LOSING CONTROL (26 page)

If 1492 marked a seismic geopolitical shock, 1519 arguably marked the beginnings of a seismic economic shock.
In February of that year, Hernando Cortés landed in the Yucatan peninsular in Mayan territory (in what is modern-day Mexico) with eleven ships, five hundred men, thirteen horses and assorted cannon.
In time, he and his fellow conquistadors destroyed the Aztec, Inca and Mayan civilizations
through a mixture of supreme violence, noxious pathogens and naked greed.
Cortés’ ambition was nicely focused.
It wasn’t long before the conquistadors discovered silver in huge quantities (notably at the Andean ‘silver mountain’ of Potosí, in modern-day Bolivia).
They had uncovered a printing press for the sixteenth century’s version of a reserve currency.
Everyone wanted silver.
The Spanish had more of this precious metal than they could possibly imagine.
Faced with a choice between spending and investing, they chose the former.
With so much silver, they could pay others to do all the hard work.
Not all Spaniards lived a life of luxury – it was no fun being on the wrong side of the Inquisition – but those who could, did.

They imported high-quality consumer goods from elsewhere in Europe.
The hardest-working people in Spain itself were a mixture of foreigners (particularly the French) and despised local minorities, most obviously Jews and Muslims.
The Spanish forgot how to struggle.
They became increasingly dependent on the efforts of other nations.
And, as those nations made more effort, they began to challenge the earlier Spanish economic and military supremacy.
While bad weather is a convenient excuse for the Spanish Armada’s failure in 1588, in reality Spanish defeat owed much to the superior shipbuilding skills the English had acquired over the previous fifty years.
Silver made sixteenth-century Spain wealthy, but it confined the Spanish nation to relative poverty in the centuries that followed.
Whereas other nations expanded their economic horizons, in some cases through an unholy alliance between sugar and slavery, the Spanish happily lived off their precious metal while fighting wasteful wars.

There is no doubt that the arrival of huge quantities of silver fuelled global trade in the sixteenth century, in much the same way that huge quantities of dollars have helped fuel world trade since the end of the Second World War.
Silver spread from west to east, across the Atlantic to Europe, overland to the Levant and beyond and around the African
Cape to India, Indonesia and other, to European eyes, exotic locations.
Spices, silks and cottons came back the other way.
Silver also headed west, across the Pacific to Manila in the Philippines.
It then went onwards to China, where high demand for silver reflected the collapse of the paper currency system of the Ming Dynasty (a case of good money driving out bad).
In fact, rising silver supplies had different effects in different parts of the world.
In Europe, the increase in the supply of silver led to a decline in its price and, hence, an increase in inflation.
In China, the increase in the supply of silver was a response to rising demand – reflecting the monetary failures of the Ming Dynasty – and left no imprint on inflation.

Increased silver supplies were thus abused by the Spanish, a source of inflation elsewhere in Europe and a welcome financial lubricant in China and other parts of Asia.
They were instrumental in creating a sixteenth- and seventeenth-century world of outsourcing and off-shoring where, for a while, the Spanish were able to live on the efforts of others.
But the Spanish ultimately lost out.

There is no particular reason why such distant history should repeat itself.
The US is a highly productive economy where there is no shortage of work ethic.
Nevertheless, like the Spanish of the sixteenth century, Americans have lived beyond their considerable means, taking full advantage of the rest of the world’s willingness to hold dollars, in much the same way that the Spanish benefited from the rest of the world’s enthusiasm for silver.
Should that willingness begin to fade, the US will no longer be able to conduct trade, or access the world’s capital, on the favourable terms it has enjoyed particularly since the end of the Second World War.
As already noted, the appetite for dollars may already be fading.
Will the US economy also fade?

