Crisis Economics Part 11

We don't mean to suggest that policy makers should impose drastic interest rate hikes to curtail bubbles. That would be dangerous. But a moderate, preemptive approach is appropriate, and far preferable to the current policy of doing nothing as bubbles grow, and then pulling out the stops when they finally pop. In a way, it's especially unfortunate that Greenspan became most a.s.sociated with this do-nothing, do-everything strategy. He was clearly worried about rising share prices when he delivered that famous speech in 1996, and as he spoke of the dangers of a.s.set bubbles, he argued that "evaluating s.h.i.+fts in balance sheets generally, and in a.s.set prices particularly, must be an integral part of the development of monetary policy." But he then abandoned this strategy, fearing, perhaps, that factoring a.s.set prices into monetary policy would have a disproportionate, destructive effect on the markets.

In reality, the danger of using monetary policy to control bubbles is not that it will be too effective but that it won't be effective enough. Had the Fed tried to control "irrational exuberance" in the 1990s by hiking policy rates by 100 or 150 basis points, this would have been insufficient in a climate where investors expected that share prices would double every year. Similarly, a decade later, comparable rate hikes might have had a limited effect among homeowners who believed that housing prices would go up 20 percent a year in perpetuity.

At such times, monetary policy alone may not be enough to control a credit or a.s.set bubble; central banks may have to deploy other powers at their disposal. The Fed has power under Regulation T, for example, to alter "margin requirements," the amount of money that investors can borrow to purchase securities. Though the Fed periodically changed these requirements in the early years of its existence, it has left them steady at 50 percent since 1974. Raising these requirements would have done a great deal to control the excesses of the tech bubble, when growing numbers of speculators bought shares on margin. Its failure to do so allowed the bubble to grow still larger.

The Fed has other "credit policy" tools that it could use to control the expansion of credit and the consequent growth of an a.s.set bubble. Regulation D permits it to alter the reserve ratio of member banks. In other words, the Fed can alter how much money a bank has to hold in reserve against certain kinds of deposits, or liabilities; this in turn can constrain credit creation. Other statutory powers give the Fed other kinds of indirect control over the availability of credit and, by extension, speculative bubbles.

Still more tools could be placed at the Fed's disposal. One proposal under consideration is to give banks the power to set a.s.set-Based Reserve Requirements (ABRRs). In one variation of this idea, central banks could unilaterally raise reserve requirements for certain a.s.sets. Had the Fed possessed this power in the years leading up to the current crisis, it could have raised reserve requirements for any a.s.sets rooted in real estate. This kind of precision would allow it to target a.s.set prices in a particular sector, while leaving other parts of the financial system unscathed.

But new powers mean nothing if the Fed won't use them. For years, the Fed has adopted a laissez-faire approach to a.s.set bubbles. That alone would be bad enough, but the Fed's behavior has arguably been worse. Far from "taking away the punch bowl," it has served as a cheerleader, flooding the system with easy money and refusing to exercise its regulatory authority over integral parts of the financial system-mortgage lending, for example. That has to change. The Fed is only as effective as the people running it. In the coming years, its leaders will need more than the power to pop a.s.set bubbles; they will need to be willing to use that power.

They will also need to know that there are limits to their power in the global monetary system. For over sixty years, the United States and its dollar have reigned supreme. Those days may be coming to an end, and how we manage that difficult transition will be integral to determining the prevalence of crises in the coming years. This is the subject of the following, final chapter.

Chapter 10.

Fault Lines.

The financial crisis that crept onto the radar late in 2007 and reached gale-force intensity in 2008 has come and gone. We live in its aftermath, and like the survivors of a hurricane, we're mopping up the damage and picking up the pieces. At this point, it's tempting to a.s.sume the worst is behind us. Unemployment may continue to climb and housing prices could resume their downward slide, but a consensus holds that we've weathered the storm.

But crises of other kinds loom on the horizon, crises of countries and currencies, in which nations default on their debt or see their monetary system collapse. Such crises were largely absent in 2007 and 2008: nations didn't default on their debt, nor did monetary systems break apart at the seams, even if currencies fluctuated wildly. Only Iceland came close to total collapse.

