LOSING CONTROL (24 page)

Long term, the second option is unappealing.
The rise in state capitalism, the theme of Chapter 7, suggests the developed world would increasingly be in danger of exposure to economic blackmail.
Workers in emerging nations might increasingly choose to work for their own benefit and not for the benefit of corpulent Westerners.
Developed market assets in the emerging world would be vulnerable to seizure.
And, in time, the ability of the developed world to impose a military solution on potentially hostile countries elsewhere in the world will fade.
This is a simple matter of fiscal arithmetic.
According to estimates from the OECD, public spending on pensions and healthcare within the G7 nations will rise by around 7 per cent of GDP between 2010 and 2050.
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Unless tax revenues also rise – difficult if the workers being relied upon to produce the necessary goods and services live abroad – the likely response will be
expenditure cutbacks in other areas.
Gunboat diplomacy might have worked well for Victorian and Edwardian Britain but, with limited resources, it will be a fading option for the developed world in the twenty-first century.

The first option is, in my view, much better.
US history, both in the nineteenth century and in the late twentieth century, shows that it is possible to incorporate into society all colours and creeds.
Border controls are a creation of the early twentieth century and, from an economic perspective, should be generally regarded as acts of protectionism.
They stifle the free flow of labour across borders and, hence, lead to an inefficient and unfair allocation of global resources.
These are not, though, the only arguments in favour of immigration.
If the developed world is to become increasingly dependent on workers coming from elsewhere in the world, surely it’s better for those workers to be broadly sympathetic to the values of democracy and freedom that are regarded so highly in the US and Europe.
That sympathy is likely to be far greater if the developed world not only recognizes its dependency on youthful workers elsewhere in the world but is also happy to welcome those workers across its own borders.
Those workers, in turn, are likely to end up earning more than they might do had they stayed at home, providing a stream of remittances to help alleviate poverty in poorer parts of the world.
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There are, admittedly, weaknesses in any approach.
Higher spending on healthcare in the developed world may take doctors and nurses away from needier patients in poorer parts of the world.
Despite the evidence from the World Bank, indigenous populations tend to be suspicious of foreigners and, often wrongly, blame new arrivals for job losses, crime and so on.
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Social-security safety nets are much more supportive now than they were in the nineteenth century; some immigrants, therefore, may be tempted to head to countries where they can, in effect, live on the efforts of indigenous taxpayers.
And, unless immigrants intend not only to stay in their
new country but also to have their own families, any increase in the population of working age may prove to be only temporary: immigrants, after all, will also eventually retire.

These are all valid arguments.
Yet the big-picture effects of the 1965 Immigration and Naturalization Act appear to have been generally beneficial: the US may have an ageing population, but the time-bomb is nothing like as worrying as is the case in Japan and in many European nations.

The main obstacle to immigration is, of course, a heady mix of nationalism and xenophobia, which has blighted the international mobility of people on and off for centuries.
This has not yet gone away.
In June 2009, L’Oréal, the French cosmetics company, and Adecco, a temporary recruitment agency, were found guilty of racial discrimination by the Cour de Cassation, the French equivalent of the US Supreme Court, with regard to their hiring of a sales team to promote Fructis Style, a shampoo.
Whereas 38.7 per cent of applicants were from ethnic minorities, of those offered a job fewer than 5 per cent were non-white.
Perhaps L’Oréal thought they weren’t worth it.

The developed world may be increasingly dependent on people from the emerging world and even poorer countries, but it’s facing huge challenges coming to terms with this new reality.
The choice, though, is stark.
Either people work for longer – either more hours per week or more years per lifetime – or borders are made more porous.
The nation state was very much an invention of the late nineteenth and twentieth centuries.
The concept now desperately needs an overhaul.

Time and again, I have returned to the key issue of cross-border capital flows, whether to explain the growing instability of financial markets (Chapter 4) or the rise of state capitalism (Chapter 7).
Indeed, these two themes are connected.
After all, the huge expansion of cross-border capital flows alongside the proliferation of nation states have become the defining features of modern-day globalization.
The stock of foreign investment, which stood at an already high 20 per cent of global GDP in 1980, rose dramatically to over 100 per cent of global GDP twenty years later, a huge increase that dwarfs anything achieved in the heyday of nineteenth-century globalization.
Meanwhile, the number of sovereign states, each with their own legal and regulatory structures, their ever-increasing public-spending commitments and, in many cases, their own currencies, has more than doubled since the late nineteenth century.

