The Decline

Consider the never-ending narrative of American decline. My historical knowledge isn't super-deep, but I know for certain that that drum has been kicked at least since Sputnik ('50s), continuing through the Vietnam War ('60s), the closing of the gold window and the oil embargo/stagflation ('70s), the rise of Japan ('80s), European integration ('90s), and now the rise of the BRICs, especially China. During this entire period critics of the U.S. have focused on its sclerotic political system and messy "laissez-faire" capitalism (ha!), which was clearly inferior to the svelte technocratic industrial policies of the USSR OPEC Japan NICs E.U. China. The U.S. is becoming more and more irrelevant, I keep hearing. The quick rebound of China, Brazil, and Germany is proof that the world is decoupling from the U.S. The world is becoming more multipolar, the U.S. needs to learn how to shift into obsolescence and be just another state among states.

And yet when the U.S. announces that it is going to reduce some of the maturity of its sovereign debt in order to boost domestic demand -- an equivalent action to normal monetary policy operations, except on 5-year T-bills rather than shorter maturities, at a time when markets expect deflation (see graph above) -- the world goes ballistic. Huh? If the U.S. was as vulnerable as folks make it out to be, and the rest as powerful and resilient, this shouldn't even register. Instead the Chinese complain about "currency manipulation" as if QE2 wasn't a demand-side domestic monetary policy. Brazil complains about capital inflows creating bubbles, and institutes capital controls to counteract them, as if protecting local capital owners and commodity exporters in one of the most inegalitarian countries on earth had nothing to do with it. Japan enacts its own QE, and South Korea is pushing for, er, something to deal with exchange rates at the upcoming G20 meeting it hosts. The entire industrialized world is concerned that a relatively small program in the U.S. is going to threaten their entire economies.

(Either that or they're using it as cover to justify policies that they wish to enact anyway. I actually think this is more likely, since they can always continue to devalue against the dollar without retribution if they wish, and anything that boosts American demand is good for Chinese, Japanese, Brazilian, and South Korean exporters. But I don't know that for certain; maybe these leaders really are freaked out.)

Of course all of this follows a financial crisis that originated in the U.S. but was not contained within it. Forgive me for thinking that at this point the importance of the U.S. to the global economy almost cannot be overstated. At this point I wouldn't be terribly surprised if the replacement of Bretton Woods II is a variant of Bretton Woods I. The U.S. needs to recognize its place in the world, and act like a hegemon should. There's not chance the G-20 is capable of doing it.

So far I think we've done a reasonably good job -- the trading system has remained intact, warnings of competitive currency depreciations have been all smoke and no fire, countercyclical lending has gotten to states (like Greece) that have needed it, international institutions have held together remarkably well -- but we can do even better. Now is the time to finish the Korea FTA and give fast-track negotiating authority to Obama. Doha isn't going anywhere right now, but in a few years time there could be a window for movement, and it would be good to have the tracks laid ahead of time. Now is the time to let other countries devalue against the dollar if they need to, while still pursuing policies that will boost domestic demand, including demand for imports. Yes that hurt employment in tradable sectors, but mostly in the sort of less-skilled manufacturing that will not yield new jobs anyway. In the meantime, it will boost employment in importing sectors, and provide low-cost goods for struggling households. I wish it were possible to push for immigration reform too, since it's the time for that as well, but I'm pretty sure the sort of immigration reform we'd be likely to see right now isn't the sort I'd support.

Now is emphatically not the time to "get tough" with other countries that also pursue policies in their domestic interest, even if they have some short-run negative consequences for the U.S. There is a lot of low-hanging positive-sum fruit hanging out there. There's no need to take an axe to the trunk.

After all, if the Federal Reserve can't get the U.S. economy moving, the Bank of Japan won't be able to either.

The U.S. should not set policy out of fear of decline.

The Return of the "Decoupling" Myth

Given the carnage that has spread across the developing world as a result of the economic crisis that originated in the U.S. and Europe, it would seem to be a strange time to resuscitate talk of "decoupling". The term refers to the ability of states in the developing world to grow their economies independent of business cycles in the developed world. And yet, according to this FT report, the idea is coming back in vogue:

Yet decoupling – which was so popular as an idea at the end of 2007 and early 2008, as many of the emerging markets continued to rally in spite of the credit crisis – is gaining traction once again.

The main cheerleader is Jim O’Neill, chief economist of Goldman Sachs and the inventor of the Bric acronymn for the world’s four biggest emerging markets of Brazil, Russia, India and China in 2001.

Mr O’Neill says there is “considerable decoupling going on” as investors switch to emerging market assets as they reckon many of these economies can grow more strongly than the developed world.

He thinks China, in particular, can lead the world out of its slump – as it relies increasingly on domestic demand rather than on exports in order to grow.

Now a statement of opinion from a Goldman Sachs analyst should always be taken with a grain of salt. But more interesting than the source is the claim the source makes: is China coping with the global crisis by boosting domestic demand? It doesn't appear so. But China's decision to stimulate the economy through infrastructure investment and stockpiling of commodities (as a hedge against price inflation when global demand recovers) has given a boost to commodity-exporting nations. From the FT article:

Optimism about Chinese growth has led directly to a revival in commodities markets. Dalinc Ariburnu, global head of emerging markets at Deutsche Bank, says: “There is no question that emerging markets are benefiting disproportionately from the surge in commodities, given that earnings of commodity firms account for close to 50 per cent of overall earnings in the emerging market economies.”

Emerging equity funds have seen inflows of $10.5bn since the Chinese stimulus package, according to EPFR Global, the data provider. That compares with an outflow of $46.73bn in developed equity funds.

This does not signal that developing countries are winding down their dependence on demand for their exports from MDCs, since China's increased orders of commodities used as inputs for production anticipate a strengthening of future demand for the exports from the developed world. For developing countries to decouple, they would have to break from an export-led growth model to one that emphasizes domestic demand. So far none of the BRIC countries, much less poorer commodity exporters, have managed to do this. In fact, none of them have even attempted such a shift. Markets remain highly integrated, and a collapse in one state will set off a domino effect that affects the entire system. This is especially true when it is the core economies that falter. So let's drop the talk of decoupling, and instead focus on dealing with the side effects of integration, which is the real concern.

What A Difference a Decade Makes

Last week, I wrote this:

We should also expand the role and capabilities of the IMF, just in case it becomes necessary to bailout a fairly large country (e.g. Great Britain?).

Today, we learn that Japan has agreed to loan $100bn to the IMF, and the Fund is also considering issuing bonds for the first time in its history. This sudden need for extra cash has not arisen because the Fund is short, but because it expects to be dealing with bigger problems in the future than it has in the past:

The IMF isn't in danger of running out of money, said deputy managing director John Lipsky, though the fund has made commitments to lend about $50 billion in recent months to Pakistan, Iceland and a clutch of Eastern European countries, and is talking to others.

But the organization has wanted for months to double its lending ability to about $500 billion from $250 billion, to bolster confidence that it could handle other borrowers amid the crisis.

Asked whether Western European countries, outside tiny Iceland, might turn to the IMF for loans if the crisis worsens, Mr. Lipsky said, "in the current circumstances, the right approach is 'never say never.'" The IMF's executive board is expected to discuss potential new sources of funding next month.

10 years ago, in the wake of the Asian Financial Crisis, Japan tried to establish the Asian Monetary Fund to directly compete with the IMF by providing loans to needy Asian countries with fewer strings attached. The effort was scuttled by the US, but many observers saw that moment as the beginning of the end of IMF relevance. Now, Japan is the one shoring up the IMF so it will have the resources to stabilize more and larger countries (presumably, so those countries will be in a position to buy Japanese export goods). The fact that the IMF is looking for hundreds of billions more funding is a bad sign; it indicates to me that the IMF has updated its beliefs and now thinks it might have to step in and bail out a major economy. In any case, the IMF is making a push for renewed influence, and nobody seems to be stepping in their way.

Once again, it appears that the New Economic Order is gonna look a lot like the Old Economic Order.

UPDATE: Emmanuel pointed out in the comments that this is somewhat old news (from mid-November). I missed it the first time around, and apparently the Wall Street Journal did as well.

Foggy Thoughts on Decoupling

Daniel Drezner on the "known unknowns" of the impact of the financial crisis on international relations:

The tight coupling of the global economy caused export-dependent economies to face significant downturns because of the collapse in demand from the OECD nations. These governments will respond to the current crisis by creating the trade equivalent of currency reserves - that is to say, creating a protected space of demand for national champions. The most direct way to do this will be to boost domestic demand while restricting competition from foreign producers. As states plan to expand their fiscal policy, it should be relatively easy - via procurement rules and concentrating expenditures on non-tradable goods - to target new government spending towards domestic firms.