Sadly, Iceland may soon have some company. In the past, speculative booms and busts often triggered a wave of sovereign debt defaults. This time around, as a consequence of bailouts and stimulus programs, many of the world's advanced economies are now running record fiscal deficits. The risk is growing that these countries-call them the risky rich-will no longer be able to finance these deficits, raising the alarming possibility that they might default on their sovereign debt or wipe it out with high inflation.

Not even the United States is immune to this possibility. Its deficits are soaring, thanks to foolish tax cuts and the cost of bailing out everyone from banks to car companies to homeowners. As the United States continues to borrow more and more money from abroad, its creditors have started to whisper the unthinkable: that the United States might resort to the time-honored way of making debts disappear, by cranking up the printing press and flooding the world with depreciated dollars.

It may or may not happen, but that such a scenario even merits serious discussion portends a major geopolitical s.h.i.+ft. For many decades the United States enjoyed international political and economic hegemony, thanks in part to the dollar's role as a reserve currency for the rest of the world. But over the last twenty years the United States has increasingly spent more than it has produced and earned, and imported more than it exports. As it went from being the world's biggest creditor to being its largest debtor, its power has weakened. So too has the dollar, which conceivably may one day be replaced by, say, the Chinese renminbi.

In this chapter we look at the origins of this disquieting development, about which a remarkable amount of confusion and misinformation reigns. How might these problems resolve themselves in the coming years? We will a.s.sess different options for managing the difficult transition from the American Century to what may well become the Chinese Century.

This tectonic s.h.i.+ft may well take place in a disruptive, disorderly fas.h.i.+on; only time will tell. But if it does happen suddenly, it won't be pretty. Sovereign debt defaults, high inflation, and currency crashes are bad enough when smaller, emerging markets crumble and fall, commonly sp.a.w.ning widespread bank runs, devastating inflation, exploding unemployment, and widespread political and social unrest. If the world's largest and most powerful economy-the United States-were to fall prey to that kind of crisis, one can only imagine the effects. Such a calamity would give "too big to fail" a whole new and scary meaning.

Accounting for the Current Account.

In order to better grasp what may lie ahead for China and the United States, we must understand an important measure of a country's economic health: the current account.

A country's current account is its "external balance," a measure of how its economy compares with those of other countries at any given time. The current account balance comes in two flavors: a current account surplus and a current account deficit. While it's theoretically possible for a country to have a current account of zero, that doesn't really happen; it would be like a corporation that reported neither a profit nor a loss.

That said, countries aren't really like corporations; they have bigger and more complicated balance sheets. One ingredient of a country's current account is the tally of its imports and exports. The difference between them yields either a negative or a positive number. Some countries, like the United States, run a trade deficit, meaning that they import more goods and services than they export. That's a negative number. Other countries, like China and j.a.pan, run a trade surplus, exporting more goods and services than they import. That's a positive number.

That number is one part of a country's current account. But the current account also takes stock of the country's foreign a.s.sets and foreign liabilities. Let's begin with a.s.sets. If the United States owns equities, bonds, or even real estate in another country, these holdings generate income in the form of dividends, interest, and rent; it all flows into the United States. That's a positive number. On the other hand, if companies in the United States have issued equities or debt that is owned by nonresidents, or if the United States itself has issued government debt owned by nonresidents, these are liabilities: they cause money-in the form of dividends or interest payments-to flow out of the country. That's a negative number.

The current account adds together the difference between exports and imports (the balance of trade) and the difference between income earned on foreign a.s.sets and payments made toward foreign liabilities (what economists call "net factor payments"). Additionally, the current account has a third component: one-sided transfers of money across national boundaries, such as foreign aid and migrant worker remittances back home. Such transfers tend to be relatively minor, except in certain countries that receive a lot of aid (in sub-Saharan Africa, for example) or that have a lot of their citizens working abroad (the Philippines and some Central American economies), so let's leave that figure aside for now. In any case, if the number derived from adding all three components together is negative, the country is running a current account deficit. If that number is positive, it's running a surplus.

As a measure of a country's overall health, the current account can be misleading. j.a.pan, for example, is now running a current account surplus. That may seem strange, since j.a.pan's government has issued an astonis.h.i.+ng amount of debt; one might expect it to be running a current account deficit. But it isn't, because j.a.pan exports far more than it imports. In addition, most j.a.panese government debt is purchased by j.a.panese citizens, so it doesn't show up as a debt owed to other countries. That helps give j.a.pan-a country not known recently for its robust economy-a current account surplus.

Now consider the United States, which is running a significant trade deficit. In addition, its government is issuing more and more debt, much of which is financed by investors overseas. Finally, until recently consumers spent far in excess of their income. That spending too was heavily financed by overseas investors, who snapped up securities derived from American mortgages and credit card debt. All these imbalances help contribute to what is now the biggest current account deficit in the world.

By contrast, China has the world's biggest current account surplus. Plenty of money flows into China as payments for all the goods that it makes and exports. Moreover, China has relatively little debt of its own, and foreigners don't own much of it. But it owns lots of debt issued in other countries, most obviously American mortgages and government bonds. China's ma.s.sive current account surplus thus leads to an acc.u.mulation of foreign a.s.sets, like U.S. Treasury bonds. In this way, money flows from countries that run current account surpluses (China) to those that run current account deficits (the United States).

A country's current account balance also represents the difference between its "national savings" and its "national investment." This distinction is key. Let's start with national savings. Both the public sector (government) and the private sector (households and businesses) bring in income, in the form of taxes, wages, salaries, or other revenue. Different sectors of the economy then spend some or all of that income on things, which qualifies as consumption: the government purchases military supplies, a household buys food, or a manufacturer procures raw materials. After all that consumption, the aggregate amount left over is known as the "national savings." It is the "money in the pocket" of the nation at large.

Let's imagine that a country's national savings is a positive number: the government runs budget surpluses, and households and businesses have money left over after their consumption too. This money now must be invested somewhere. It can be invested at home: underwriting the construction of a new factory, for example, or going toward other capital improvements. The sum total of the various investments made at home is the national investment. If some savings are still left over after all that national investment, then the country is said to be running a current account surplus. The current account is the difference between national savings and national investment; when that difference is a positive number, as it is in this case, then the extra savings end up flowing out of the country.

This example is very simplistic: more typically, a country's government will run a deficit, even when its households and businesses are running an even bigger surplus. But a country with a positive national savings isn't necessarily running a current account surplus. Not at all. Let's say it plows all of its savings into investments at home, but that doesn't exhaust the demand for investments. (Emerging-market economies, for example, often have a demand for investments that domestic savings alone can't fill.) When that happens, the country is likely to attract investment from abroad, in which case borrowed money flows into the country. The country ends up running a current account deficit.

Clearly there are many ways of looking at current account surpluses and current account deficits. In itself, a surplus or a deficit is neither a good thing nor a bad thing; it's merely a reflection of a more complicated underlying reality. Soaring government budget deficits can fuel a current account deficit, but so can a boom in investment. A fall in private savings because people are consuming too much-particularly goods from abroad-can drive a current account deficit as well. All these different factors can come together either in a deficit or in a surplus.

Let's say a country is running a current account deficit, with excesses in spending over income, investment over savings, and imports over exports. How does it finance these various excesses? Usually other countries will lend the country money by buying up its debt or by investing in its economy by purchasing stocks, or buying real estate, or by directly investing in, acquiring, or creating productive firms (as j.a.panese and European automakers have built factories in the United States). Alternatively, a country may finance its current account deficit if its central bank sells off its holdings of foreign currency or if domestic investors sell off their a.s.sets overseas. Thus the sum of the current account balance and what economists call the "capital account"-the change in the country's private foreign a.s.sets minus its foreign liabilities-is equal to the change in the reserves of the central bank.

Normally some countries run deficits and others run surpluses. But in recent years these imbalances have became ever more, well, imbalanced. Up to 2007, when the recent financial crisis. .h.i.t, the United States and a few other countries ran ever larger current account deficits. How did this happen?

Lessons from Emerging-Market Crises.

Economic theory holds that for the most part emerging economies will run current account deficits while more advanced economies run current account surpluses. Theoretically, advanced economies, having a surplus of savings above and beyond their own capital investments, will invest in emerging markets, where capital investment opportunities exceed domestic savings. Investors from advanced economies can buy up debt, equities, and real estate in emerging economies, as well as make foreign direct investments, all in the hope of earning high returns. When they make such investments, sometimes both sides ultimately benefit. At other times, crises are the consequence.

For centuries, as we have seen, crises have followed a pretty predictable path. Foreign investment flows into a country and helps fuel an a.s.set bubble of one sort or another. In the process, as private consumption rises and investment booms, the country's current account deficit widens. Large fiscal deficits may emerge-and debt and leverage acc.u.mulate. At some point the bubble bursts, and various sectors of the economy suffer: households, corporations, financial firms, and the government. Eventually the country defaults on its debt; or its currency collapses; or both happen at once.

In recent years emerging markets around the world have endured some version of this rags-to-riches-to-rags story. The reasons vary greatly. A typical culprit is a current account deficit driven largely by growing fiscal deficits. Fiscal deficits aren't bad in themselves; a country may be issuing debt abroad in order to finance improvements in its infrastructure, which eventually will enable the country to be more compet.i.tive, producing and exporting more goods and services, and ultimately turning that current account deficit into a surplus.

Unfortunately, government spending can also be the road to ruin, especially if it ends up going toward the salaries of government officials rather than toward investments in, say, infrastructure. In various ways countries may run large fiscal deficits and issue too much debt. Eventually foreign investors balk at renewing the debt, or refuse to purchase new debt. The result is a "sovereign debt crisis." That's precisely what happened in Latin America in the early 1980s, as well as Russia in 1998, Ecuador in 1999, and Argentina in 2001 and 2002. These countries effectively defaulted on the sovereign debt held by their own citizens and by foreigners, and their currencies collapsed. In each case foreign investors fled, and the domestic economy plunged into a severe recession. In Argentina, for example, consumer prices rose 40 percent in a single year, and unemployment approached 25 percent. Other countries-Ukraine and Pakistan in 1999, and Uruguay in 2002-avoided outright default but sustained significant damage nonetheless. Most of these countries experienced currency crises as well.

A current account deficit, as we've said, need not degenerate into a sovereign debt default or a currency crisis. An emerging market may be borrowing heavily from foreigners in order to finance investments in its economy: for example, in new factories that may become future sources of income. Ideally, these investments will enable the country to produce more goods and services that it can export abroad, enabling it to repay its debts and, it is hoped, run a current account surplus.

But a current account deficit driven by foreign investment can also go awry, as happened in Indonesia, South Korea, Thailand, and Malaysia in the 1990s. None of these countries were running significant fiscal deficits; rather, their current account deficits derived almost entirely from an excess of capital spending relative to private saving, with foreign investors making up the difference. Yet their current account deficit swelled to unmanageable levels, and eventually these economies crashed. Why?

For starters, much of the borrowing from foreign investors was denominated in foreign currencies: the dollar and the yen. These countries were willing to borrow in foreign currency partly because their central banks were buying and selling foreign currencies in order to maintain a somewhat inflated value for the local currency. They could then borrow even more from foreign creditors, adding to the amount of their foreign debt denominated in foreign currency.

When one of these countries' current account deficits reached extreme levels, some investors finally lost their nerve and fled. The central bank tried to maintain the old rate of exchange, but to no avail. More foreign investors cashed out at the fixed exchange rate, draining the central bank of reserves and undercutting its ability to prop up its own currency. Eventually, the old exchange-rate regime collapsed, as did the currency.

As the value of the local currency plunged, the real value of the debt denominated in foreign currency soared. Borrowers who exported goods had no problem with such debt: they earned foreign currency when they sold their wares and could repay their own debts. But for those whose investments in real estate and local services generated only local currency, the currency collapse was a disaster. They could no longer pay their debts, and many went under.

Other forces conspired to make these countries particularly vulnerable. Most of the foreign investment in these countries arrived in the form of loans rather than equity investment. With equity financing, profits and dividends can decline when times get tough and rise once conditions improve. Debt financing, by contrast, allows much less flexibility: interest and princ.i.p.al on bank loans and bonds have to be paid both in good times and in bad. When a crisis. .h.i.ts, that commitment can be tough to maintain.

For many of these countries it was particularly tough, because their obligations consisted of short-term debt, which had to be rolled over on a regular basis. That effectively gave foreign investors plenty of opportunities to pull out, which they did when they got spooked. They declined to renew their loans and asked the debtors to pay in full. Many of the latter lacked sufficient liquid a.s.sets, such as central bank foreign currency reserves, or could not convert their a.s.sets into liquid funds, and defaulted.

Most of the emerging markets that succ.u.mbed to crisis ended up going hat in hand to the IMF. The IMF deemed Russia, Argentina, and Ecuador effectively insolvent and pulled the plug, letting them default on some of their sovereign debt. It deemed other countries illiquid but not insolvent and rescued them by offering loans (bailouts) or by brokering agreements in which private creditors agreed to give them some breathing room by rolling over their debt obligations, or by partic.i.p.ating in a formal debt restructuring (a "bail-in"). None of this prevented defaults on privately issued debt, and eventually huge numbers of banks and nonfinancial corporations defaulted on debts denominated in foreign currencies.

The string of emerging-market crises that began in the 1980s and continued for the next two decades left an indelible impression on policy makers in many countries, who concluded that a current account deficit was a bad thing: it had, after all, left economies vulnerable when the flows of foreign capital ("hot money") stopped and s.h.i.+fted into reverse. They also concluded that their countries had to prepare for future crises by acc.u.mulating war chests of foreign currency reserves that could be used to provide liquidity where needed. Accordingly, they cut their budget deficits and private spending, thereby reducing their foreign borrowing. Having put their financial houses in order, these countries then started to run current account surpluses-and acc.u.mulated ma.s.sive amounts of foreign currency reserves to s.h.i.+eld themselves from future crises.

For many of these economies, this acc.u.mulation of reserves had another, complementary purpose. A country that runs a current account surplus is likely to see its currency appreciate. For economies that depend on exports, an appreciating currency reduces their products' compet.i.tiveness on the global markets. So these economies deliberately bought up foreign currencies on the foreign exchange market, propping up the foreign currencies' value while simultaneously undercutting that of their own. China, home to the world's biggest current account surplus and possessor of one of the world's most undervalued currencies, has honed this dual strategy to perfection.

That current accounts in most emerging economies in Asia and Latin America went from deficit to surplus surprised most economists. So did the fact that a number of advanced economies-Ireland, Spain, Iceland, Australia, the United Kingdom, New Zealand, and, most important, the United States-went from running surpluses to running deficits.

In fact, these advanced economies started to resemble the emerging economies of a decade earlier: they played host to a.s.set booms financed from abroad. Much of the U.S. housing bubble, for example, was financed by nonresidents-during the boom years they purchased more than half the mortgage-backed securities and collateralized debt obligations. This helped housing prices soar, and Americans felt richer, saved less, and spent more, further exacerbating the country's current account deficit. Residents of other advanced economies did the same. After the financial crisis, these current account deficits narrowed, but none of these countries is likely to run a surplus in the foreseeable future.

These developments ran counter to the conventional wisdom, as well as to historical precedent. Ordinarily advanced economies run surpluses and emerging markets run deficits; a surplus of savings acc.u.mulated in advanced economies ends up invested in emerging economies, not the other way around. But we now live in a world where the opposite is increasingly true-a world turned upside down.

Rash.o.m.on.

The debate over current account imbalances resembles Akira Kurosawa's cla.s.sic film Rash.o.m.on. In that saga a terrible crime has occurred in the forest, and various characters concede that something bad has occurred, but each gives a different explanation of what happened and who is to blame.

Likewise, no one disputes the facts of the current economic "crime": global account imbalances are very large and until recently were growing larger. The United States and a few other advanced economies live beyond their means, while most of the rest of the world-China, j.a.pan, emerging Asia, various oil exporters, and much of Latin America, as well as Germany and a handful of other countries in Europe-do precisely the opposite. But as for who is to blame-and who should be punished-there's very little consensus.

Why? For one thing, within economic circles there are multiple accounts of this "crime," multiple accusations and alibis. While some of them contain shadings of truth, misinformation also abounds. So we must clear the air by addressing a few key questions: Why have these imbalances materialized in recent years? Are they sustainable? And if not, who should address them, and what policies should they pursue?

One of the more specious attempts to account for the current account deficit is the "dark matter" explanation. Proponents of this fairy tale-the economists Ricardo Hausmann and Federico Sturzenegger, among others-deny that the current account deficit is really as big as official figures suggest; if it were, they argue, the United States couldn't possibly be borrowing from the rest of the world at such low rates. They point to the fact that the United States is getting a better return on its foreign investments than foreigners are getting on their U.S. investments, which is hard to explain in the context of a ma.s.sive current account deficit.