For those who believe markets can solve everything, the rise of cross-border capital flows is a remarkable result.
The national constraints on capital movements that dominated much of the twentieth century have been removed.
In their place, investors have been served a smorgasbord of investment opportunities.
Balance of payments surpluses and deficits have ended up much bigger, not necessarily because countries have been pursuing foolish domestic policies, but, instead, because capital has been able to travel in an increasingly unconstrained fashion across borders, eking out the highest returns for the benefit of both savers and borrowers.

The creation of an apparently unconstrained global capital market is, nevertheless, something of an oddity, sitting uneasily with the proliferation of nation states.
If both creditors and debtors reside within one nation, it’s relatively easy to see how the political process could deliver a resolution in the light of, for example, rising default risk.
If, however, creditors and debtors reside in different nations, and include sovereign actors among their number, it’s much harder to achieve a meeting of minds.
Indeed, the lack of any coherent international approach to capital markets is both a source of potential short-term volatility within capital markets themselves – as argued in Chapter 4 – and a long-term threat to the international economic, financial and political order.
That long-term threat stems from three factors: a single global capital market; the participation within that market of an increasing number of sovereign nations as opposed to commercial investors; and the dominance of the dollar on the foreign exchanges.

To understand why, we have to think about a ‘perfect world’ where distortions to capital markets are minimized.
In this world, there would be a single currency issued by a single central bank that would take into account global economic and financial developments and not be swayed by local or regional peculiarities in its pursuit of price stability.
The capital market would be made up of many players,
none of whom would be large enough to distort prices.
All players would, therefore, have to accept the prevailing price: they would all be ‘price takers’.
Those people investing funds would be doing so purely on the basis of risk and reward, with no consideration given to alternative rent-seeking or political aims.
With one currency, there would be no debate over currency manipulation through the accumulation of foreign-exchange reserves.
Meanwhile, those choosing to borrow would do so knowing the money would have to be repaid in full, with interest, and that failure to do so would result in the ignominy of default, possible loss of access to capital markets for years to come and, perhaps, the threat of incarceration in the nearest prison.

This, of course, is a fantasy world to be found only in textbooks.
The real world is much more complicated.
There is more than one currency.
Some currencies are more ‘liquid’ than others.
Put simply, people are generally happier to transact their international affairs in US dollars than, say, the Mongolian tögrög.
Many countries have yet to establish any real sense of monetary and financial credibility.
As noted in Chapters 4 and 5, their leaders end up choosing to shadow popular, liquid currencies like the US dollar or, more recently, the euro.
Changes in US or Eurozone monetary policy therefore have an impact which spreads well beyond national or regional borders.
The world’s big lenders increasingly are made up of public-sector entities in the emerging world and, of the world’s biggest borrowers, the US government is the neediest by far.
The legal rules of the game vary hugely from one country to the next.
It’s very difficult, therefore, to argue that international capital markets are really markets in the textbook sense.
There are all sorts of incentives for governments to behave badly and, thus, for markets to malfunction.

I am not trying to imply that capital markets are powerless to exert any influence on government behaviour.
That clearly is not the case.
Rather, I’m suggesting that governments exert a series of distorting
influences on capital markets.
Governments either pursue their own agendas or, through revolution,
coup d’état
, invasion or the democratic process, are forced to listen to the will of their, or their neighbours’, people.
Those views may not easily gel with the interests of, say, a government’s international creditors.
Indeed, why should they?

In Chapter 8, I referred briefly to the rising costs in the developed world of pensions and healthcare.
It’s now time to think about the possible long-term consequences for taxpayers, government popularity and the vulnerability of foreign creditors of these growing burdens.

In an insightful paper published in 2003, Jagadeesh Gohkale and Kent Smetters produced deeply disturbing calculations regarding the future tax liability of the American people.
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Their starting point was to think about future federal spending from the perspective of the long-term payment obligations associated with social security and Medicare.
By doing so, they were able to calculate the likely changes in fiscal policy required to make the budgetary numbers add up over time.
They offered a series of bleak policy options: a doubling of the tax on US payrolls,
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an increase of two-thirds in income tax revenues or the permanent elimination of all future federal discretionary spending: no new roads, no new schools and no new bombs.

Since that paper was written, the fiscal situation has rapidly deteriorated on both sides of the Atlantic.
As populations have aged, so governments should have been running fiscal surpluses, thereby saving for their nations’ futures.
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Governments chose otherwise.
In the first decade of the twenty-first century, the US and UK governments, in particular, allowed their budget deficits to rise even before the sub-prime crisis took hold.
Following the crisis, deficits rose to hitherto unimaginable levels, advancing into double digits as a share of national output in both the US and the UK,
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with associated huge
increases in government debt.
To put these numbers into context, never before in peacetime has either the US or UK government had to borrow so much.
The tax and discretionary spending implications of these fiscal positions are potentially alarming.

