The Needle’s Eye

The destinies of the aging but affluent people of the West and the young but impoverished people of the Global South are joined”and joined by a very simple economic fact: The old tend to have savings, while the young tend to have energy. To fund their retirements, old people must find young people to whom they can lend. And to start families and businesses, young people must find old people from whom they can borrow.

The extreme poverty of so many in the Global South offends morality for many reasons, but one reason hardly anyone seems to mention is that this poverty persists despite the economic interests of the world’s people being complementary. We ought to help the poor, and we need to improve our own economic situation”and yet, somehow, we seem unable to do either.

This isn’t a failure of charity. It’s a failure of intellect, a failure of law, and a failure of imagination. Capital wants to flow from the West to high-return outlets in the South, but third-world corruption and first-world insularity combine to block these mutual needs and interests.

Despite its recent financial woes, the United States remains the only actor on the world stage that can break down the barriers impeding the natural flow of capital around the world. In that sense, our present economic crisis is both a prod and an opportunity for American leadership to act in the interest of both America and the world.

With the continued rise in American unemployment, despite nearly a trillion dollars in fiscal stimulus and more than eight trillion dollars in federal subsidies and guarantees to the financial system, this mutual dependency should be glaringly obvious. Americans, at the cusp of the biggest retirement wave in their history, must save as they never have before, particularly after the wealth destruction of the past two years. As they reduce consumption in order to save, employment falls”so far that one in five American adults is unemployed, underemployed, or “discouraged from seeking employment.”

Americans could increase both their savings and their employment by exporting manufactured goods”but that is like saying that, if we had some ham, we could have ham and eggs, if we had some eggs. America has neither the capacity to manufacture such exports nor the customers to buy them. Half the world thirsts for capital, while half the world is drowning in it.

Two decisive actions would help open the floodgates that separate the capital-thirsty Global South from the capital-rich savers of the West. We need, first, monetary policy to stabilize currencies”currencies of developing nations, in particular”while creating conditions for the rapid development of their domestic capital markets. And we need fiscal and regulatory changes to encourage savings and investment in the United States, to rebuild its equity.

In many ways, America’s present position resembles that of the final years of the Carter administration, when Keynesian fiscal stimulus and lax monetary policy gave the country the worst of both worlds: economic stagnation and a collapsing currency. The present administration’s policy mix of “Keynesian deficit spending” and near-zero interest rates will not produce a recovery either. In fact, by going down this road, we can only make matters worse.

Post-Carter, the Reagan administration trampled on economic convention by applying the economist Robert Mundell’s idea of combining tight monetary policy (to save the dollar) and tax cuts (to encourage investment and risk-taking). This prescription began the longest economic boom in American history”and the nation can look forward to another long economic boom if policymakers have the courage and imagination to throw out Keynesian convention.

But, as Mark Twain said, history does not repeat itself; it only rhymes. We cannot simply replay the tape of the Reagan years, and we have to do something else to save the dollar from a devaluation spiral and rebuild equity. In 1981, Ronald Reagan faced a situation very different from what we face. The personal savings rate stood at 10 percent, and America was lending to the rest of the world rather than borrowing from it. The top marginal tax rate was 70 percent, and the baby boomers were young and ready to take risks, rather than about to retire.

Today, America is coming out of a decade without savings and years of borrowing from the world instead of lending to it. Rather than exporting and saving, America is vacuuming capital out of the rest of the world and going further into debt. Once we exclude the option of admitting a few million skilled, entrepreneurial young immigrants”as Israel did from Russia two decades ago”the present crisis can be solved only by opening the world to American exports and restructuring the American economy to create the necessary export capacity.

The greatest crisis the present administration faces is the collapse of the dollar and its role as the world’s main reserve currency. Paradoxically, preventing the dollar’s collapse also represents a once-in-a-century opportunity for American leadership. Our present fiscal and monetary policies degrade the dollar’s value and force part of the burden of financing a misguided fiscal stimulus onto America’s trading partners. They have no alternative for the moment but to shoulder this burden, however reluctantly. But they will not do so ­forever.

The United States should establish a fixed parity for the dollar with the currencies of its largest trading partners, starting with China. By stabilizing the dollar against the yuan and, eventually, other currencies, the United States can create a shield behind which the capital markets of developing countries can flourish and capital can continue to flow to the United States. Developed nations can protect themselves against ­sudden shifts in the flow of capital, but poor nations with nascent capital markets cannot. Currency stability is the first precondition for the creation of capital markets in the developing world.

The irony of America’s predicament is that, as the government struggles unsuccessfully to revive consumer demand, the global demand for American products appears almost bottomless. Most of the young people of the world live in countries with capital markets that are primitive, inefficient, corrupt, and risky. But their demand for capital”to build homes, water systems, energy plants, cellular-phone towers, schools, highways, and railroads”is just as large as the demand, among the aging savers of the West, for safe capital instruments with a better return than zero.

