The Monetary Causes of the Debt Crisis

On February 22, 2012, in economic theory, monetary policy, by Jon Lewis

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99 What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex [...]

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99

What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex than one might initially realize. In Paper Promises, Philip Coggan of The Economist forces the reader to think differently both about the nature of money and the concept of debt. “Modern money,” writes Coggan, “is debt and debt is money.” Throughout this engaging work, he successfully demonstrates how, throughout history, societal attitudes toward money and debt have changed and that they may be about to change once again.

The author contends that one can view all of economic history through the prism of a perennial contest between creditors and debtors, between those who lend money and those who borrow it. Anyone reading a newspaper these days knows all-too-well that much of the West is in debt. The battle between creditors and debtors aptly described by Coggan is being played out in front of our very eyes. Although some countries, like Greece, are in far more perilous shape than others, both the European Union and the United States face the looming prospects of increased sovereign debt and the possibility of default.

“As these debts become due,” writes the author, “rich creditors will be pitted against poor debtors; private-sector taxpayers against public-sector workers, young workers against the retired, domestic voters against foreign bondholders. It is impossible to forecast who will win each of these battles but one thing seems certain: not all these debts will be paid in full.” One of the book’s myriad takeaway lessons is that creditors will be disappointed. The breaking of these paper promises, as Coggan describes them, will result in economic turmoil akin to the end of the gold standard in the 1930s and of fixed exchange rates in the 1970s.

The book’s first chapter, entitled, “The Nature of Money” is a thought-provoking introduction to the concept of money. “For thousands of years,” writes Coggan, “the nature of money has been subject to change at the whim of those in power.” Indeed, the relationship between state power and money is nothing new. Coggan suggests, however, that something new did occur in eighteenth-century France, when John Law, a Scottish economist advising Louis XV, fathered modern monetary economics and attempted to redefine money. Law advised the French king that the way out of the country’s fiscal mess was to create a bank with the right to issue paper money, even if it were not backed by gold. This, recounts the author, led to an asset bubble in the form of land speculation in the Mississippi basin.

In a more theoretical section of the same chapter, the author delineates three uses of money. As a medium of exchange, money allows people to buy and sell goods and services without having to barter or ship bullion across great distances. He rightly notes that, with regard to the “media of exchange, paper and electronic money are much more useful than precious metals.” Money is also a unit of account, meaning that it expresses “the price of goods and services with relation to one denominator.” Finally, as a store of value, money allows one to save and not spend what one earns immediately. This facilitates investment. Coggan posits that, “the means of exchange and the store of value . . . lie at the heart of the struggle between creditors and debtors.” For the last forty years, he argues, the pendulum has swung toward loose money and money’s medium of exchange function. In other words, credit and money have expanded, benefitting debtors.

In Coggan’s estimation, our troubles began with the breakdown of the Bretton Woods system in the early 1970s, when the formal link between money and gold disappeared. “Paper money prevailed. Without a gold anchor, and without full capital controls, fixed exchange rates were not really feasible. Governments preferred the freedom to govern their own economies as they saw fit, using both monetary and fiscal policies to support demand.” According to Coggan, these governments and their central banks “overdid it, a process that culminated in the debt crisis of 2007 and 2008.” As he writes in the book’s introduction, the developed world financed their economies through debt.

Although Coggan tells a compelling story of how we got into our current debt crisis, it need not have ended up this way. The author certainly makes a strong case for the argument that the breakdown of the Bretton Woods system likely contributed to the vast increase of debt in the western world. Demography, fiscal policy, globalization, housing policy, and technology, however, also played dispositive roles in destabilizing the world economy. In my opinion, if voters throughout the past decade were more demanding that politicians in Washington adhere to a balanced budget and not engage in excessive spending, many of our current problems could have been avoided.

While Coggan accurately notes that the Clinton administration ran “a fairly conservative fiscal policy,” he seems to imply that the 1990s boom and budget surpluses were an anomaly in the post-Bretton Woods era, rather than part of a natural ebb and flow cycle in which politicians and bureaucrats alternatively acted fiscally responsibly and irresponsibly. After all, governments throughout history have made financial decisions that would prove, in retrospect, to have been significantly flawed.

One should not underestimate China’s potential to make financial, or political, mistakes that will inadvertently benefit the United States. Given the infeasibility of returning to a gold standard in an age of electronic money and instantaneous transfers, western countries are going to have to find a way to create a more stable fiscal and monetary system. If they do not, and the United States experiences a lost decade of anemic growth, then the world’s new monetary system may very well, as Coggan suggests, be made in China.

Due to his willingness to acknowledge readily that, “there are no easy answers in economics,” Coggan’s work stands apart. Paper Promises certainly doesn’t have all the answers; it, however, does force the reader to think differently about the nature of money and of debt. One need not agree with Coggan’s analysis of fiat money to appreciate that Paper Promises is an extremely thoughtful contribution to the ongoing debate about the financial crisis and our current debt problems.

