A. Ross


By common consent, we have been living through the greatest economic downturn since World War II. It originated, as we all know, in a collapse of the banking system, and the first attempts to understand the resulting economic crisis focused on the reasons for bank failures. The banks, it was said, had failed to “manage” the new “risks” posed by financial innovation. Alan Greenspan’s statement that the cause of the crisis was the “underpricing of risk worldwide” was the most succinct expression of this view.1 Particular attention was paid to the role of the American subprime mortgage market as the source of the so-called “toxic” assets that had come to dominate bank balance sheets. Early remedies for the crisis concentrated on bailing out or refinancing the banks, so that they could start lending again. These were followed by “stimulus packages,” both monetary and fiscal, to revive the real economy.

Now that we are—or may be—over the worst of the crisis, attention has partly switched to trying to understand its deeper causes. The two most popular explanations to have emerged are the “money glut” and the “saving glut” theories. The first blames the crisis on loose fiscal and monetary policy, which enabled Americans to live beyond their means. In particular, Greenspan, chairman of the Federal Reserve in the critical years until his retirement in early 2006, used low interest rates to keep money too cheap for too long, thus allowing the housing bubble to get pumped up till it burst.

The second explanation sees cheap money in the US as a response to a “global saving glut” originating in East Asia and the Middle East. The “exorbitant privilege” enjoyed by the US dollar as the world’s key currency allowed the US to pursue a fiscal and monetary policy that pushed domestic demand for goods and services well beyond domestic output, thereby absorbing the foreign savings hurled at it. The trouble was that foreign, and particularly Chinese, “investment” in the US economy, which in recent years has taken the form of buying US Treasury bonds, failed to create a corresponding flow of American tradable goods and services with which to repay the borrowing. As a result, America’s domestic and foreign debt just went on increasing. In the technical jargon, both the US current account deficit and its debt-financed housing boom were unsustainable: it was unclear whether the dollar or the housing bubble would collapse first.


Concern about the US current account deficit—the excess of expenditures over receipts in a country’s balance of payments—long preceded the financial crisis. By 2005, it had already ballooned to 5 percent of GDP. How had this happened? The conservative explanation was that the US monetary and fiscal authorities had provided Americans with the money to make payments to foreigners for imports far in excess of the payments they received from foreigners for exports. This “spending beyond your means” is the classic road to ruin, for households as well as for countries. In the case of households, it is normally brought to an end by a notice from your bank or credit card company saying that you have reached your credit limit or your account has been frozen. In the case of countries, it is normally ended by the refusal of other countries to lend the profligate country the means to continue its spending spree. The puzzle, though, was why the countries with surpluses continued to pour their hard-earned savings into the debt-ridden American economy.

In a notable lecture in 2005, Ben Bernanke, about to become chairman of the Federal Reserve, gave the answer. At first, he said, it was because the US was a highly productive economy. But following the financial crisis of 1997–1998, East Asian countries had deliberately started accumulating foreign exchange reserves to guard against another flight of capital similar to what they had just suffered or observed. To accumulate reserves they had to run current account surpluses, by earning more in exports than they spent on imports. This tied in with their policy of undervaluing their currencies against the dollar in order to maintain export-led growth.

After the collapse of the dot-com boom in 2000, the US became a much less desirable place for direct foreign investment. So East Asian countries, especially China, started to buy US Treasury bonds. They adopted aggressive policies of buying large quantities of dollars and resisting market pressure for appreciation of their currencies. Investing their dollars in US securities was a way of segregating their dollar purchases from the domestic money supply, thereby preventing domestic price increases that would have eroded their export competitiveness. Like other economists at the time, Bernanke saw considerable merit in the arrangement: it enabled emerging and developing countries to reduce their foreign debts, stabilize their currencies, and reduce the risk of financial crises. Without US willingness to act as a “consumer of last resort,” the global savings glut would exert a huge deflationary pressure on the world economy.


But Bernanke also pointed out three snags in the situation. First, for developing countries to be lending large net sums to mature industrial countries with abundant capital was undesirable: the flow should be going the other way—to countries with a capital shortage. Second, much of the inflow of capital to the US went not into improving productivity but into the housing sector and consumption. Third, the arrangement depressed US exports, encouraging instead the parts of the economy that produce nontraded goods and services, such as the financial industry. Yet to repay its foreign creditors, the US needed healthy export industries. A fall in the dollar was, therefore, needed to shrink the nontradable economy relative to the export sector. Nevertheless, Bernanke concluded, “fundamentally, I see no reason why the whole process [of rebalancing] should not proceed smoothly.”

This was the standard view before the present crisis broke. Martin Wolf, the world’s most respected financial columnist—mainly for the Financial Times —published a book in 2004 called Why Globalization Works.2 He saw globalization as a mighty engine for ending global poverty, and was scornful of arguments against it, most of which he dismissed as lacking professional competence. He pointed to the huge success of China in reducing extreme poverty (people living on less than $1 a day). He saw no problem arising from the macroeconomic imbalances that resulted from lopsided trade. As he wrote:

The pattern of surpluses and deficits will create difficulties only to the extent that the intermediation of the flows from the savings-surplus to the savings-deficit countries does not work smoothly…. But no insuperable difficulty should arise. If some people [Asians] wish to spend less than they earn today, then others need to be encouraged to spend more.

As late as mid-2007, he thought that the possibility that “huge calamities” could be generated by world financial markets “looks remote.”3

His message just two months later was very different:

Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter…. Today’s credit crisis…is also a symptom of an unbalanced world economy.4

Wolf more recently argued that the accumulation of dollar reserves by China and other East Asian countries that have maintained undervalued exchange rates against the dollar explains the low long-term interest rates and monetary easing of the US in the 2000s. Cheap money, he writes, had “encouraged an orgy of financial innovation, borrowing and spending” that created housing bubbles:

High-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.5


Wolf’s most recent book, Fixing Global Finance, marks a turning point in his worldview. Written in 2007, just before the first signs of the current financial crisis were starting to register, it explains how unprecedented macroeconomic imbalances have repeatedly created the preconditions for financial crises over the last three decades. It offers the reader a chance to test Wolf’s predictions and prescriptions a few months after they were made.

Wolf’s main argument is that the microeconomics of finance is intimately intertwined with the nature of the global macroeconomy. If the latter is not sound, the former will not be sound either. His eight chapters take us through a detailed account of the role of exchange rate regimes—i.e., policies used to maintain currencies at a desired level against the dollar—and their influence on balance of payments and, ultimately, on the availability and use of credit in domestic economies.

It was the large macroeconomic effects of financial crises in emerging markets in the 1990s that enabled America to become what Wolf calls the “borrower and spender of last resort.” There were four steps toward these crises: mismanaged liberalization (and globalization), run-up to currency crisis, currency crisis, and, finally, full financial crisis. South Korea offers a good example. During the 1990s, in order to qualify for OECD membership, South Korea had been liberalizing its exchange controls and credit markets. Spurred by their government to keep growing, large Korean companies and banks started borrowing abroad despite dwindling profits. Rising foreign interest rates undermined their creditworthiness and increased the cost of servicing their debt. They therefore needed to borrow even more—but now under worse conditions. This led to a general skepticism among foreign lenders. Whether solvent or not, Korean companies were faced by an ever-worsening credit situation.

Under these conditions of uncertainty, Koreans and other foreigners started selling the domestic currency, which therefore plummeted in value and triggered a currency crisis. This is when the full financial crisis of the 1990s really got going. With a devalued domestic currency, neither private nor public institutions could afford to take out new loans in foreign currencies, and the old ones could not be repaid. Interest rates soared and insolvent companies were wiped out, bringing solvent banks down with them. “Domestic credit seizes up. Inflation surges as the currency tumbles. The economy falls into a deep recession.” Partly because of similarity of circumstances and partly because of contagion effects, this was the fate of most East Asian economies in 1997–1998.


