Saturday, July 30, 2011

Book Review (#24 of 2011) The End of Influence

The End of Influence: What Happens When Other Countries Have the Money by Stephen S. Cohen and J. Bradford Delong.
This book would go well with an undergraduate International Macroeconomics course. DeLong and Cohen explain in plain English the national income accounting identity between the U.S. and China -- what Neil Ferguson called "Chimerica." China saves 40% of its national income, the U.S. saves almost nothing. Since China's Savings > Investment, they run a current account surplus, exporting more than they import and purchasing more foreign assets than foreigners purchase of their assets. Investment in the U.S. > Savings so it runs a current account deficit. China lends to the U.S. who in turn buys Chinese products and the process continues.

An estimated 70% of China's $2.5 trillion of reserves is invested in dollar-denominated debt, primarily U.S. Treasuries. China isn't looking to make money on the deal, it loses money, but the accumulation of reserves is necessary to keep its currency and, by extention, goods & services undervalued to a dollar that is steadily depreciating.

The U.S. "enjoys" this position because after World War II, it was the country "with the money," and the dollar has been the world's preferred reserve currency. Since we are the free-market arsenal of democracy, other countries were willing to emulate us and aspire to be like us. But with our affluence came our debt-- developing countries are happy to lend to us and we are happy to import their cheap goods.

The point of the book is that this won't last forever, or much longer:
When you have the money—and “you” are a big, economically and culturally vital nation—you get more than just a higher standard of living for your citizens. You get power and influence, and a much-enhanced ability to act out. When the money drains out, you can maintain the edge in living standards of your citizens for a considerable time (as long as others are willing to hold your growing debt and pile interest payments on top). But you lose power, especially the power to ignore others, quite quickly—though hopefully, in quiet, nonconfrontational ways. And you lose influence—the ability to have your wishes, ideas, and folkways willingly accepted, eagerly copied, and absorbed into daily life by others.

DeLong and Cohen predict the end of neo-liberalism, the worldwide movement of the last 35 years to privatize, deregulate, and loosen barriers to trade and capital movements. The world heeded our neoliberal advice through the 1990s but now watches with cynicism as we practice what we didn't preach:

"When the United States bails out its auto industry, or its banks, or insurers, or airlines—shouldn’t France and Germany do so, too?"

The authors examine the history of the U.S. financial system, in a similar fashion as Johnson and Kwak do in 13 Bankers. From the 1940s to 1970s, we had high income taxes and major restrictions on financial sector activity. Yet, we saw low unemployment and 2.5 percent annual increases in productivity. From the 1970s onward we had lower income taxes and deregulated all sectors of the economy and saw The Great Stagnation-- lower productivity growth. DeLong reminds us that deregulation was championed by those on the Left, like Ted Kennedy and Jimmy Carter:

"Deregulation was, however, a fringe technocratic good-government movement. And it would have in all probability remained a fringe technocratic good-government movement were it not for the macroeconomic breakdown of the 1970s...The failure of the managers of the mixed economy to produce full employment and price stability in the 1970s undermined the whole enterprise—and created the opportunity for the neoliberals to attempt to implement their dream."

The neoliberal enterprise was embraced by those on the center-left as much as those on the far right. The Fed had been soft on inflation in the 1970s, and there were solid arguments for freeing up the private sector from onerous regulation in an increasingly competitive global market. The answer to the central question of whether to make the pie larger or make it more equally distributed became more slanted toward increasing the size of the pie:

"Politicians on the left tended to give a Rawlsian defense that the best way to help the poor was not to punish but to incentivize the rich: Shrinking the regulatory, interventionist, and management role of the states and cutting back on progressive taxes would align the economic incentives of the rich with the social goal of economic growth, and in the end, the relatively poor would wind up better off in a more unequal but much richer society. Politicians on the right tended to regard greater inequality as an absolute virtue: Those at the top of the economic pyramid—because of their smarts, their skills, their enterprise, their industry, their luck, their success at choosing the right parents—deserved a very comfortable life and to be sharply distinguished from their fellow citizens."
The widening income desparities-- the growth in income has been extraordinarily slanted toward upper-incomes has quashed progressive faith in the enterprise.
"The ratio of the top 1 percent (of incomes) to the middle fifth went from 10 to 26 times. What caused the change?"
1. "The top 10 percent (of income) owns 77 percent of all stocks
," and those rose in value. 2. Marginal tax rates on upper-incomes were cut. 3. "Huge, recent waves of unskilled immigrants, legal and illegal, compete for low-wage jobs, pulling down the bottom of the income scale."
4. "Imports and offshoring: The influx of imported goods pushed down employment and pricing power at American manufacturers."
5. The decline of unions.
6. Technology replacing low-skilled workers.
7. Culture: CEO pay, top athlete pay, etc. have grown very disproportionately to everyone else.

The authors then relate the phenomena:
"Is there a connection between rapidly rising inequality, stagnant middle-class earnings, and the collapse of savings in the United States? It is very likely that these trends are all closely linked. Faced with stagnant incomes, seeing themselves falling behind those above them on the income scale, and spending their evenings watching Lifestyles of the Rich and Famous, what did the average American family do?"
The average American family took on debt to keep their lifestyles in line with the increasingly wealthy.
"Between 1966 and 2006, this debt, adjusted for inflation, rose by almost 3,000 percent."

This is the agreed-upon hypothesis for our financial crisis from both DeLong on the Left, and Raghuram Rajan on the Right. The push for homeownership--sponsored by the government--increased the amount of this debt, and the bubble built:
"(T)hough mortgage debt rose from about one-third of GDP in 1990 to over 80 percent now, home equity (the percentage of the house not owed as mortgage debt) fell from two-thirds of GDP in 1990 to one-half of GDP by 2006; it has, infamously, fallen since."
The beneficiary of this movement was the financial sector.
"As manufacturing declined as a percentage of what Americans produced—from 21 percent of GDP in 1980 to 14 percent in 2002, finance grew to fill the gap—exactly! And though just about every think tank and politician issued dire warnings about soaring health-care costs, none came forth with programs, or even warnings, to restrain the growth of finance...Finance was the driving force. It had achieved the cultural dominance that so often goes hand-in-hand with economic dominance: its gigantism and ubiquity, its tonic impact on the entire economy, its fabulous success, the sheer gushing of money, its generous funding of elected politicians, its seconding of its top executives to top posts throughout the regulatory apparatus of government, and its simple and powerful message of “let the market work its magic.” It was so easy."
People with degrees in math, engineering, physics, etc. moved from building stuff to engineering financial instruments-- CDOs, CDS, etc. Hence, most of our recent productivity gains have been in the financial sector alone.

DeLong points out, as I thought about recently, there were always two exceptions to the neoliberal rule: Technocratic central banking and defense spending. Through the space race and winning the Cold War, the U.S. government subsidized the invention of the semi-conductor, microwave oven, the Internet, and other private sector "spin-offs." What we called "defense spending" the rest of the world called "protectionism." What DeLong doesn't point out is the rise of monopolies in the financial sector that, as Hayek preached, threaten the neoliberal order before government does.

The fear that international economists had in the last 15 years was of a sudden collapse of the dollar from, for whatever reason, the international community losing its faith in this system. That didn't happen, as the various countries involved worked to keep the value stable. Instead, the world witnessed the collapse of the U.S. financial system and the problems seemingly created by the neoliberal shift in the last 35 years.

But the other aspect of the global economy that threatens the neoliberal order that DeLong and Cohen highlight is the rise of sovereign wealth funds. It's not just rich private citizens making major investment decisions, it's rich countries-- Russia, Norway, Saudi Arabia, China... over $3.5 trillion dollars held in foreign investments. These countries aren't going to be content holding low-yielding assets like U.S. Treasuries forever, especially if America looks unwilling to deal with its long-term structural deficits (Medicare). Eventually, they will move more and more into ownership of private companies. We've already seen some of that tension recently-- the xenophobic reaction when a Dubai company tried to buy a Houston port. They already have the power to direct investment in their own countries-- to engage in industrial policy.

The authors look at some of the rules proposed for these sovereign wealth funds, but it's quite silly to think that national interests won't rule the day. And the U.S. has now lost its ability to influence or preach.

So, what must happen? The U.S. needs to save more and spend less. China needs to save less and spend more. One hopes this happens gradually, orderly, because it will cause shifts in our productive sectors that will be difficult overnight. We'll be manufacturing and exporting more, and our currency will likely no longer be the world's reserve.

I give this book 3.5 stars out of 5. The authors don't bother giving an exposition of where neoliberalism comes from, or explicitly state that countries that eschew markets do so at their own risk (although DeLong preaches this to his students). They also don't talk about how the U.S. is supposed to start saving more when it has a social safety net unfunded into the future with long-term structural deficits as a result.

But that makes it a short read, easy for a layperson or undergraduate to understand.

No comments: