by Adam Tooze
The Clinton administration had midwifed China into globalization. In November 1995, Washington encouraged Beijing’s application to join the newly founded World Trade Organization (WTO). America had done this before, of course, with Western Europe after 1945, with Japan and East Asia in the 1950s and 1960s and with Eastern Europe in the 1990s. Opening markets was good for American business, for American investors and for American consumers. America’s economic interests were so widespread that they were de facto identical with global capitalism.15 By the mid-1990s Washington had abandoned any frontal challenge to the Chinese Communist regime over human rights, the rule of law or democracy. Instead, globalists of both the Democratic and Republican parties wagered that the powerful and impersonal force of commercial integration would in due time make China into a biddable and congenial “stakeholder” in the world order.16
China’s growth was spectacular. Huge profits were to be made for American investors. American manufacturers like GM would stake their future on China.17 After a brief storm over the Taiwan Strait in 1995–1996, diplomatic relations calmed. But China’s sheer size made it a contender. With the Tiananmen crackdown of 1989, the Communist Party had signaled its intent not to abandon its one-party leadership. Since then it had fashioned a popular ideology that was as much nationalist as Communist.18 If Washington was betting on international trade and globalization to “Westernize” China, the Chinese Communist Party took the other side of the bet.19 The party’s leaders wagered that supercharged growth would not weaken them but would consolidate their position as the successful helmsmen of their nation’s spectacular comeback. Beijing took advantage of trading opportunities. But it never subscribed to fully open markets. It decided who would invest and on what terms. It controlled movement of funds in and out. That, in turn, allowed the People’s Bank of China to fix its exchange rate, and since 1994 it had done so by pegging against the dollar.
In choosing a dollar peg, China was far from unique. Despite the reigning narrative of market liberalization, the financial world was not flat. The global monetary system was hierarchical with the key currency, the dollar, at the top of the pyramid.20 The twenty-first century began with a network of dollar-linked currencies accounting for c. 65 percent of the world economy (weighted by GDP).21 Those currencies that were not pegged to the dollar tended to be hooked to the euro. Often pegging was a sign of weakness. In many cases the exchange rate was set at an aspirational, overvalued rate. This created short-term advantages. It made imports cheap. Local oligarchs could snap up prestige foreign real estate at a discount. But it also harbored huge risk. The peg could break and frequently it would do so with a bang. The appearance of stability offered by a fixed exchange rate encouraged a large inflow of foreign funds, which helped to stoke up domestic economic activity, creating an unbalanced trade account funded from abroad. Banks that acted as the conduit for foreign funds boomed. This set up the crisis.22 When international investors lost confidence, the result was a devastating sudden stop. Then the central bank’s foreign exchange reserves would drain and it would have no option but to let the currency peg go. Stability would give way to a disastrous devaluation. Those who got their money out first would be saved. Those who had borrowed in foreign currency would face bankruptcy.
This was the saga of the 1990s: 1994 in Mexico; 1997 in Malaysia, South Korea, Indonesia and Thailand; 1998 in Russia; 1999 in Brazil. It was containing these crises that earned US Federal Reserve chairman Alan Greenspan, Treasury secretary Robert Rubin, and Larry Summers, Rubin’s number two, the accolade of the “Committee to Save the World.”23 What happened when the American superheroes were not on hand was revealed in 2001. With the Bush administration fully distracted by the terror attack of 9/11, financial speculation built against Argentina. Despite a $22 billion loan from the IMF, without American backing the Argentinian position became untenable; 80 percent of Argentine private debt was in dollars, whereas only 25 percent of Argentina’s economy was export oriented.24 In December 2001, with dollars draining out of the country, the Argentine government suspended access to bank accounts. Amid rioting that claimed the lives of twenty-four people, the government collapsed. On December 24, 2001, Argentina announced the suspension of payments on $144 billion of public debt, including $93 billion owed to foreign creditors. The peso plunged in value from 1:1 to 3:1 against the dollar, bankrupting the dollar debtors. The economy reeled backward to levels not seen since the early 1980s. As the twenty-first century began, more than half of Argentina’s population fell below the poverty line.25
China had no intention of becoming either the victim of a sudden stop or the needy recipient of US assistance.26 To reverse the balance of risk, when Beijing pegged its exchange rate it chose one that was not too high, but too low. This was what Japan and Germany had done in the 1950s and 1960s.27 It was a recipe for export-led growth, but it created tensions of its own. Undervaluing the currency made imports more expensive than they needed to be, which lowered the Chinese standard of living. When it ran a trade surplus with the United States and bought American government bonds, poor China was exporting capital to rich America, funding American consumers to buy the products of its huge new factories. Moreover, maintaining the artificially low peg was a battle in its own right. With China’s trade surplus with the United States surging from $83 billion in 2000 to $227 billion in 2009, to hold the value of the yuan down the Chinese central bank had to continually buy dollars and sell its own currency. To do so it printed yuan. In the normal course of things this would have unleashed domestic inflation, wiping out any competitive advantage and triggering social unrest. So, to “sterilize” the effects of its own intervention, the People’s Bank of China required all Chinese banks to hold large and growing precautionary reserves, effectively removing the currency from circulation. It was a profoundly unbalanced situation and one that could be sustained only because of the extremely tight relationship between the Chinese regime and the business elite, a relationship built on common affiliation to the Communist Party, coercion and mutual profit. Chinese businesses and their owners, the emerging oligarchs, profited spectacularly from a gigantic export-led development boom.28 Chinese peasants and workers chased the dream of urban prosperity. Meanwhile, Beijing’s giant foreign currency reserves were the best guarantee an uncertain global economy could offer that in case of a crisis, it would not be China’s sovereignty that was violated.
China’s Foreign Reserve Accumulation (in $ billions)
Note: Estimates adjusted for Belgian holdings and UK flows.
Source: Brad Setser, “How Many Treasuries Does China Still Own?,” Follow the Money (blog), Council on Foreign Relations, June 9, 2016, https://www.cfr.org/blog/how-many-treasuries-does-china-still-own.
With so many currencies fixed against the dollar, without the possibility of adjusting export competitiveness by means of devaluation or appreciation, it was no surprise that the world economy polarized into export surplus and import deficit countries. In the first three months of 2005 alone, the United States ran a current account deficit—an excess of outward payments on trade in goods and services and investment income—of almost $200 billion. For the year it came to $792 billion and was showing signs of further deterioration in 2006. For those on the surplus side of the “global imbalances,” so-called sovereign wealth funds (SWF) became huge repositories of capital. According to estimates by the Peterson Institute for International Economics in Washington, DC, by 2007 emerging market sovereign wealth funds held at least $2 trillion in assets, in addition to the trillions in reserves held by their central banks.29 The Saudi Arabian Monetary Authority was flush with cash, as were the SWF of Norway and Singapore. Some SWF made adventurous investments in equities. China’s State Administration of Foreign Exchange looked for safe and predictable returns. Its safe assets of choice were long-dated US government debt and securities guaranteed by the US government.
The imbalances were worrying, but, at lea
st as far the surplus countries were concerned, they promised that the first shock in the case of an unwinding would be borne by the other side. It was the United States, the world’s great deficit economy, that would see its currency devalue and its interest rates surge as foreign investors abandoned American assets. It was this scenario that caused Orszag, Rubin and Senator Obama such concern. Nor were they alone. In the prestigious house journal of the Council on Foreign Relations, Foreign Affairs, Peter G. Peterson, chairman of the council, the Institute of International Economics and the Blackstone Private Equity Group, raised the alarm about America’s twin deficits.30 Economists Nouriel Roubini and Brad Setser warned that if investors were to lose confidence, the United States could face a very sudden depreciation of the dollar and a massive hike in interest rates.31 It might well turn out to be the worst recession experienced since World War II.32 And America would not only be depressed. It would be humbled at the hands of the rising power of Asia. Of course, if the United States suffered a crisis, China would be hurt too.33 Niall Ferguson and Moritz Schularick came up with the term “Chimerica” to describe the Sino-American economic complex.34 For Larry Summers, who had moved from the Treasury to an ill-fated stint as president of Harvard, it reawakened memories of cold war–era mutually assured destruction. At the heart of the world economy, he told Washington audiences, was a “balance of financial terror.”35 The difference was that in the cold war the economy had been America’s strong suit. Now America’s trump card consisted of the hope that it was simply “too big” for China to let it fail. It was hardly a reassuring diagnosis.
III
To ease these imbalances, the obvious solution, as the Hamilton Project demanded, was fiscal restraint. Reduce the federal deficit, squeeze domestic demand, reduce the import of Chinese goods and Chinese money. But the Bush administration didn’t seem to care. In 2004 former Treasury secretary Paul O’Neill, fired from the cabinet in 2002, released his revealing exposé of the early Bush administration. It contained a nugget that haunted the economic policy community. In November 2002 O’Neill tried to warn Vice President Dick Cheney that the surging “budget deficits . . . posed a threat to the economy.” Only for Cheney to cut him off with the following remark: “You know . . . Reagan proved deficits don’t matter.” The Republicans had won the congressional midterms; tax cuts were the Republican “due.” Within the month O’Neill was fired.36 From the perspective of the Rubinite Democrats, this was not just economically illiterate, it was also a political scandal. Following in the footsteps of George Bush senior, they had spent agonizing years working off Reagan’s deficits. If Cheney’s version of Republicanism prevailed, it undermined the basis for turn taking in America’s two-party system. How could the Democrats conduct responsible “national” economic policy if the Republicans viewed the economy as a resource to be milked for the benefit of its privileged constituency? As Brad DeLong, deputy assistant secretary for economic policy in the Clinton-era Treasury, ruefully remarked: “Rubin and us spear carriers moved heaven and earth to restore fiscal balance to the American government in order to raise the rate of economic growth. But what we turned out to have done . . . was to enable George W. Bush’s right-wing class war: his push for greater after-tax income inequality.”37
The question was pressing because following the momentous November 2006 midterms, control of the House and the Senate changed hands. In a turn of events that can only be described as fateful, it would be the Democrats who held power in Congress during the greatest crisis of American capitalism since the 1930s. But that was in the future. In 2006 the question was whether the Democrats, as the new power on Capitol Hill, should once again take responsibility for cutting the deficit. Many in the party, especially those on the Left, were wondering why they should accept the burden.38 As one centrist remarked: “On fiscal responsibility, it takes two to tango, and insofar as the GOP doesn’t want to dance, Democrats can’t afford to take sole responsibility.”39 Perhaps the best way to prevent another “wealth-polarizing offensive” by a Republican Congress would be to spend so much on public works, welfare and job creation that even a Republican would not consider adding tax cuts on top. As DeLong resignedly observed, the “surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be ‘normal’ again?”40
Given this dilemma, the disaster scenarios invoked by Orszag and Rubin take on a different meaning. They were as much about controlling the agenda within the Democratic Party as about winning over Republicans. If all that was at stake in the struggle over the deficit was a percentage point of economic growth here or there, why should the Democrats not put their own partisan priorities first? But if what threatened was a Weimar-style disaster, then, surely, the left wing of the Democrats would fall into line and prioritize budget cutting.