Jon Lewis (c) 2012

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The Dollar Abides

On January 28, 2012, in Federal Reserve, monetary policy, by Jon Lewis

Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Barry Eichengreen. Oxford University Press 2011, pp. 215, $27.95 The Great Recession, precipitated in part by excessively low interest rates in the early 2000s, has caused more Americans to pay attention to monetary policy than they have in [...]

Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Barry Eichengreen. Oxford University Press 2011, pp. 215, $27.95

The Great Recession, precipitated in part by excessively low interest rates in the early 2000s, has caused more Americans to pay attention to monetary policy than they have in the past. Governor Rick Perry, former Speaker Newt Gingrich, and Congressman Ron Paul, to various degrees and in different ways, all made criticism of the Federal Reserve components of their presidential campaigns. Academics and policymakers have debated the necessity and wisdom of the Fed’s two quantitative easing initiatives. Unquestionably, the fiscal and monetary outlook of the United States is not nearly as rosy as it looked when President George W. Bush took office, a time when the United States was running a budget surplus.

Is the current situation in the United States so perilous, however, that we should worry about an imminent dollar crash? And if so, who would be to blame for an occurrence that would have far-reaching financial and geopolitical implications? In Exorbitant Privilege, a nuanced study of how the dollar became the international reserve currency and what the future might hold for the dollar, Barry Eichengreen concludes with his assessment, “that the only plausible scenario for a dollar crash is one in which we bring upon ourselves.” In contrast to those who contend that China can, or will, cause the dollar to crash, Eichengreen contends that the dollar’s fate is in our hands, making it “within our grasp to avoid the worst.” The United States, it would seem, is not a passive actor, merely biding its time before it is swept away by a rising China. Not yet anyway.

In this comprehensive and clearly written academic monograph, Eichengreen argues that, while the dollar is now by far “the most important currency for invoicing and settling international transactions,” this may not necessarily be the case in the future. According to Eichengreen, the dollar’s status as a reserve currency does not make as much sense now as it did fifty years ago when the United States was more economically dominant.

For much of the period since the Second World War, the United States benefitted from what former French finance minister Valery Giscard d’Estaing critically termed America’s ‘exorbitant privilege.’ The noted statesman was referring to Washington’s ability, due to the dollar’s sole status as the international currency, to run an external deficit amounting to the difference between what it must pay on its liabilities and the rate of return on the country’s foreign investments. In other words, cheap money from abroad allowed Americans to live beyond their means.

As specific examples of exorbitant privilege in action, the author cites how, in 2008, when the financial markets were in turmoil, Washington was able to borrow at low interest rates because foreign investors flocked to the dollar, believing it to be the safest currency at the time. Likewise, in 2010, when market volatility spiked, investors went for treasury bonds, lowering the cost of borrowing for the federal government and, subsequently, mortgage interest rates.

Eichengreen criticizes what he perceives to be the conventional wisdom regarding the dollar’s current status and its likely future. He contrasts the view that widespread use of a country’s currency internationally gives it geopolitical power with his belief that “it is a country’s position as a great power that results in the international status of its currency.” He also criticizes the notion that incumbency is exceedingly advantageous in the global competition for reserve currency status, citing how the dollar began to rival sterling by the mid-1920s shortly after the Federal Reserve system was established in the United States.

Most significantly, Eichengreen argues that, “the idea that the dollar is doomed to lose its international currency status is equally wrong.” Both the euro and the renminbi, he suggests, have their problems, arguing that, “the fundamental fallacy behind the notion that the dollar is in a death face with its rivals is the belief that there is room for only one international currency.” It is the author’s belief that the late twentieth-century, when the dollar reigned supreme as the world’s reserve currency, was unique by historical standards.

Eichengreen foresees the possibility of a global economy wherein countries bordering China may use the renminbi, countries close to the Eurozone utilize the euro, and countries transacting with the United States will make use of the dollar. Reserve currency status, therefore, may not be a zero-sum game. “The world for which we need to prepare,” contends Eichengreen, “is thus one in which several international currencies coexist.” The dollar may have future international competition, he suggests, but it won’t decline just yet because of external pressure from China.

In conclusion, the dollar is not about to crash tomorrow. Eichengreen is most likely correct in his contention that, “the plausible scenario for a dollar crash is not one in which confidence collapses on the whims of investors or as the result of a geopolitical dispute but rather because of problems with America’s own economic policies. The danger here is budget deficits out of control.” Sobering words indeed.

Jon Lewis (c) 2012

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China’s rise, America’s relative decline

On November 4, 2011, in economic theory, monetary policy, by Jon Lewis

Eclipse: Living in the Shadow of China’s Economic Dominance. Arvind Subramanian. Peterson Institute for International Economics Press, 2011, pp.216, $21.95 It is too soon to ascertain whether the latest attempt by Europe’s political elites to deal with Greece’s public debt, and to salvage the Euro in the process, will result in anything remotely resembling a [...]