During the three decades preced- ing 1997, financial crises were always followed by periods of large inflows of capital into emerging market economies ranging from East Asia to Latin America, as foreign investors shrugged off their losses and cheerfully started lending again. However, East Asian countries realized that being a net importer of capital comes at huge cost when their domestic currency faces devaluation. Thus, at the end of the 1990s, most emerging economies simply said “enough.” No longer would they run current account deficits; instead they would keep their currencies artificially low—but stable—to facilitate export-led growth and become net exporters of capital.

Ben Bernanke
Ben Bernanke; drawing by John Springs

To prevent inflows of capital from private foreign interests and banks from jeopardizing this policy, the governments of these countries have since been accumulating huge foreign-denominated reserves. In particular, they have been hoarding dollars. As Wolf puts it:

In essence, this is government recycling of money earned through the current account and money received from private sector capital flows: the emerging market economies are…smoking capital, but not inhaling.

This set the stage for unprecedented global imbalances. There can be no net exporter of capital without a net importer of capital. And if the net exporters happen to include countries such as China, you need a really big economy to absorb that capital. Enter the United States.

What follows in Wolf’s account is largely a rehash of Bernanke’s 2005 lecture. Wolf explains the “saving glut”/”money glut” debate, which is also an argument about the conduct of US macroeconomic policy in the years leading up to the bank crash of 2008. The official view of the Federal Reserve was that the existence of a “global saving glut” required the US to step forward as the superborrower to rescue the world from a recession. The “money glut” view holds that the direction of causality was quite the opposite: US monetary excess brought about low interest rates, which sparked a rapid growth in credit while reducing the willingness of American households to invest. This then resulted in trade deficits that weakened the dollar. To preserve competitiveness, East Asian governments were forced to embark on open-ended foreign currency intervention.

Thus, in the “money glut” view it was excessive US spending that led to excessive saving in emerging markets and not the other way around. Wolf prefers the “saving glut” to the “money glut” explanation. As he puts it:

Many blame the United States’ predicament on the policies of the Federal Reserve and lax regulation of the financial system. These arguments are not without merit, but they are exaggerated.

Wolf’s book is overloaded with diagrams and tables to back up this argument. The very density of the material may obscure the reader’s understanding of the causal mechanisms by which “surplus Chinese saving” became “excessive American spending.” Evidently, Americans didn’t directly spend Chinese savings. The US dollars earned by Chinese exporters weren’t being borrowed by American firms and households: they were being borrowed by China’s central bank, which then hoarded or segregated them to keep them out of the domestic money supply and to keep the exchange rate low.

The story goes somewhat like this. Instead of having to borrow from the American public to finance its fiscal deficit, the US government could borrow Chinese savings by issuing Treasury bonds that were bought by the Chinese. Therefore federal deficits did not raise the cost of domestic borrowing, which they would have done had the government had to borrow American savings rather than selling debt to China. If the economy is working to capacity, the more governments borrow, the less private investors borrow. This is called “crowding out.” With Chinese savings available, the US government could run a deficit without crowding out private spending. This allowed the Fed to establish a much lower funds rate—the rate at which banks borrow from the Fed and one another—than it would otherwise have been able to do, helped in this by the downward pressure on prices exerted by the import of cheap Chinese goods produced by cheap Chinese labor. Cheap money, in turn, enabled banks to expand their deposits and their loans to customers more than they could otherwise have done. In short, it was via their impact on the financing of the federal deficit that Chinese savings made it possible for the US consumer to go on a spending spree.

Provided that the Chinese were prepared to go on lending money to the US, why was this position unsustainable? Wolf suggests the answer when he remarks that the glut of savings by the Chinese might be better thought of as an “investment dearth” in the United States. This echoes Alan Greenspan’s finding that cheap money hardly raised the level of US investment. A key indicator of this, as Greenspan put it, was

the dramatic swing in corporations’ use of their internal cash flow…from fixed investment to buybacks of company stock and cash disbursed to shareholders.

The lack of opportunities for profitable investment determined the pattern of American spending. Americans borrowed not to invest in new machines but to speculate in houses and mergers and acquisitions. The resulting growth in paper wealth triggered a consumption boom. The situation was unsustainable because no new resources were being created with which to pay back either domestic or foreign borrowing.

This much was apparent to Wolf by 2007. But he took the view that to take any action to correct this enormous imbalance between China and the US risked upsetting the delicate, if unsound, mechanism that was keeping the world economy afloat. Indeed, he remarked:

As I write these words in August 2007, there seems to be good reason to welcome the global imbalances…: the world economy is growing strongly and in a more balanced way than in previous years, as demand picks up across the globe; the developing world is also performing well, particularly in Asia; and the world has not experienced a significant financial crisis in emerging markets since 2001.

Yet the name Wolf gives to his fifth chapter—“Calm before a Storm”—provides a hint of coming trouble.

In fact the present financial meltdown is producing the market-led adjustment that has eluded policymakers. Willy-nilly Americans are having to spend less and save more; the decline of Chinese export markets forces China to shift its growth emphasis to domestic development; the weakening of the American economy has produced an automatic decline in the relative value of the dollar against other currencies. But unless these market-led adjustments to acute crisis become conscious policy choices in both China and the US, the global imbalances will recreate themselves and we will limp out of this crisis into the next. Crisis always enlarges the possibility for reform. Wolf’s prescriptions for rebalancing the world economy are still relevant: emerging market economies need to spend more and save less, and mature market economies need to spend less and save more. This would automatically right the listing ship. But how is this to be done?

In line with the “saving glut” hypothesis, Wolf argues that it is up to the Chinese and other East Asian countries to take steps to eliminate the excess savings they have created. This is in their own self-interest. The Chinese save and invest almost 50 percent of their GDP. Wolf claims that they get very poor return for their frugality. Chinese employment has hardly grown, because investment in export-led growth is highly capital-intensive: in 2005, the excess capacity in China’s steel industry was 120 million tons—more than the annual production of Japan, the world’s second-largest producer. Moreover, there are political risks in channeling current account surpluses into foreign reserves instead of greater consumption, improved health care, and infrastructure. This is particularly the case when the nominal returns on dollar debt are as low as they have been in the last few years.

Emerging-market governments should pursue expansionary fiscal policies to stir more private demand since, if the provision of public goods improves, private actors will have less of an incentive to keep up their current rates of precautionary savings. Emerging-market governments should also undertake financial reforms to enable them to raise funds in their own currencies—the only way to avoid the exchange rate problem that frequently caused crises in the past. The best way to achieve this is to develop markets in emerging economies for bonds denominated in the local currency. Unless these domestic credit markets are developed, emerging-market governments will be unwilling to run deficits, since the only funding now available—mostly in dollar-denominated instruments—exposes them to the risk of being unable to service their debts if the exchange rate fluctuates.

Another element in the East Asian adjustment should be a move to more flexible exchange rates, though Wolf recognizes that floating exchange rates are an obstacle to securing net capital flows from rich to poor countries. Global reform is necessary alongside domestic reform. Wolf ends with a raft of small but useful ideas for reforming the World Bank, regional development banks, and the International Monetary Fund (IMF). The IMF must be better at delivering technical assistance, surveillance, coordination of macroeconomic policies and exchange rates, and crisis management. It must reform its system of representation and resume its role as a credible lender during economic crises. The decision by the G-20 in April to expand the IMF’s special drawing rights (SDRs) available to its members by $250 billion is an important step in this direction. Fred Bergsten, director of Washington’s Peterson Institute for International Economics, argues that this opens the door to China’s proposal to create a new global reserve currency to replace the dollar. But the door is only slightly ajar. What will ensure the general acceptability of the SDRs as reserves? And how will their issue be regulated? These questions have hardly been discussed.6


Despite the density of its argument and its skepticism about the possibility of reform in the short term, Wolf’s book offers important pointers to the way ahead. But his story is only half-told. He has very little to say about America’s responsibility for both creating and ending the system of global imbalances. For the fact is that the present system has suited the United States—specifically the power holders in the United States—just as much as it has those in China. The phrase “it has enabled the Americans to live beyond their means” is too vague to be useful. One needs to ask: which Americans? Certainly many middle- and low-income American households have been given opportunities to borrow beyond their means.

