Nobody knows the kind of trouble we're in Nobody seems to think it all might happen again - Gram Parsons, "One Hundred Years from Now"
I'm not thinking about the start of a new Cold War as Maverick McCain and his neoconservative admirers would have it. I'm thinking about the financial apocalypse that is happening right now. On Monday, Morgan Stanley and Goldman Sachs were considered sturdy investment banks, in contrast to Lehman Brothers and Merrill Lynch. The feds arranged a buyout of Merrill, which could wind up taking down Bank of America at some point, since it is far from digesting Countrywide and its massive problems.
But they let Lehman go under, with Barclay's now picking up the healthy pieces. AIG, up to its eyeballs in liabilities related to the mortgage-backed securities meltdown, was crashing and burning. It's now been nationalized, as were Freddie Mac and Fannie Mae not long ago. The United States government is now the 80% owner of the world's largest insurance firm. Britain's largest home mortgage lender, HBOS, was just acquired under crisis-driven pressure from the British government by Lloyd's.
And that was just this week through Wednesday!
Paul Krugman wrote on Sunday that Treasury Secretary Henry Paulson blocked efforts by the Federal Reserve to directly bail out Lehman. And he wrote, "Mr. Paulson seems to be betting that the financial system ... can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish." Events since Sunday indicate that the markets are leaning heavily toward "foolish".
The point of my title is that what we are experiencing this week could well be seen in retrospect as the end of Cold War for the United States, or more accurately the end of the post-Cold War world system that we've had for close to 20 years now. For the United States, that system has conveyed enormous advantages, not least because the dollar has remained the world's reserve currency.
But the current position of the United States has a definite downside, in that it has been based on the ability of the US to borrow indefinitely from abroad, particularly from China and Japan. If the current crisis persuades foreign lenders to start moving diversifying away from American securities, the consequences will be major.
I'm trying to avoid being too pulled in by the panicky tone that always grips the business press when a financial crisis hits. They're habitually too sanguine about booms and bubbles, and way too quick to panic in bad times. But what's happened this week is really very serious, the growing repercussions of the mortgage finance bubble popping.
Then there's another problem: The banks no longer trust each other. Last August, as mortgage-backed securities unraveled, finances froze up worldwide. Why? Because banks knew how much undisclosed junk they had on their own books. Who could say what the next fellow had? Overnight lending between banks—the process that ensures that every bank has funds when it needs them—fell apart. This is a very big deal. If banks will not lend money to each other, why (except for the blessings of federal insurance) should anyone else leave their money to them? Economists like me wait entire careers to study events such as these—which should provide no comfort to anyone else.
Since August, America's big banks have been wards of the Fed, and those in Europe equally so of the Bank of England and the European Central Bank. The system survives because central banks keep the lending windows open, and the result is that - except for one instance in Britain - the public has not pulled out of the banks. Let's be clear. The private financial markets did actually fail. It's only the fact that the public trusts government that keeps the system from dissolving in panic. But even if the Fed and its counterparts can hold the line, the problem of mistrust among the big bankers won't go away soon. And that means we're at the end of the age of credit expansions, for now. [my emphasis]
The financial system with its use of the dollar as the reserve currency didn't start in 1989 with the fall of the Berlin Wall. It goes back to 1971, when President Nixon pulled the US out of the post-Second World War Bretton Woods agreement. But western Europe and Japan were willing to acquiesce in the dollar remaining as the world's reserve currency for several reasons, a major one being the security umbrella provided by the US against the perceived threat of the Soviet Union.
As Galbraith explains in his new book The Predator State (2008):
When the cold war ended, one pillar of the dollar was weakened, for now the need for an American-led security umbrella came into question. The aftermath of 9/11 briefly restored this belief, but with the Iraq invasion, confidence in U.S. foreign policy further eroded, and so did the dollar. This has partly to do with distrust of American motives, partly with the perception that the global war on terror is a fraud. And it has partly to do with the understanding, which prevails everywhere outside the United States, that the solution to the threat of terror is political, diplomatic - and a matter of police work. It is not primarily military, and there is not very much that military means can contribute to it.
I'm not suggesting here that the weakness of the dollar is the cause of the current crisis; it's not. The foolishness of pretending that there is or could be an efficient "free market" in capital is at the root of it, with the buccaneering in the subprime mortgage racket being the precipitating cause. As Krugman writes at his blog in Larry King not so live 09/16/08:
... we’re talking about balance sheets here; by and large the United States has liabilities in dollars (e.g., Chinese holdings of agency debt), while we have many assets that are, effectively, in foreign currency (Ford Germany is worth more when the euro rises against the dollar). So America’s balance sheet improves when the dollar falls, which is actually a major issue in international macro modeling.
Plus, the weak dollar is good for exports, which are about the only source of strength our economy has.
What I'm thinking about is the ability of the United States to borrow from foreign countries on the scale we've been doing for the last three decades or so. With the security justification gone and the GWOT (global war on terror) not able to replace it in anyone's mind but delusional American war fans like John McCain and Joe Lieberman and the American financial system battered, our ability to borrow from China and Japan could be impacted. Galbraith emphasizes in Predator State that there's no way to predict with a high probability, because there are several alternative scenarios that could take place. But he writes:
The international consequences of a crisis in the U.S. credit markets could be, under these conditions, even more severe [than a prolonged housing slump]. In this grim environment, it is to be expected that foreign investors and foreign central banks will begin to look for other ways to ensure their financial stability. The possibility is certainly there, and some will certainly take it, of shifting into euro or at the least a more balanced and diversified portfolio of dollars, euro, pounds, and yen. From this point of view, the days of the hegemonic dollar system may be numbered.
But while this is possible, it is not certain. The dollar reserve system still is not dead. It is not even necessarily dying nor its fate sealed. Like the Ottoman Empire it may endure for a time - perhaps a very long time - simple because it would be costly and dangerous to let it fail.