This kind of decoupling would contribute to the unwinding of the macroeconomic imbalances caused by the Bretton Woods II arrangements. It would also, however, be sure to reduce overall economic growth even further. It would also reduce whatever constraints economic interdependence has placed on aggressive action in world politics.

This is, essentially, what Emmanuel and I have been arguing about. He sees decoupling-through-protectionism as a net positive because it would correct imbalances. I see it as a net negative because it seems sure to reduce overall economic growth. In any case, I don't see that decoupling is inevitable, or even especially likely. It certainly has not occurred to this point in the crisis.

I also remain skeptical that it is "obvious," as Drezner says, that the free market model is in peril and that China will benefit (in relative terms) from the financial crisis. I keep hearing that mantra a lot, but I've to hear a strong, persuasive theoretical case as to how (or even why) this shift will occur. As far as I can tell, the new economic order looks a lot like the old economic order: the international community (esp. Europe) waits for the U.S. to make the first move, the old international institutions (e.g. IMF) get back some of the importance they'd lost in the wake of the Asian financial crisis, the global recession knocks down the petrostates by a peg or two, and China steps back a bit to focus on domestic pressures. Most commentators agree on these points even as they say that the old economic order is over, and the new economic order will be massively different. When asked about details of the new order, or the mechanism by which the world economy will move to it, they generally "don't have the foggiest idea" despite being certain of the inevitability of the shift.

Emmanuel may be correct in saying that the only way to get the needed adjustment is through renewed protectionism; Drezner may be correct in saying that renewed protectionism is somewhat likely, but not profitable; Rodrik may be right that a new world economic order is inevitable. All these things remain to be seen. But for my money, the new economic order is going to look a lot like the old economic order, and the needed structural adjustments will come in spite of, not because of, targeted government interventions into the economy. I'll try to say more about that last point later.

Remember When Europe Was Going to Lead the Way?

Germany refuses to enact stimulus until after Obama is elected:

Germany will wait to launch its next fiscal stimulus until it has a clearer view of the economic plan of Barack Obama, who is to be sworn in as US president on January 20, say German officials.

Michael Glos, economy minister, said – after a meeting of government officials and business leaders on Sunday night – the government would decide late next month whether to adopt more measures to stimulate the economy, Reuters reported.

That would mean Berlin would not top up its €12bn ($16bn, £10.7bn) growth-boosting package at an extraordinary meeting of leaders of the governing coalition on January 5, as many economists and international leaders had hoped.

“We will probably know what Obama is going to sign before January 20 but I would be surprised if any decision were made on January 5,” said an official before the meeting.

All indications are that Obama plans to enact a large-scale spending program -- probably in between $700bn and $1,000bn -- to boost economic activity in the short run while improving infrastructure in the medium run. The fact that Germany refuses to move until it gets even more specifics signals that America's standing as the leader of the international financial system has not taken such a great hit after all.

Latin America and the Financial Crisis

Many of you are well aware of the popular phrase, "When America sneezes, the rest of the world catches a cold." This was especially true for Latin America, when any small sniffle used to send ripple effects throughout the region. 

However, why is it that this time around, 

not a single bank or financial institution [has gone] bust in the region while the United States and Europe [have] faced [the] collapse of companies and banks with turnover of more than that of the GDP of many of the Latin American countries.

None of the Latin American countries have gone to the IMF for rescue, even as some East Europen countries have done so. While Iceland, situated far from the epicenter (USA) of the financial earthquake collapsed and had to seek rescue from Russia, none of the Latin American countries, which are in the proximity of the earthquake zone have suffered serious damage. There has been no panic summit meetings or rescue packages or nationalization of banks in Latin America.

This is truly a very interesting puzzle. Was the decoupling theory partially right, in that certain regions, rather than the entire world, is no longer completely at the whim of the American business cycle?

From the UN Economic Commission for Latin America comes the finding that:

Compared to previous shocks in the United States economy and the world at large, Latin America and the Caribbean(LAC) is much less vulnerable than in the past, with a current account surplus, sounder public finances, a lower level and better profiles of public and external debt, and larger international financial reserves. Considering the severity of the global shocks, LAC economies are, on average, weathering the crisis significantly better than in the past.

Has Latin America simply insulated itself from external shocks by amassing large amounts of reserves, lowering their debt levels, and implementing sound fiscal and monetary policies? Has the financial crises simply not reached Latin America yet? Has Latin America finally emerged from the Lost Decades (1970-2000)? Over the next few weeks, these are some of the questions I will explore, in a special series on Latin America and the Financial Crisis.