Given the political impasse over fiscal policy and the evident imbalances of the US economy, the other agents that one might have expected to swing into action were the mighty guardians at the Federal Reserve Board. Under the chairmanship of first Paul Volcker (1979–1987) and then Alan Greenspan (1987–2006), the authority of America’s central bank soared to new heights. In terms of its expert authority and unassailable position within the structure of the US government, it came to rival the US security apparatus.41 The irony, however, was that as the Fed’s reputation and authority grew, its key tool of policy seemed to be losing its effectiveness. The short-term interest rate set by the Fed no longer seemed to be setting the pace for the rest of the economy.
Following the dot-com crash Greenspan had cut rates to 3.5 percent. After the 9/11 attacks there were further cuts, reaching 1 percent in the summer of 2003. Then, from 2004 on, the Fed started raising rates. Faced with America’s trade deficit and its rapid domestic boom, this was the standard prescription. It should increase private saving and restrict investment.42 But to the Fed’s dismay, the results were feeble. Most strikingly, as the Fed hiked short-term rates, rates in long-term bond markets failed to respond. There were too many buyers of long-term bonds, driving prices up and yields down. Nor should this have been a surprise.43 By fixing their currencies against the dollar, many of America’s trading partners prevented not only a downward movement of the dollar, which might have restored America’s competitiveness. They also prevented an appreciation of the American currency, which would normally have followed on an interest rate increase. Under de facto fixed exchange rates, an increase in the interest rates would not reduce the supply of credit. It had the opposite effect of making investment in the United States more attractive, drawing in a greater flow of foreign funds.
The Fed found itself boxed in between China’s determination to peg its currency and the refusal of Congress to curb America’s budget deficit. China’s unbalanced growth path created an excess of savings that needed to be invested abroad. AAA-rated US Treasurys were the reserve asset of choice. As a newly appointed member of the Federal Reserve Board, one of the first contributions to the policy debate by the Princeton economist Ben Bernanke was to coin the term “global savings glut” to describe this situation in which the Fed’s principal policy instrument lost its leverage on the economy.44 The availability of foreign funding negated Fed efforts to raise interest rates. At the same time it reduced the pressure on Congress to tighten fiscal policy. As capital surged in, this pushed down US interest rates, stoking the domestic economic upswing and sucking in imports, above all from China. But barring a change of heart on the part of Congress or a general liberalization of exchange rates, there was little the Fed could do. This was the ambiguous inheritance that Bernanke stepped into on February 1, 2006, as he took up the baton of Fed chair.
Bernanke’s placid and undersized persona would soon come to occupy an
outsized space in global economic history. He would turn out to be an unusual but highly significant case of the possibility of “learning lessons from history.” In November 2002 at a birthday celebration for Milton Friedman and Anna Schwartz, Friedman’s coauthor in the monumental Monetary History of the United States, the bible of monetarism, Bernanke promised: “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”45 Given the association forged in the 1970s between monetarism and inflation fighting, one could easily confuse Bernanke’s promise with a conventional central banker’s commitment to price stability. Indeed, Bernanke was making a commitment to price stability, but what he was promising to prevent was deflation, not inflation. The lesson of the 1930s was that the Fed must act promptly not just to prevent the money supply expanding excessively but also to prevent bank failures from causing it to implode.46 On Bernanke’s watch there would be no deflation. That single-minded determination, embodied by the new Fed chair but shared across the US policy-making establishment, would define the response of monetary policy to the crisis. In the process Bernanke would redefine what a central bank can do as an agency of modern government. Given the weight of this hindsight, it is easy to forget how unremarkable his appointment seemed at the time. He was a safe pair of hands, no outsized ego, a reliable middle-of-the-road Republican. In policy terms he was known, above all, for his belief that the best way to perpetuate the era of the great moderation, in which both unemployment and inflation were fluctuating much less than ever before, was a rules-based approach to policy making he described as “constrained discretion.”47