Friday, July 25, 2014

The biggest surprise of the financial crisis

Free trade for you! Win MacNamee/Getty Images

When you hear "2008 financial crisis," is your first thought "proof that the global economy works"? Mine neither, but in his new book, provocatively titled The System Worked, Dan Drezner makes a strong case that it should be.

Drezner, an international relations professor at the Fletcher School of Law and Diplomacy at Tufts University and popular world affairs writer, thinks the financial crisis should have been a whole lot worse. At the beginning, it actually looked like it was going to be worse than the Great Depression. But then something miraculous happened: the global economy didn't collapse. By working together to keep trade free and capital flowing, the world's major powers and economic institutions prevented us from re-running of 1929.

Drezner and I sat down to talk about why he thinks the global economy is doing OK despite American and European woes, whether he thinks we could weather another financial collapse, and whether global cooperation to save the global economy means the world might get its act together to do something about climate change. What follows is a transcript of our conversation, edited for length and clarity.

Zack Beauchamp: So, it feels totally ridiculous to say the financial system worked.

DD: First of all, we've got to be clear. When I said "the system worked," I'm not talking about the financial system. I'm talking about the system of global economic governance — the rules of the game and the collection of institutions both international and domestic that are supposed to regulate the economic system.

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I'm not even saying that the governance system that I'm talking about worked terribly well before 2008. What I am saying is that, in the middle of the worst crisis since the Great Depression and despite the fact that there were many excellent reasons to think that the system was going to crack up in the fall of 2008, most of these institutions did what they had to do to preserve the global economy.

The initial shock of the 2008 financial crisis was worse than what happened in 1929, and yet we didn't experience another Great Depression. Outside the developed world, the global economy has actually done remarkably well. That's the interesting story, as far as I'm concerned.

ZB: Why should I believe that the global economic system worked?

DD: I look at three different levels. First, what happened to the global economy after 2008. I think here the biggest misperception if you live in Washington is the notion that "the US economy hasn't done great, so clearly that's evidence that the global economy hasn't done great."

Actually, the global economy has done reasonably well since 2008. You have trade and production higher than it was at the peak in 2007. You have significant amounts of poverty reduction — in fact, a faster rate of poverty reduction globally than you had in the 90s, which we think of as the boom times. And you haven't had any deglobalization. Part of the reason the system worked really well is that no one moved towards protectionism or towards financial closure.

At another level, I look at what these institutions did. Did they do what you would have wanted them to do? And the system did what you have wanted it to do. There's a pretty strong break applied to increases in protectionism, there hasn't really been any shift towards economic closure, and most of the central banks pumped a fair amount of liquidity into the global economy, which is what they're supposed to do. In fact, the critiques you can make are that some of them didn't do it enough, like the European Central Bank.

The third leg is to what extent the key institutions reform themselves, both for trying to deal with policy errors from the previous period and to better reflect the distribution of power now. And it worked there too. We quickly shifted from the G8 to the G20 as the focal point for managing these institutions. The IMF and the World Bank engage in various forms of quota reform, and some of the other more hidden structures — like the Basel Committee on Banking Supervision or the Financial Stability Board — expanded their membership to include [Russia, China, Brazil, and India] and other developing countries.

If I told you 15 years ago that, during the next crisis, the IMF was going to a) say that capital controls might be a good idea once in a while and b) push hard for Keynesian policies rather than austerity, you would have been surprised. So would have everyone else. It's a reflection of the extent to which the system actually did reasonably recommend the things it was supposed to do.

ZB: One of the interesting themes in your book is the relationship between the United States and China. Can you talk a little about why what's often seen as a competitive relationship ended up preserving the global economy?

DD: One of the biggest misperceptions out there is this notion that we're in the middle of a power transition, and China has clearly supplanted the United States as the most powerful economy in the world. If you take a look at surveys, that's what a broad majority of people say.

In the book, I argue two things. First, that the United States actually retains significant amounts of structural power. If you look at things like capital flows, the United States is even more important now that it was in 2007. This is the biggest surprise to a lot of people: the US is even more the epicenter of global finance than it was prior to 2008.

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Jewel Samad/AFP/Getty Images

The United States still owns 40 percent of the world's wealth. It's still the wealthiest country in the world. There would have been excellent reasons for the Washington Consensus set of policies to be discredited after 2008, and what's fascinating is that didn't happen. And the reason that didn't happen is that China ended up acting like a responsible stakeholder.

China did not, despite a lot of grumbling, raise its tariffs. It didn't suddenly introduce a whole lot of non-tariff barriers. It kept its economy relatively open. It also engaged in significant lending to developing countries to make sure they had liquidity in the system. It contributed to things like anti-piracy [efforts] and the World Bank. After 2010, China started to let its currency appreciate — more slowly that the United States would like, but it was significant to the point where the McKinsey Global Institute and The Economist said there's been significant rebalancing going on by the end of 2013.

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As to why they did this, it was in some ways enlightened self-interest. For a lot of loose talk about the Beijing Consensus as an alternative to the Washington Consensus, I think the Chinese themselves never saw that as a real viable model.

If you look at internal debates about Chinese economic policy, they've shifted closer to the Washington Consensus, not further away. Because they recognize that the sort of growth model they were relying on — massive state-funded investments in state-owned enterprises — it works if your GDP is $100 per capita. Once you get to middle-income status, the diminishing marginal returns of that really kick in.

It's a debatable question as to whether China is really going to to reform and look more like, say, South Korea. But the fact is that, at the level of ideas, China is not proposing a serious challenge to what the liberal international order looks like.

ZB: The broader global openness that you describe doesn't seem to have fixed the big problems in the developed world. Why wasn't keeping trade open and the like enough to fix their economies?

DD: That's a fair question. There are two answers.

First, global economic openness is never a cure. It's like keeping the fever down while you allow the patient to get better. Recessions really do turn into depressions if you start pursuing a policy of economic closure. Because that didn't happen, it gave most of the major economies a chance to recover.

This leads to the dark side of the Washington Consensus: the United States and the European Union committed so many policy own-goals after the crisis that really the fault lies at the national level, not the global level.

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Louisa Gouliamaki/AFP/Getty Images

It's worth noting that the United States committed fewer of these errors. TARP was pretty quickly initiated, the Fed was willing to pump a lot of money into the system. And you had two years of some degree of fiscal expansion [stimulus]. That's not nothing, and I would have preferred to see more, but that's not nothing.

The Europeans were much slower to engage in quantitative easing, and were much more skittish with respect to fiscal stimulus. Then when Greece goes south, suddenly they do this massive shift towards fiscal austerity. It was a wrong-headed policy, but part of the reason it wound up being so attractive was because conservative fiscal policy is part and parcel of the Washington Consensus. So it's not shocking that this seemed more attractive to Europeans.

The other reason is that — this is Paul Krugman's argument — it was almost morally appealing: "we have committed sins in the past with excessive debt, and we will not do that again." Without realizing that the way you cure excessive leverage in the private sector is to leverage the public sector, which then allows the private sector to deleverage.

That's happened a fair amount in the United States. Not so much in Europe.

ZB: Do you think the ideas behind the global economy are, on balance, more broken than they are effective? Your book is fundamentally optimistic, but the past few minutes of this conversation have taken a darker turn.

DD: I'm a huge fan of the microeconomic set of policies that the Washington Consensus, neoliberalism — whatever you want to call it — has advocated. Has the world has benefitted from more globalization? I think undoubtedly so. Could you tweak it at the margins in terms of capital controls in a time of emergency? Absolutely, and in fact the IMF has gone in that direction.

Macroeconomic policy is different. There's less consensus there, and what consensus there is more on the notion that you shouldn't do much on the fiscal side and let the monetary side handle things. Even that might actually apply during normal times, but post-2008 we weren't living in normal times. Which is why you wanted to see a return to Keynesian fiscal policy, which is what you got for a few short years.