There are only two ways to bridge this gap: Bring the capital to the young people, or bring the young people to the capital. Tens of millions of illegal immigrants make their way from Latin America to the United States, or to Europe from Africa and Asia, in search of the financing that might give them employment. Hungry and frightened people do not wait for their governments to address the central concern of the day. They vote with their feet. Among the facts that a moral view of economics ought to consider, this one has been badly neglected: The failures of economic policy generate the social problems associated with illegal migrants. If we want a more stable world, then we must give people more opportunities in their own countries.

Our old mistakes, in the shape of debts, are compounding on corporate and governmental balance sheets. In Washington, however, the problem is not taken to be the compounding of debt. Rather, the Obama administration (influenced, apparently, by the Keynesian outlook of Larry Summers, director of the White House’s National Economic Council) insists, our financial crisis endures because Americans save too much and spend too little. Thus, to restart the economy, the government has to spend money, in the form of an $800-billion stimulus package.

There are two things terribly wrong with this notion. The first is related to the fact that the administration perceives the situation through the Keynesian notion of a diminished “marginal propensity to consume.” But Keynes was constructing a short-run model of a closed economy, and the United States today confronts the accumulation of long-run problems. A huge jump in the retirement rate coincides with the collapse of an asset-price bubble that has left a dangerous level of debt on domestic balance sheets. The consumer-driven model cannot be restored, because the problem it faces has nothing to do with the random, temporary shifts in psychology (“animal ­spirits”) that Keynes noted. The problem we face instead is that the accumulation of mistakes and loss of wealth happened just as the baby boomers were about to retire.

The second thing wrong with the administration’s present course stems from an insular focus on spurring consumer spending within the United States, the lip service paid to global cooperation notwithstanding. The solution to the savings“investment disparity does not lie in tinkering with government spending but in helping savers and investors come together across national frontiers. We can correct the balance sheets of both the United States and its trading partners by financing the capital markets in places where young people actually live.

Barriers of politics, law, regulation, and institutional practice”together with volatile reserve currency”stand between young people who need capital and old people who need investments. These barriers perpetuate the imbalances that the world will have to manage while restoring accountability to Western financial markets. These imbalances can be fixed. The tools to do so are well understood and have been thoroughly tested. But these solutions are at present invisible on the political horizons in Washington.

Currency policy is the key to opening the world to American exports. What seem like minor errors in Western monetary policy have devastating effects on developing economies. The large industrial economies are like oceangoing vessels designed to withstand typhoons; ten-meter waves may roil them but will not sink them. Not so for the fragile craft in their wake. As former Federal Reserve chairman Paul Volcker once observed, the industrial nations’ deep financial markets allow participants to hedge against large shifts in currency parities. Not so for the shallow, inefficient financial markets of developing nations, in which the vast majority of firms do not qualify as derivative counterparties, and the yield curve is not liquid past the two-year mark.

A case in point is the Asian financial crisis of 1997. During the early 1990s, Thailand pegged its baht to the dollar. When the dollar rose sharply against the yen, Thai purchasing power rose sharply against that of Japan, then Thailand’s largest trading partner. The rising baht prompted short-term capital flows into Thailand and fueled a real-estate bubble not unlike the United States’ bubble of the past several years. The bubble collapsed in 1997, and the Thai currency collapsed along with the country’s real-estate market and banking system.

China, in particular, is the natural fulcrum for America’s proper economic policy. China’s ­requirements for infrastructure and capital equipment are enormous: Two-thirds of its 1.3 billion people still live in conditions of extreme backwardness. But rather than invest in its own interior, China has diverted its savings to securities in Western currencies as a rainy-day hedge against potential political and economic disruption. America should help China stabilize its currency by a solemn and formal agreement to link the renminbi to the dollar; China in turn should make its currency convertible and open its capital market to American institutions. Other countries may wish to participate in this arrangement; with the world’s two largest and most dynamic economies as an anchor, a Sino-American currency agreement would quickly become the point of orientation for the rest of Asia and eventually for other countries.

China’s demand for savings, to be sure, stems in part from the one-child policy, which requires Chinese to provide for their retirement with financial assets rather than offspring. But a good deal of Chinese savings is precautionary. With a nonconvertible currency and limited outlets for investment, Chinese are apt to exaggerate their rainy-day savings.

In effect, China needs to reduce its saving rate drastically while America increases hers. Why wouldn’t just letting China’s currency be convertible on its own, without coordinating with the United States, be part of the solution, as some propose?