But their explanation is simple: there is no current account deficit. It is, they explain, "just a confusion caused by an unnatural set of accounting rules." Instead, there is "dark matter" out there that the existing accounting has failed to capture. This valuable dark matter is difficult to price because it consists of intangibles that the United States provides: things like insurance, liquidity, and knowledge. The authors put particular emphasis on knowledge, arguing that superior "know-how deployed abroad by U.S. corporations" isn't captured in the statistics, and that all this talk about a current account deficit is nonsense.

This argument has been challenged on a number of points. One, that foreigners investing in the United States have earned less than the United States earns overseas is not surprising: many of them invest in the United States for reasons other than turning a profit. China, for example, has sunk hundreds of billions of dollars into low-yield U.S. Treasury bonds in order to keep its currency cheap and its exports affordable. Moreover, economists at the Fed have collected data suggesting that the returns realized by the United States abroad and those realized by foreigners investing in the United States are actually the same. That too seriously undercuts the argument.

A more serious explanation of the current account balance is the "global savings glut" hypothesis. Ben Bernanke came up with this one; it effectively deflects the blame for the U.S. current account deficit onto other countries. The problem isn't that Americans aren't saving enough, says this hypothesis, or that the U.S. government is running ma.s.sive deficits. Rather, the problem is that China and other Asian countries are saving too much.

At first glance this argument seems counterintuitive. But many advanced industrial economies in Europe, Bernanke points out, are saving a great deal in antic.i.p.ation of an aging workforce. Without sufficiently attractive investment opportunities at home, they have sunk those savings into the United States. Even more central to his hypothesis is the idea that frugal citizens of various Asian countries, particularly China, are saving too much and spending too little.

This argument has some superficial truth. Savings rates in China are very high, and consumer spending is relatively low. That's partly due to structural constraints: China has no social safety net and lacks a sound consumer credit system; it's hard to borrow money there to buy a house. So China and other emerging economies have acc.u.mulated surplus savings for a reason. Moreover, in an age of financial globalization, money can flow easily across national borders and into the United States, making current account deficits more sustainable than in previous eras.

That said, this line of reasoning has a serious problem: it subtly s.h.i.+fts blame for the ma.s.sive current account deficit onto foreigners. By that logic, the U.S. consumer shouldn't be blamed for the housing bubble; it's the fault of all those penny-pinching Chinese who sent us their surplus funds. Blaming them is like blaming drug lords in Bolivia for the c.o.ke habits of some Americans: there's some truth to the allegation, but the story is far more complicated.

In fact, other forces played a far bigger role in the rising current account deficit, particularly since 2001. Thanks to a recession and the enormous tax cuts that George W. Bush rammed through Congress, fiscal deficits soared. After having taken the trouble to put its fiscal house in order in the 1990s, the United States once again started to issue lots of debt, which the Chinese and other emerging-market economies purchased. Their only crime was purchasing that debt; American policy makers' crime was consciously pursuing policies that exacerbated the U.S. current account deficit.

The Federal Reserve played a role too, making plenty of easy money available after 2001 and doing little to supervise and regulate the financial system. These policies, more than any "global savings glut," helped create the housing boom, leading to an increase in residential investment and a decline in savings. Yes, much of the investment was financed with savings from other countries, but the Fed helped create the unsustainable boom that attracted these savings in the first place.

Looking back, it's clear that different factors at different points in time have driven today's global account imbalances. In the 1990s the tech boom and the corresponding rise in the stock market attracted an influx of foreign capital and thereby drove the rising current account deficit. That led many Americans to save less and consume more, further fueling the current account deficit. After the bubble's collapse, the deficit should have declined, but it didn't: instead, reckless fiscal policies enacted by the Bush administration sent it soaring.

The current account deficit increased even more after 2004, thanks in part to a dubious housing boom enabled by lax federal regulators. Savings rates fell, and foreign investors snapped up securities derived from the growing number of mortgages. Only after 2007 did the current account deficit finally decline, as the housing bubble burst, imports fell, and households started to save more. A drop in oil prices contributed to the decline as well.

So unlike Kurosawa's Rash.o.m.on, the tale of the current account deficit "crime" has an obvious culprit. To paraphrase Pogo, "We have met the enemy, and he is US"-the United States.

That's not to say that the United States didn't have help: everything from surplus savings from China to financial globalization enabled the country to run a current account deficit. But enabling is not the same as coercing. So the ultimate responsibility for this mess rests with the United States, which for a decade pursued policies that sent its current accounts deficit soaring. With its reckless tax cuts and its unwillingness to rein in the housing boom, the United States has dug itself deep into a hole.

Dangers and Dilemmas.

Economists of a Panglossian bent use several arguments to dismiss concerns about the American current account deficit. Emerging-market economies, they say, will happily finance the deficit for the foreseeable future: they need to keep their currencies cheap, and one way to do that is to buy up U.S. equities and debt. Others point to the fact that the United States enjoys what Valery Giscard d'Estaing, the French minister of finance in the early 1960s, called the "exorbitant privilege" of having the world's reserve currency. Surely, the reasoning goes, this will forestall the sort of currency crises that plague less fortunate countries. Given these advantages, the United States should be able to keep running ma.s.sive current account deficits for many years.

That's absurd. The status quo is unsustainable and dangerous, and absent some difficult reforms it will ultimately unravel. Indeed, if the United States doesn't get its fiscal house in order and start saving more, it's headed for a nasty reckoning. When that reckoning will come is anyone's guess, but the notion that it might be put off for decades is delusional. Indeed, some signs suggest that the tide is already beginning to turn. Back in the 1990s the current account deficit was financed in no small part by foreign investment in U.S. equities, which by its peak in 2000 topped $300 billion. After the tech bubble burst, foreign investment collapsed, and while it has rebounded some, it has not returned to previous levels. Yet during that same period the current account deficit grew ever larger. This was made possible by foreign purchases of debt. The government issued some of that debt; plenty more was issued on the backs of private mortgages and other a.s.sets.

Foreign central banks and sovereign wealth funds purchased most of it. In fact, nonresidents now hold about half of the outstanding U.S. Treasury bills and bonds (outside of those held by the Federal Reserve), and two-thirds of these are held by central banks and sovereign wealth funds. In other words, it's not private investors who have financed the lion's share of the current account deficit. They're not stupid: they know the dollar might depreciate and have no interest in putting their money at risk. But governments and their proxies, as we've discussed, have other motives for buying up this debt.

But they too have their limits. As evidence of foreigners' growing unease, they're not holding on to U.S. debt as long as they once did. A decade ago the average maturity of U.S. public debt was close to sixty months. By 2009 that figure shrank to below fifty months, which reflects growing worry that the dollar will decline in value, whether by chance or by design. Indeed, as the United States acc.u.mulates ever more staggering loads of debt, some of its creditors fear that it may try to deliberately depreciate the dollar by "monetizing" the deficit, effectively printing money out of thin air. But then, it's already doing that via quant.i.tative easing.

If the United States were an emerging market, it would have long ago suffered a collapse of confidence in its debt and its currency. That it hasn't reflects the fact that the United States is still regarded as a country that raises taxes and cuts spending when necessary, putting its fiscal house in order. It did so in the early 1990s after a decade of soaring deficits; there's no reason it can't do so again. Moreover, unlike many emerging economies, the United States has never defaulted on its public debt. That goes a long way toward rea.s.suring investors. Finally, and most important, the United States borrows from abroad in its own currency. The potential depreciation of the dollar doesn't increase U.S. liabilities. Instead, that currency risk is transferred to foreign creditors.

That's a key difference. But it doesn't mean foreign creditors will keep piling up hundreds of billions of low-yield government bonds forever. At some point they're going to demand real a.s.sets-owners.h.i.+p stakes in American companies. So far the United States has resisted foreign owners.h.i.+p of its most important corporations. In 2005 public outcry stopped the China National Offsh.o.r.e Oil Corporation from purchasing an owners.h.i.+p stake in Unocal, and the following year a similar reaction prevented a state-owned company in Dubai (Dubai Ports World) from a.s.suming management control of a number of key U.S. ports.

These skirmishes reflect a kind of "a.s.set protectionism," in which the United States tries to tell its increasingly powerful creditors where to direct their money. a.s.set protectionism continued during the financial crisis, when several of the nation's biggest banks went hat in hand to sovereign wealth funds in the Middle East and Asia but refused to cede any significant control to these investors. Many of those investors got burned, which makes it highly unlikely that they'll be content to sit in the backseat next time they're tapped to prop up the financial system.

Many politicians and policy makers seem blithely unaware of how little leverage the United States has with the countries financing our twin fiscal and current account deficits. They tell China it can't buy up American companies, and they threaten to take protectionist measures if China doesn't revalue its currency. That's very quaint-and foolish. In effect, China is underwriting U.S. wars in Afghanistan and Iraq, never mind the bailout of the financial system and any costs a.s.sociated with reforming health care. Biting the hand that feeds us may play well with voters at home, but with China it has its limits.

Is China's path to global hegemony free of obstacles? No. Only 36 percent of China's gross domestic product comes from consumption. In the United States that figure is upward of 70 percent. While U.S. domestic consumption is too high, China's remains far too low. For now, its continued survival and growth depend heavily on cheap exports to the United States, which are in turn financed by the sale of debt to China. This perverse symbiosis ("They give us poisoned products, we give them worthless paper," explains Paul Krugman) poses a threat to China's long-term interests.

China has other problems too. Undeniably it has staggering reserves, and it has plowed some of its sizable war chest into a ma.s.sive stimulus program aimed at improving the nation's infrastructure and at forcing state-controlled banks to make loans to various state-owned enterprises. That may work in the short term, but it's not sustainable in the long run. Loaning money to build more factories in a global economy that's already drowning in overcapacity isn't the road to salvation. All it may do is foster a speculative bubble in China that will ultimately leave the nation's banks with a bunch of nonperforming loans.

As of 2010, China and the United States remain locked in what economist Lawrence Summers has described as a "balance of financial terror." Neither side can make a move without upsetting that balance. China can't stop buying U.S. debt, or its biggest market will collapse. Conversely, the United States can't throw up protectionist barriers, or China will stop financing its profligate ways.

To get out of this bind, both countries need to take simultaneous steps to bring their current accounts into some semblance of equilibrium. The United States must tackle its twin savings deficits: its ballooning federal budget deficit and its low level of private savings. As its first step on the road to redemption, it will have to repeal the misguided tax cuts that the Bush administration pushed through earlier in the decade. If Americans think they can enjoy European-style social spending-universal health care, for example-while maintaining low tax rates, they are wrong. It won't work, and betting that the Chinese will forever foot the bill is wishful thinking.

For their part, China and other emerging economies in Asia need to let their currencies appreciate. They also need to adopt structural reforms to discourage saving, so that more of what China produces gets consumed at home. They must take concrete steps to promote the growth of consumer credit: at present, most Chinese continue to purchase their homes in cash, rather than relying on mortgages. And they must inst.i.tute the sort of safety nets common in advanced economies, like unemployment insurance and affordable health care. These very basic steps would give China's citizens some a.s.surance that they don't need to save every penny-or renminbi-for a rainy day. Absent these reforms, China will have a hard time stopping its famously frugal citizens from indirectly subsidizing the United States.

The rest of the world can help by trying to trim their own surpluses. More mature economies like Germany, France, and j.a.pan need to accelerate structural reforms that will increase investment, productivity, and growth and (it is hoped) shrink their current account surpluses. Oil exporters like Saudi Arabia need to let their currencies appreciate and start spending more on domestic consumption and on investment in infrastructures and in the exploration and production of more oil.

All these measures would foster an orderly rebalancing of international current accounts. Unfortunately, none of the players in this drama seem to be taking the necessary steps. Everyone seems to be hoping that the status quo-soaring surpluses on one side, widening deficits on the other-is somehow sustainable. It's not. Unless things change, the pressure will continue to build until it can no longer be contained. Then it will snap, with unpredictable effects. The resulting crisis would be very different from the garden-variety booms and busts we discussed in chapter 1. It would be less a function of capitalism's inherent instability than a deep ebb and flow of geopolitical power. If ordinary financial crises are minor tremblors, the abrupt unraveling of global imbalances-never mind the a.s.sociated sovereign debt defaults and currency crashes-would const.i.tute an earthquake.

So far, we have felt only tremors. The financial crisis wounded a number of advanced economies, raising doubts about the long-term creditworthiness of Greece, Ireland, Italy, Portugal, Spain, and even the United Kingdom. Some of these nations-particularly the so-called Club Med countries of Greece, Italy, Portugal, and Spain-may default sooner rather than later, threatening the European Union and potentially plunging these regions into the sort of chaos that touched Argentina in 2002 and Iceland in 2008.

These tremblors will shake the global economy. But they're minor compared with the "big one"-a rapid, disorderly decline of the dollar.