Friday, May 8, 2009

a prolonged recession would usher in chaos


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May 7, 2009

America will still rule the post-crisis world

As green shoots sprout on Wall Street, other nations are emerging from the recession in worse shape than the US

I am just back from Washington where the green shoots of recovery have sprouted into a jungle on Wall Street, if not yet on main street or in other countries. I was addressing a meeting of US and European diplomats to survey the geopolitical horizons.

As the world economy gradually returns to something approaching normality after the catastrophe triggered by the Lehmans bankruptcy on September 15 last year, thoughts naturally turn to the longer-term effects of the crisis.

Economic models are never good at predicting turning points in cycles, but in these conditions they are completely useless. To assess the long-term political and ideological impact, it makes more sense to consider two scenarios.

In the first, which has dominated thinking throughout the crisis, the deflationary forces of the credit crunch prevail and the world sinks into a recession lasting many years, with unemployment soaring to levels last seen in the 1930s. In that case, this crisis really will mark the end of US dominance, not only as a global power, but also as an economic model and source of political inspiration. But rather than neatly shifting the mantle of global leadership to China or maybe Europe - if we take seriously the triumphalist rhetoric of President Sarkozy after the London G20 summit about the death of the Anglo-Saxon model - a prolonged recession would usher in chaos.

China is far too poor, too technologically backward and too inward-looking to be a credible economic leader and its social arrangements are hardly a model for the democratic world. As for Europe, it would suffer even more institutional damage than the US from a prolonged depression, as it did in the 1930s. In short, the widely predicted depression would lead to what some investors describe as the Mad Max world: a state of global anarchy in which the only assets worth owning would be farmland and oil wells - and the guns and ammunition to protect them.

The alternative possibility is that monetary and fiscal stimulus succeed and the world returns to normal growth and moderate unemployment within a year or so. To judge by much commentary, this benign outcome is unlikely. But on Wall Street and in much of Asia it is becoming the mainstream assumption.

In my view, the benign scenario should be the focus of all policy discussions for two reasons. First, because economic theory tells us that fiscal and monetary reflation will succeed and hints of success are starting to show. The second reason is an economic equivalent of Pascal's Wager: if the world is about to collapse into anarchy and nothing can be done, there is no benefit in predicting it. If, on the other hand, the end of the world can be averted, acting on this assumption, will make recovery more likely. But even on this benign assumption, some big upheavals may lie ahead.

The financial crisis has profoundly changed US politics. It has convinced voters of the need for government, and of leaders who believe in government. With the election of an Administration dedicated to competent government, things have improved, as voters have noticed. Thus US and European ideology have moved closer together. Many Bush Administration foreign, social and environmental policies have been reversed, sending the signal that Americans no longer live on a different planet from the rest of us. As a result, America has become more attractive as a political model throughout the democratic world.

Less obviously, the US economic model, far from being discredited, may be strengthened by this crisis. If the US returns to growth much faster than Europe and Japan, the crisis will reaffirm the resilience of Anglo-Saxon capitalism, provided that it is not confused with totally deregulated market fundamentalism.

Moreover, the crisis may strengthen the US economy structurally by promoting President Obama's agenda of clean energy and healthcare reform. Developing new energy sources will play to America's advantage in technology, while correctly-managed healthcare reform could reduce the cost burden that has crushed many US industries.

For Europe, the crisis has exacerbated three distinct problems. First, global deleveraging is having a bigger impact on Germany than on the US or Britain. Second, Eastern Europe faces a catastrophic financial crisis, like the one in Thailand and Indonesia 12 years ago. Third, the euro has been transformed into a source of vulnerability rather than strength because Europe's sovereign borrowers can no longer print their own money, making them prone to default in the same way as state and local governments in the US.

The result of this perfect storm is that Europe will probably become more inward-looking. The question of more or less Europe will have to be debated anew, as maintaining the status quo may not be compatible with the survival of the euro or the new financial regulations now widely demanded. In Central Europe the painful consequences of the harsh economic reforms imposed by Germany, the European Commission or the IMF in exchange for financial support will probably strengthen the influence of Russia, which handled its own financial crisis surprisingly well.

Turning to Asia and China, does this crisis mark the moment of transition from US to Chinese dominance? Probably not. For Japan even more than Germany, the crisis has been a total disaster and the concept of export-led growth has been discredited.

China's leaders understand the dangers of excessive dependence on exports and are trying to shift emphasis to domestic growth. But this will slow productivity growth and economic development and it is not clear if China's authoritarian politics can adapt to a society emphasising consumption rather than production.

Finally, what of the dollar's status as a reserve currency? Those who argue that US budget deficits and monetary expansion will destroy its international status must point to another currency underpinned by stronger fiscal and monetary foundations. At present, there is no such currency, except possibly the Chinese yuan, which cannot be legally owned by foreign investors.

Those who argued that the dollar would collapse because of the global crisis forgot that to sell one currency it is necessary to buy another. The currency game is not a beauty contest but an ugly contest, in which investors must choose the currency that is least ugly.

In some ways this is true of global geopolitics. The crisis may have revealed grave flaws in the US economic and political models. But the weaknesses in other countries have become even more obvious. The logical conclusion is that President Obama's post-crisis America will be more powerful and influential than it was under President Bush."

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