The answer is partly out of America’s hands.
Yes, heightened immigration could make a difference by providing more taxpayers to fund the elderly.
Yes, successive governments could find ways to
raise taxes (if the US ever becomes really serious about climate change, it could raise taxes on energy by a substantial amount) to pay for the elderly and infirm.
Yes, wishful thinking in favour of another productivity miracle might eventually come true.
Yes, households could repay sack-loads of debt, thereby allowing a permanent reduction in the US balance of payments current- account deficit and even, perhaps, a move into surplus to replicate the nineteenth-century British model.
If all these were achieved, then the dollar might retain its reserve-currency status.
My impression, though, is that the rest of the world – at least those parts with a penchant for state capitalism – is fast running out of patience and, importantly, able to survive without having to depend on the US consumer.

The dollar’s reserve-currency status has given Americans an unfair claim on global resources.
For a while, the rest of the world was willing to tolerate this unfair claim.
After all, other countries didn’t go away empty-handed.
They were able to trade internationally in a currency that was better than their own.
Strong American domestic demand gave those countries with a mercantilist bent an extremely attractive export market.
In time, other countries became increasingly skilled in producing goods for a hyper-competitive US market.
It is often forgotten that, in the 1970s, few goods destined for the American market were ‘made in China’.
Yet the system has worked only through rising foreign claims on future US taxpayers.
In a world where other countries have been growing more quickly than the US, that aspect of the arithmetic has never really seemed to add up.
It was, and remains, an unstable situation.

If political leaders in the emerging world have their way, the dollar’s reserve-currency status will slowly dwindle.
Trade and capital flows will increasingly take place within the emerging world, creating room for other currencies to play the role hitherto performed by the US dollar alone.
The process will lead to significant costs for the US.
As the dollar declines in value, so oil and other commodity prices will rise for Americans.
America’s ability to access global capital will deteriorate, leading to higher interest rates.
A higher cost of capital, in turn, will squeeze American demand and place limits on the size of the capital stock.
The long-term growth rate will fall away, making the fiscal situation an even bigger headache than it is today.

America’s position in the world economic order is, thus, under threat.
Indeed, the Western world as a whole is increasingly vulnerable to the economic revolution taking place within the emerging world.
How the Western nations react to this threat is the subject of Chapter 10.

For the Western world, major challenges lie ahead.
Economic life is increasingly unpredictable and (dare I say it) unfair.
Markets cannot easily resolve the key issues – economic instability, income inequality, state capitalism, demographic change – that are now confronting policymakers in both the Western and emerging nations.
The choices open to nations vary, however.
In this chapter, I spell out some of the good, bad and downright ugly options open to Western policymakers.
We are, I believe, living in a highly unstable world where Western policymakers will be tempted to choose options that, while offering short-term political advantages, could be destructive for globalization and, ultimately, destructive for Western prosperity.
We have reached a point where the Western world has to recognize and accept its growing dependence on economic and political ties with the emerging world.
For the West to reject these ties would ultimately be damaging not just for the emerging nations but for the West as well.

My concern is a return of the complacency exhibited by Keynes’s fictional English gentleman, a man I first introduced in Chapter 2.
Here was an individual who failed to see how the political and economic landscape was beginning to change at the beginning of the twentieth century.
It wouldn’t take much for the gains of the late twentieth century, like those of the late nineteenth century, to evaporate.
Our policymakers could just as easily be sleepwalking into another crisis.

There are, of course, plenty of people willing to defend the West’s economic superiority.
They do so in a number of different ways.
For the religious, the West’s superiority represents the triumph of Christian values, a view which might be shared, at least in private, by George W.
Bush and Tony Blair.
For libertarians, the West’s superiority represents a triumph of political freedoms.
Freedom of speech, freedom of association and the spread of liberal democracies were instrumental in creating a climate conducive to scientific investigation and associated technological breakthroughs, even though many of those freedoms either occurred too early (the Magna Carta in 1215) or too late (Switzerland finally got around to giving women the vote in 1971) to explain satisfactorily the West’s progress.
For free-marketeers, the growth of legal systems that created and protected property rights allowed people to enter into binding contracts which, in turn, allowed the invisible hand to do its work (even though the state plays a much bigger role in the allocation of resources in the developed world than it did at the end of the nineteenth century).
And there are those who embrace the supposed benefits of the post-industrial ‘knowledge economy’.
For example, in
The Writing on the Wall
Will Hutton says:

There is something rather theological about this approach, in part because it is so intangible.
It encapsulates the idea that the West will continue to outperform because (i) it has done so in the past; (ii) its social arrangements are more ‘advanced’ than in countries elsewhere; and (iii) liberal democracy has triumphed over all other systems.
It’s easy to imagine nineteenth-century missionaries proselytizing with similar, albeit more religious, zeal, guiding the peoples of other nations to the one true path.

These arguments, however, don’t sit very easily with the history of the twentieth century.
Should the First and Second World Wars be described as triumphs of Enlightenment thinking?
Should the Great Depression be described as a victory for market forces?
Should the credit crunch of 2007/8 be described as a success for soft knowledge?
And should Asia’s relentless rise over the last sixty years – the greatest economic expansion of all time – be simply described as a multi-decade credit-fuelled flash-in-the-pan, a wealth-creating machine that will ultimately be brought to its heels by crony capitalism and silly bank lending?

That, after all, is the argument.
The claim that Asia and, indeed, other emerging economies offer no real threat to Western economic superiority strikes me, however, as absurd, for the reasons outlined in this book.
Those who take comfort in the idea of the West’s destiny point to Japan’s stagnation since the 1990s, arguing that while Japan successfully caught up with the US and Western Europe economically, it never surpassed them, despite projections to the contrary.
Indeed, in the effort to do so, it stagnated.
As noted in
Chapter 3, however, Japan’s lost decades should be seen not as a relative triumph for Western economic systems but, instead, as a sign of what may lie ahead for the developed world as a whole.

For me, the issue for the developed world is not so much that China will fail because it refuses to embrace Enlightenment values, or that Russia will collapse because it isn’t behaving in the liberal democratic tradition.
Rather, the threat is home-grown.
Will the rise of the emerging nations lead the developed world to reject its current liberal values, particularly in the international arena?
And what sort of dystopian world might then emerge?

The triumph of the second half of the twentieth century was, ultimately, the degree to which the world economy opened up to allow wealth to spread much more widely.
In the first half of the twenty-first century, it’s easy to imagine the reverse.
For Western commentators, seduced by the superiority of the Western model, it’s the emerging economies that are most likely to shut up shop.
In Beijing’s case, the threat is a repeat of the 1400s, not through the destruction of China’s ocean-going fleet but, instead, through the obliteration of new forms of communication such as the Internet in an attempt to preserve the political status quo.
In Moscow’s case, the failure fully to embrace liberal democracy by, for example, limiting press freedoms will leave the Russian economy facing years as a one-trick energy pony, seemingly condemned to wax and wane on the basis of movements in global energy prices and unable to diversify into other areas.
If openness matters, these countries are apparently in trouble.

But wait.
These countries are still benefiting from openness in other ways.
They increasingly trade with the developed world.
They increasingly trade with each other.
Mutual trade within the emerging world is a supreme example of Ricardian comparative advantage – China with its manufacturing skills, India with its new software technologies, Brazil and Russia with their various raw materials.
They are signing
bilateral deals with each other.
What we’re beginning to see, in fact, is the creation of a new, global Silk Road linking emerging nations in Asia, the Middle East, Eastern Europe, Africa and Latin America via land, sea and the electronic ether.
It is a new, major and incredibly important artery linking the nations of the emerging world.
There may ultimately be political constraints on economic progress, but it’s doubtful that those constraints are going to be triggered in the near future: instead, we are witnessing the creation of new emerging economic synapses that will enable non-liberal democratic political regimes to survive more easily.

The biggest threat to economic openness comes less from the emerging nations – who are beginning to enjoy their time in the economic sun – and more from the West.
The US and Europe will need to come to terms with their diminished role in the world economy.
No longer will their economies determine the price of raw materials.
Their workers will be unable to determine the market price for their labour.
Their people will not be able to pursue so easily the rent-seeking agendas that allowed returns on all factors of production in the US and Europe to rise far beyond those seen elsewhere in the world.
Their pensioners will not be able to look forward to a guaranteed real income.
And they will no longer so easily be able to manage their economic destinies.