Eclipse: Living in the Shadow of China’s Economic Dominance. Arvind Subramanian. Peterson Institute for International Economics Press, 2011, pp.216, $21.95

It is too soon to ascertain whether the latest attempt by Europe’s political elites to deal with Greece’s public debt, and to salvage the Euro in the process, will result in anything remotely resembling a success. Although some in Europe hoped that Beijing would rescue the Continent from its economic morass, Chinese President Hu Jintao has downplayed a Chinese leading role in bailing out Europe.

Nevertheless, the recent statement by the head of the European Financial Stability Facility that the European bailout fund might one day issue bonds denominated in yuan is yet another indication that many observers increasingly perceive China as the world’s economic power broker. Furthermore, some Chinese officials have reportedly floated the idea of European borrowing in renminbi to lower China’s foreign exchange risks and to bolster China’s monetary policy internationally. This suggests that there are strategic-minded policymakers in Beijing who see the European debt crisis as an opportunity to advance national goals and is particularly interesting in light of China’s recent investments in non-dollar assets.

In Eclipse, Arvind Subramanian (Peterson Institute for International Economics and the Center for Global Development) contends that China is well on its way to being the world’s dominant economic power, and advocates for multilateralism as the best means of protection against China in the unlikely event that Beijing would decide to use its future economic dominance for less than benign means. This timely academic monograph begins with a chilling scenario set in 2021: a recently inaugurated Republican president heads to the office of the International Monetary Fund’s Chinese managing director to secure IMF financing. China is able to utilize its economic muscle within the IMF to make the removal of the U.S. Navy from the Western Pacific as a precondition for funding; the terms of the IMF agreement itself would force the United States to engage in tax increases, entitlement reform, and a substantial reduction in defense spending.

While Subramanian doesn’t necessarily believe that the situation will come to pass in this exact manner, he indicates that he does not believe it to be out of the realm of possibility either. Indeed, in the book’s postscript he writes as follows: “To clarify, the 2021 scenario described in the introduction is still very low probability one. But stranger things have happened, as the recent global financial crisis showed.”

That said, Subramanian does challenge the notion of American exceptionalism and, more significantly, the idea that if only the United States got its fiscal house in order, it could withstand China’s challenge to American economic dominance. Subramanian is skeptical of this line of argument; he is not convinced that Washington can successfully arrest China’s emergence as the dominant economic power. Readers will have to decide for themselves whether the author gives far too little credit to the quintessential American ability to overcome seemingly insurmountable obstacles, even if the cards are stacked against the United States.

What sets the author’s work apart from an already significant corpus of scholarly literature on China’s economic rise and America’s decline is his skillful utilization of quantitative methods. Subramanian creates an index of economic dominance in which resources, trade, and external financial strength are the three determinants. He employs that index both to compare several prominent economic powers past, present, and future. The results are sobering and should garner attention from both American policymakers and investors. Subramanian projects, for instance, that by 2030 China will likely become the dominant world economic power, eclipsing the United States much like the upstart former colony eclipsed the United Kingdom. Subramanian boldly contends that, not only is there a transition in economic dominance and reserve currency status, “but that the shift away from the United States toward China is more imminent, more broad-based, and greater in magnitude than is currently anticipated or contemplated.” He projects, for instance, that in 2030 China will account for close to 20 percent of world GDP and 15 percent of world trade. There is no particular reason for the reader to doubt these projections. That said, we are increasingly living in an uncertain world in which it is becoming increasingly difficult to predict what will happen next week, let alone twenty years from now.

In terms of currency dominance, Subramanian is less certain of impending Chinese supremacy. He contends that the three determinants for economic dominance – resources, trade, and external finances – also account for the status of a country’s reserve currency. “Together,” he writes, “they explain nearly 70 percent of the variation in reserve currency holdings.” That said, whether the renminbi will achieve reserve currency status is yet to be determined. Subramanian suggests that a transition to Chinese currency dominance “is far from inexorable. It will be conditional on China undertaking far-reaching reforms of its financial sector and exchange rate policies.” Subramanian is spot on when he writes that China is demonstrating its desire to elevate the renminbi’s status, “not least because internationalization of the renminbi offers China’s policymakers a possible exit from the current mercantilist strategy.” This is particularly salient in light of the European debt crisis and in Beijing’s all but certain role in helping to resolve it, at least in some fashion.

It should be noted that the author, subsequent to the publication of Eclipse, penned an op-ed for the New York Times in which he argues that China should play a considerable role in bailing out Europe. Whether increased Chinese influence in Europe, even if through multilateralism, is in the American national interest, however, is debatable. This is particularly true given the significant cultural and political ties between the United States and the European Union’s member states.

While Eclipse is clearly written and mostly avoids academic jargon, much of the material will be inaccessible to a general readership. Those with an academic background in economics or public policy, on the other hand, would find much to appreciate in Subramanian’s nuanced work. It behooves those who seek to take the Chinese challenge to American dominance seriously to give the author’s views ample and due consideration, particularly given the author’s acknowledgment that “[p]rojections of Chinese economic and currency dominance are of course conditional.” In conclusion, one need not agree with all of the author’s views to acknowledge that Eclipse is a serious book and that the author’s arguments should be taken seriously.

Jon Lewis (c) 2011

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