this is not some random crisis resulting from illiquidity in the financial markets, but rather the overall collapse of the Bretton Woods II system. Try as they might, they will be unable to put the Humpty-Dumpty bubble economy back together again.
The difference this time is that there are no more China’s and Japan’s to buy our debt and enable us to live beyond our means. All of the bailouts in the world won’t do a bit of good without a package to make the transition to a production-oriented economy. Consumers are unwilling to take on any more debt, and banks have learned the hard way that they can’t extend shady loans to shady borrowers without consequence. The sooner Congress and the Fed realize this, the sooner they’ll stop throwing good money after bad, and the sooner we can start to recover. Simply put, the era of free lunches has come to an end.
Cross-posted at my new blog, DailyElitist.com.