The simple answer is that China’s capital markets”and, by extension, its political system”are still too fragile to withstand the tsunami-sized capital flows caused by the dollar’s instability. Dollar devaluation sends capital rushing into China, distorting asset prices. By contrast, a repetition of the global liquidity crisis that followed last year’s failure of Lehman Brothers could provoke massive capital flows out of China, in a repeat of the 1997 Asian crisis. As long as the United States subjects its currency to extreme volatility, China cannot take the risk of making its own currency ­convertible.

Notwithstanding China’s fast economic growth, Beijing is profoundly aware of the dangers to stability that arise from disparities between the country’s prosperous coast and the backward interior. The Chinese government claims that it is correcting the economic mistakes of fifty years of rigid communism, and it must bet on policies to create employment quickly for about 25 million people every year for the next few years to prevent discontent from boiling over into social unrest.

Yet China does not have the financial, legal, or administrative capacity to match people and capital. Its efforts to spend a fifth of its gross domestic product on infrastructure face enormous problems of governance. In the United States, voters approve public spending at the local level, and the federal system provides checks and balances against abuse of public funds. China, like all emerging countries, must rely on the probity of a small number of officials with enormous power; and the rule of men, instead of the rule of law, is never an effective check against corruption. After Beijing sends a cadre of officials to clean out corruption in a province or an agency, it must send a second group to clean out the corruptions of the first.

Corruption intensifies the risk of political instability because extreme wealth disparities are less tolerable if people perceive them as arbitrary and unrelated to merit and achievement. No developing country has ever overcome corruption by hiring more police. The only way out of the vicious circle is to make it possible to earn more money through honest markets than through corruption. Creating open and efficient capital markets in China will not eliminate corruption, but it will create parallel and ultimately more compelling opportunities. To collaborate with the United States and other Western countries in the development of an internal capital market is profoundly in China’s interest. Stabilizing currency parities is not a panacea but a precondition. Establishing the rule of law, eliminating corruption, and deepening financial institutions are indispensable, but confidence in local currencies comes first.

At the same time, America should ease restrictions on Chinese and other foreign investment in American companies. For narrow political reasons, the United States has rebuffed Chinese efforts to acquire equity in major American brands. China wants to reduce its exposure to American debt in favor of equity in firms that produce what it requires: food, energy, minerals, and technology. A crucial part of stabilizing the dollar is to increase global demand for dollars by selling more American assets to reduce America’s overhang of ­foreign debt.

A partnership on this scale would constitute a revolution in American policy. For all its rhetoric about global cooperation, the Obama administration has followed an egregious unilateralism in economic policy, running the federal deficit to 12 percent of gross domestic product in a vain effort to reanimate the atavistic model of a forever-young consumer-based economy. As of the third quarter of 2009, the Federal Reserve was buying Treasury securities at an annual rate of nearly $700 billion, and commercial banks (with cheap funding from the Federal Reserve) were buying Treasuries at a $350-billion annual rate. Directly and indirectly, the United States is monetizing debt at a trillion-dollar annual rate. Little wonder, then, that the dollar’s exchange rate is falling, and its status as a reserve currency is in doubt. The trend cannot be sustained. The world eventually will cease accumulating dollar assets, placing America’s capacity to finance its deficit in jeopardy.

Opening the world for American exports is half the task. The other half requires restoring the nation’s export capacity. Despite the present crisis, America remains the world’s strongest platform for innovation. America continues to lead in every field of technology: software, communications equipment, aircraft, biotechnology, and electricity production. China plans to install more than twenty nuclear-power plants per year and could benefit from double that number; America possesses the world’s best nuclear-reactor technology but not the capacity to fill Chinese demand.

The way to increase American export capacity is economically simple, but it requires visionary political leadership. We have been borrowing in order to consume; we need now to save in order to invest. We need to shift the tax burden, moving it away from savings and investment and toward consumption. We should replace individual and corporate income taxes with consumption-based taxes (value-added and sales taxes). Instead of attempting to revive the dead cart horse of consumer-driven growth that the present administration is beating, we should make our tax policy encourage savings and investment at the expense of consumption.

If America looks outward, toward the young people of the Global South, rather than inward, toward the exhausted consumers of the baby boom, the ensuing economic boom could outpace the great expansion begun by the Reagan administration.

There are close to 2 billion people in China and the countries in its immediate periphery, and a further 1.1 billion people in India. Half the world’s population lives in emerging Asia, and that region’s productivity could triple in a generation. America has the capacity to generate innovations and commercialize them in the world’s largest and fastest-growing markets. Tax and monetary policy can create a conveyer belt that takes American innovations and turns them into productivity gains among billions of people in the Global South.

Out of the present crisis, the world might enjoy one of the longest and fastest economic booms in history. Or it might remain in an economic mire for the ­foreseeable future.

Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management and is author of The Force of Finance and A World of Chance. David P. Goldman is senior editor of First Things .