But for whom?
There is an obvious conflict between the interests of, first, the current domestic taxpayer (or current voter), second, the future domestic taxpayer and, third, foreign creditors.
If a country has been living beyond its means for too long, and current taxpayers are unwilling to pick up the bill for their past indiscretions – or, indeed, for their future healthcare and medical ‘rights’ – the obvious options are either to rob future generations by deferring tax payments to them or to default to a nation’s creditors.
If those creditors live abroad, the default option is particularly enticing.

The thinking behind emerging-nation purchases of US government paper (in effect, IOUs) has already been explained in earlier chapters.
While each of the reasons – protection against capital flight, links to Federal Reserve monetary credibility, mercantilist trade policies, Ricardian comparative advantage – may stem from short-term clear-thinking, the longer-term consequences of these policies are less encouraging.
Partly, this reflects a ‘merry-go-round’ effect.
The more US government and quasi-government paper is purchased by emerging nations, the more the price of this paper comes to depend on emerging-nation beneficence.
Should a major emerging nation then attempt to sell any of this paper, the signal to the rest of the market would be, to say the least, discouraging.
The price of US government paper might collapse in response, leading to much higher American interest rates and huge losses for holders of US paper around the world.
To avoid this, emerging nations feel compelled to buy more and more pieces of US paper even though their ultimate exposure to US problems becomes greater by the day.
Future US taxpayers may never be able, or willing, to repay their foreign creditors.
In the meantime, the merry-go-round spins faster and faster.

The US appears to have adopted some of the techniques of Catholic priests in mediaeval times, when the sale of indulgences became a lucrative money-raising operation for the construction of cathedrals and churches and the funding of crusades (given the ultimate dependence of the US military machine on foreign creditors, George W.
Bush’s post 9/11 crusade gaffe as he prepared the world for the Second Gulf War and the war in Afghanistan was historically rather accurate).
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Indulgences offered the promise of salvation in exchange for a contribution to whichever pet project the priest wanted to support.
Priests became bond salesmen for the hereafter.
Trading indulgences was, of course, partly an act of faith, but it was also, for a while, a very useful way for the Catholic Church to raise money and, thus, increase its power.
Eventually, in 1517, Martin Luther came along with his Ninety-Five Theses, and, allegedly, nailed them to the church door, thus sparking the Protestant Reformation.
As Abraham Lincoln said, ‘you cannot fool all the people all the time’.

Whereas indulgences were supposedly repaid in the hereafter, the time frame for repayment of US government debt is a little shorter.
Nevertheless, the act of faith is still there.
Investors elsewhere in the world choose to own US assets because they believe the US has a strong rule of law, excellent protection of investors’ rights and a central bank determined to keep inflation under control.
They also believe that other investors have the same beliefs: in that sense, each investor benefits from an act of ‘groupthink’ faith.
However, at some point, the merry-go-round may spin out of control, threatening a major financial disaster.
Can this be avoided?
If so, who picks up the cost of bringing the merry-go-round to a halt?
Will there be a financial equivalent of a Protestant Reformation?

The issue at stake is America’s reserve currency status.
On a variety of different measures – foreign-exchange transactions, depth and liquidity of financial markets, the rule of law – the US dollar scores very favourably.
Everyone is happy to hold dollars.
This, in turn, makes it very easy for the US to raise funds in international capital markets.
Many countries – notably emerging economies – have to transact with the rest of the world in foreign currencies.
It’s an expensive business.
They have to export and import in dollars, not their own currencies.
They have to borrow in dollars and not in their own currencies (although this is now beginning to change).
That leaves them cruelly exposed to speculative attack.
Should their currencies fall in value, the burden of their own dollar-denominated debt rises in domestic currency terms, thereby increasing default risk and triggering a vicious circle.
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The US, in contrast, has none of these worries.
It’s a key reason why the US is easily able to run a persistent balance of payments current-account deficit while many emerging nations choose to run protective surpluses.

This is an unstable, asymmetric, relationship.
It cannot easily continue.
The US extracts too many benefits and the rest of the world ends up with most of the costs.
But what can other countries do about it?
It’s not possible to create a new reserve currency overnight.
Trying to conduct transactions in an alternative currency that is not universally acceptable is no easy business.
It’s like trying to challenge Microsoft’s supremacy in computer software.
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Yet the dollar’s supremacy may be on the wane.
The threat comes not so much from the rise of the euro, even though it, too, now offers deep and liquid currency markets, but, rather, from countries within the emerging world.
Speaking at the World Economic Forum in Davos on 28 January 2009, Vladimir Putin, prime minister of Russia, said: