The National Interest: PAST ECONOMIC cataclysms have led to dramatic changes in international financial arrangements. The Great Depression knocked the world off the gold standard. The economic turmoil of the late 1960s and early 1970s led to the collapse of Bretton Woods. Will the current crisis bring about similar changes? Berkeley professors Stephen S. Cohen and Brad DeLong argue in The End of Influence: What Happens When Other Countries Have the Money, that since the end of the Second World War, it has been the locomotive of the United States that has propelled the global economy and kept it on its tracks.
The basic pact was that America would act as the underwriter of world prosperity, allowing other countries to keep their currencies undervalued and thus promote economic development through export-led growth. Foreign countries were not only granted access to the enormous U.S. market, they were provided with liquid markets and a reasonably stable currency in which to invest their excess savings. The United States used its financial muscle to push free-market policies like open trade on the rest of the world. It was this economic Pax Americana that enabled Europe to rebuild after World War II, Japan and the countries of East Asia to industrialize, and China to take off.
In return, Americans got a lot of cheap goods from abroad and were collectively allowed to live beyond their means. For in order to provide a market for all these export-heavy countries, someone had to do the importing. The United States was thus constantly compelled to run current-account deficits, driving it further and further into debt. It was only a matter of time before this economic engine ran out of steam. This is a new take on an old problem that was first identified back in the early 1960s by Robert Triffin, a Belgian-American economist at Yale who wrote about Europe’s accumulation of dollars. Because the system carried the seeds of its own destruction, it came to be known as the Triffin paradox.
Many people have predicted that this unstable arrangement (which has lasted much longer than anyone anticipated because new countries keep buying into the system) would eventually result in a calamitous decline in the dollar that would then cripple America. This has not happened nor, according to DeLong and Cohen, is it likely to. Holders of the dollar have few alternatives and a fall in the currency would not be a disaster for the U.S. economy. Instead, they believe that the whole setup will end not with a bang but a whimper as the American ability to lead the world economy progressively slips, its cultural hegemony diminishes and support for the free-market policies it has championed begins to erode.
At one point in their book, the authors draw a comparison between the position of Britain in the early twentieth century and the current position of the United States. I was surprised that they did not make more of the parallels. Through much of the nineteenth century Britain was the linchpin of the world financial system. It was the capital supplier of last resort during crises and acted countercyclically as the economic locomotive for the world. But, almost bankrupted by the First World War, it was no longer able to fulfill that function after 1919. The mantle of leadership should have passed to the United States. But American leaders were too parochial and insular to seize the opportunity. Thus, during the 1920s and 1930s, the United States was unwilling to lead and Britain unable.
American economic historian Charles Kindleberger used to argue that ultimately the Great Depression happened because of this failure of economic leadership on the world stage. He believed that a well-functioning global economy required one country to act as the leader, in effect to do more than its fair share of keeping the global economy moving, fully recognizing that smaller countries will freeload off of its efforts. If we are at a similar transition point in world leadership, if the United States has indeed been knocked off its pedestal in much the same way as was Britain in the early twentieth century, it does not bode well for the ability of the global economy to navigate its next storm.
MOST OF the books initially published about the financial crisis were by financial journalists documenting exactly what happened. A second wave by economists that tries to bring an analytical perspective to the events is now arriving in bookstores. The economics profession has clearly been shaken by its failure to anticipate the astounding vulnerability of the financial system and the steepness of the economic downturn that followed the banking collapse. Many of the books about the current crisis thus end with a call to arms for a more grounded approach to economic theorizing, one that is less abstract and more anchored in the real world—a return, they all say, to the methods of John Maynard Keynes.
In 1930, Keynes, in an essay entitled “Economic Possibilities for Our Grandchildren,” wrote that he looked forward to the time when “economists could manage to get themselves thought of as humble, competent people, on a level with dentists.”
We are clearly still a long way away from that point, I fear, and we may never reach it. Our grasp of the way the economy functions and what to do when it breaks down is still significantly less than our still-imperfect knowledge of human anatomy. Our understanding of the economy is likely more akin to our even-murkier grasp of the human mind with its unfathomable processes, its bizarre synaptic firings.
Perhaps the best economists can achieve, therefore (in the present state of the discipline), is to be thought of as on par with psychologists. They are most useful when, like Reinhart and Rogoff or DeLong and Cohen, they contribute to our knowledge of how the world actually works. In the instances when those in the economics profession are called upon to tell us what we should do, like good clinical psychologists, they need to be modest about the cures they promise, recognizing that their advice is quite often mixed up with their own values and set of prejudices. They can be most helpful when, rather than lecturing us, they act as a sensible sounding board and give us the tools for thinking through our problems on our own.
Liaquat Ahamed is the author of Lords of Finance: The Bankers Who Broke the World (Penguin Press, 2009).