How will policymakers come to terms with the West’s diminished status?
The policy options available are, I believe, a mixture of the good, bad and ugly.

Many words in this book have been devoted to problems associated with inflation and capital markets, notably the arbitrary redistribution of income and wealth both within and between nations.
These problems stem in part from a lack of proper regional or global
institutions designed to cope with the twin, but conflicting, desires of monetary sovereignty and free cross-border capital flows.

The easy answer for those who wish to satisfy both desires is to have a world of flexible exchange rates.
I argued in Chapter 5, however, that this is not always a workable option, as demonstrated through my fictitious account of the monetary problems associated with Lilliput and Blefuscu.
In any case, there is something very strange about the call for many separate currencies.
The more currencies there are, the less likely it is that the world will continue to enjoy the benefits of a single capital market.
Frequent currency crises have become part and parcel of modern international financial shocks, leading to huge volatility in economic activity and inflation.

Policymakers have to stop the pretence and confront head-on the conflict between a single global capital market and the proliferation of nation states, many of which have their own currencies.
Either nations can attempt to hang on to their financial sovereignty by reintroducing capital controls or, instead, new institutions need to be developed which can pool financial sovereignty effectively.

The idea of dampening down capital markets through capital controls has a long and rich history and was, of course, part of the post-war international financial consensus: if countries wanted to control simultaneously their exchange rates and their domestic inflation rates, they had no choice but to regulate capital inflows and outflows.
As that consensus began to unravel in the 1970s with the failure of the Bretton Woods system of fixed but adjustable exchange rates, countries slowly moved away from capital controls to the world we’re now living in.
In a world of constant financial innovation, it became increasingly difficult to impose capital controls successfully.
Moreover, capital controls allowed countries to pursue bad domestic policies for too long, ultimately to their own detriment.

Nevertheless, the abolition of capital controls has hardly been plain sailing.
Some economists foresaw the problems associated with newly liberalized capital markets.
James Tobin (1918–2002), for example, suggested in 1972 a (now-eponymous) tax – to be paid on foreign-exchange transactions – to limit speculative cross-border capital flows.
He feared that the failures of Bretton Woods would be replaced by anarchy in the capital markets.
On occasion, he was proved right.

Enthusiasm for some kind of capital control has recently returned (as I wrote this book, capital controls were making a comeback: Brazil and Taiwan, for example, introduced capital controls in November 2009).
In the light of the 2007/8 credit crunch, central banks began to argue the need for two separate policy instruments: short-term interest rates to control inflation and some kind of ‘macro-prudential’ policy to limit the impact of unstable capital inflows on domestic bank lending.
In the macro-prudential world, banks would be forced to put aside extra savings in the form of higher levels of capital during the years of cross-border lending feast as an insurance against the famine that was likely to follow.
In other words, there would be an attempt to limit the domestic implications of cross-border capital flows by imposing the equivalent of a variable tax on the banking system.

At the global level, however, these kinds of reforms seem rather messy.
If one country alone imposes them, that country might end up with some protection against the volatility induced by currency speculation, for example.
In the UK’s case, a policy to force banks to raise their capital ratios during cross-border lending booms might limit the extent of speculation in the domestic housing market.
If, however, all countries went down this path, it’s difficult to see anything other than the financial equivalent of the primordial soup
developing: at the very least, cross-border flows of capital would drop and many countries might find themselves cut off from international capital markets altogether; indeed, the world might descend into capital market protectionism, a mirror-image of the infamous Smoot–Hawley trade tariff, enacted by US Congress in 1930.
Whatever the problems associated with the disruptive effects of capital flows, it’s difficult to avoid the broader conclusion that their huge increase since the 1970s has been instrumental in raising living standards in many parts of the world.
As I have reiterated throughout this book, openness matters.