Thursday, February 07, 2008

No going back

And then there were three.

As Mitt Romney stepped aside, there were—with apologies to Mike Huckabee—three candidates left vying for the Presidency, each now given a one-in-three chance of taking office in January 2009, according to the futures market trading at With nine months still to go until Election Day, the country—and the world—have a long time to consider what will come next.

According to a British friend, the American election has captivated Europe—much to the astonishment of the European press—and to the chagrin of the Gnomes in Brussels. This was, after all, to be the time of the Great Decoupling. This was to be the time when Europe, with a strong currency and an America besotted by war and internal division, would free itself from the economic bondage of Wall Street and the Dollar and American suzerainty.

Instead, the turmoil in the markets over the past six months has had the opposite effect. Since last August, the world financial markets have been in the grip of a liquidity and financial crisis as bank balance sheets have suffered the after effects of a massive lending bubble and credit has disappeared. While the sub-prime market meltdown has reached the front pages of the newspapers, the extent of the liquidity crisis last August that left the world markets shaken never really made it beyond the financial press, despite the firing of a bank CEO here and there and a growing public awareness that things could get a lot worse before they get better.

But with the collapse of the European equity markets two weeks ago, reality came crashing home. Early that Tuesday morning, the Federal Reserve Bank dropped its key interest rates by 75 basis points—three quarters of one percent—to buttress the markets against a spillover effect from Europe and a global unraveling. Then, a few days later, the Fed dropped rates a further 50 basis points.

The Fed actions were heretical. After all, faced with a collapsing dollar and oil at nearly $100 per barrel, the last thing that the United States can afford is a run on its currency. And that would seem to be the natural consequence of the Fed’s actions. After all, who would keep money in Dollars if the value loomed to decline further, and the interest rates were declining, rather than shifting in to Eurobonds, offering stability AND a higher yield? What oil producing country would not want to denominate oil in Euros, or some other basket of currencies, instead of in Dollars? What country holding our bonds as their reserve currency would not want to diversify?

And why not dump the Dollar? After all, each nation needs to look after itself. America had it coming, no? With our trade deficits, our budget deficits and our gas-guzzling SUVs—to say nothing of our militant unilateralism—the world was ready for new leadership. America’s time was past.

But the tell-tale signs did not emerge, and there was little evidence of a new run on the Dollar. By all accounts, the countries that have financed our deficits have not sold. Our long-term bond interest rates have gone down, not up. Asian countries and Arab countries, flush with cash from selling us cars and computers and oil have been the first in line to buttress our financial system and invest capital in our banks.

Only the Europeans have waited to the last minute to recognize the depth of their dependence on the United States. Only after their markets collapsed did the sophisticates of the Eurozone grasp what was evident to the new financial elites of China and Singapore, Dubai and Abu Dhabi: The new globalized world, the world of markets and trade and commerce and finance, remained America’s world. It was America’s creation, and for the moment, it is dependent on American leadership.

This is the world that we wanted. That we created. American foreign policy since World War II has been to lead to a world of free markets, where political divisions would give way to economic interdependency. Our objective was to see the nations behind the Iron Curtain—China, Russia and their satellite nations—and the socialist block countries of India and Egypt and their non-aligned fellow travelers, forsake military competition for economic competition.

This is the world that we desired, and it is the world that we have achieved. The closed factories of the Rustbelt. The migration of our economy from manufacturing to service. The two-income family. The end of defined benefit pension plans. The new imperative of lifelong learning. The pressure for new, non-workplace health insurance. These are all manifestations of our victory in the Cold War, and our success in creating the world of our imagination. The world of economic competition and competitive markets, in the hope of forestalling a world of resource wars and nuclear confrontation.

While much of this is old news, the past several weeks have added a new reality, a new granularity, to our picture of the world. When the Fed threw caution to the wind and reduced interest rates by 25% in one week, when they dispensed with the traditional incrementalism, they were struggling with a new reality. In a world where the Dollar has become the reserve currency, the Feds core monetary policy tools for managing our economy have lost power. Similarly, as Congress passed a stimulus package, it was clinging to an antiquated notion that the tools of Keynesian fiscal policy—spending as a tool for spurring economic growth—had more than marginal influence in a world of massive and unchecked deficit spending.

The new reality is that in a world where much if not most of our currency circulates beyond our borders, our tools of monetary and fiscal policy no longer have the power they once had. This is not just our new reality, but the reality of others as well. As central bankers in Brussels struggle with growing demands that they spur growth, while those in Shanghai struggle to contain it, each now realizes that their future—if not their currency—is pegged to ours.

President McCain. President Clinton. President Obama. One of them will inherit a world where the rules have changed, and where domestic monetary and fiscal policy tools will no longer be adequate to dictate our economic future. The new president will have to build new strategies for the coordination of economic policies that address this new and deep interdependency. China and Singapore, Dubai and Abu Dhabi know full well that a collapse of the American Dollar will bring all of them down with it. But only over the past few weeks have their counterparts in Europe come to realize that like the American people, their future will depend on the quality of leadership that emerges from our elections, and whomever that person turns out to be, they have a very real interest in their success.

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