But secondly, the American–Chinese symbiosis has been excellent for US business profits. American businessmen have been complicit in Chinese “super-competitiveness” by arranging for manufacturing jobs to be moved to China from the US in order to cut costs. The decline in US manufacturing and the growth in nontradable services, and the financial operations that secured this restructuring, have enabled financiers and businessmen to earn huge profits that should have been shared with their workers. Morally, the financial community has been living well beyond its means. But perhaps above all, by getting other countries to finance its imperial pretensions, the US government has been able to live beyond its means. Wolf refers in several places to the “exorbitant privilege” of the US dollar, but omits entirely to discuss the political benefits that this privilege buys.

This points to the main weakness of Fixing Global Finance: the lack of a historical perspective. The history of the overprivileged dollar, after all, goes all the way back to the 1960s. Its roots lie in the failure of John Maynard Keynes’s plan for a Clearing Union, which he worked out during World War II. The Keynes plan was specifically designed to prevent creditor countries from hoarding reserves by trading at undervalued currencies. If they did not spend their surpluses, the surpluses would be confiscated and redistributed among debtor countries. In this way a global balance between saving and investment would be secured through a balanced trade position, which would in turn allow fixed, but adjustable, exchange rates.

The Bretton Woods agreement of 1944 adopted the proposal for fixed but adjustable rates, but failed to provide a remedy against countries with trade surpluses accumulating, or hoarding, reserves. In practice, the problem was solved by the United States taking the place of nineteenth-century Britain as the chief supplier of foreign investment funds. The outflow of American savings helped reconstruct Europe after the war, and kept global demand buoyant throughout the Bretton Woods era. The dollar replaced gold as the world’s chief reserve currency. This allowed the US to print dollars to cover its growing trade deficit. The arrangement suited both the Europeans and the United States, because it not only enabled the Europeans to export to America at undervalued exchange rates, but it also covered the cost of America defending Western Europe and non-Chinese East Asia against communism. In other words, the “exorbitant privilege” of the dollar allowed the US to pursue an imperial mission that, in the era of the cold war, was greatly to the satisfaction of its partners and allies.

The privileged position of the dollar survived the collapse of the Bretton Woods regime of fixed-exchange rates in 1971. In theory, the resulting system of floating exchange rates removes the need for any reserves at all, since adjustment of current account imbalances was supposed to be automatic. But the need for reserves unexpectedly survived, mainly to guard against speculative movements of short-term investment—“hot money”—that could drive exchange rates away from their equilibrium values. Starting in the 1990s, East Asian governments unilaterally erected a “Bretton Woods II,” linking their currencies to the dollar, and holding their reserves in dollars. This reproduced both the benefits and faults of Bretton Woods I: it avoided global deflation, but undermined the long-run credibility of the dollar as the global reserve currency.

The new arrangement allowed the United States to continue to enjoy the political benefits of “seigniorage”—the right to acquire real resources through the printing of money. The “free” resources were not just unpaid-for imported consumer goods but the ability to deploy large military forces overseas without having to tax its own citizens to do so. Every historian knows that a hegemonic currency is part of an imperial system of political relations. Americans acquiesced in the unbalanced economic relations initiated by East Asian governments in their undervaluation of their currencies because they ensured the persistence of unbalanced political relations.

A willingness by the US government to end macroeconomic imbalances thus depends on its willingness to accept a much more plural world—one in which other centers of power in Europe, China, Japan, Latin America, and the Middle East assume responsibility for their own security, and in which the rules of the game for a world order that can preserve the peace while effectively tackling the challenges posed by terrorism, climate change, and abuse of human rights are negotiated and not imposed. Whether, even under Obama, the US is willing to accept such a political rebalancing of the world is far from obvious. It will require a huge mental realignment in the United States. The financial crash has disclosed the need for an economic realignment. But it will not happen until the US renounces its imperial mission.

—June 17, 2009