The history of macroeconomic policy cooperation is not a distinguished one. Even two years of a relatively OK policy constitutes a major policy victory.

This is what happens when you study the history of the global economy. You realize if they got something really right in a time of global crisis, you thank God for that.

ZB: What happens if the pessimists about the financial system are right, and we're primed for a re-run of the 2008 crisis? Do you think the system would be able to work again? Or do you think that it wouldn't be able to take the stress?

DD: The factors that I say caused the system to work are mostly still in place now. You're still operating in a world of the global supply chain, there's been no disaggregation or segregation of that. So you have a powerful incentive to keep markets open.

US structural power hasn't waned as a result of 2008 — in terms of finance, military, or [influence on] ideas. China certainly has risen in power, but the shift in their ideas has been more towards neoliberalism than not. And there's been no serious challenge to the set of ideas that animate the global economy.

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Michael Mandiberg/Flickr

Would any of these things change if there was a crisis? I tend to think not. The only caveat I will offer is that if the crisis is caused by a geopolitical crisis between the United States and China, that's a whole separate thing. Because then you might be in a situation where great powers prioritize what they think of as security issues over the global economy.

That said, the US and China are so closely intertwined in economic terms that it would take something worse than 2008 for either side to think that they need to start shifting towards autarky.

The other thing I would add is that because of Basel 3 and Dodd-Frank, we've actually built a little more resiliency into the global financial system. So the odds of another crisis happening anytime soon are fairly low.

That said, we'll have another crisis. Crises are endemic to the system. I'm skeptical that there's going to be one anytime soon.

ZB: Isn't it a little scary to be confident that the world's gonna be alright?

DD: Oh, I'm scared to death.

The trendy thing to do in my industry is to predict disaster. Even if you're wrong, it doesn't matter. You can just say you were being prudent, or that you averted disaster by claiming it was going to happen.

The worst thing you can do is make an optimistic prediction that then turns out to be wrong.

ZB: Is that why you think that most people are saying the system failed?

DD: In some ways, yeah. God forbid you say "Oh, I think we actually turned the corner" and then Goldman goes under, or something like that.

But in the book, there are other reasons I offer. A lot of people who write about the global economy are based in the least-robust parts of the global economy, the advanced industrialized states. I don't blame them for saying the American economy or the European economy isn't doing great. That's different from saying the global economy hasn't rebounded.

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Spencer Platt/Getty Images

Second, as I said, there's a conflation of national policy errors [i.e., austerity] with global ones. Third, I hear some nostalgia for the way the system worked — this belief that the Bretton Woods like the IMF and the World Bank were really built to last. But as someone who's studied these things, trust me: we didn't pay that much attention to them back then either. The idea that there's somehow been an erosion of the order is pretty amusing.

Finally, the dirty secret about this is a lot of people who write about international relations don't actually know a lot about international economics. What they'll tend to do is draw on the most superficial data points — which might support them! For example, the Doha [trade negotiations] haven't been completed. The Copenhagen climate change summit was a fiasco. We haven't solved Syria or Ukraine, or the South China Sea. You go from that and you conclude the system failed.

ZB: Do you think that there was this unprecedented global cooperation in the face of a crisis for a global economy says anything interesting about broader capabilities for global economic cooperation? Say, climate change?

DD: Actually, I'm relatively optimistic going forward that there might actually be some climate change cooperation. You see the United States and China taking some steps in the last month that, if I told you two years ago were gonna happen, you would have been surprised by.

In some ways, the climate change story is the tough test of my argument. It's a really serious cooperation problem, because it really involves tough costs born by the great powers. On the other hand, you do see both in the United States and China a recognition that there actually is a crisis out there and that action might be called for.

It's also an area where you might say technological change has actually made things a little bit easier. The fact that we now have this windfall of shale gas and oil — it's not like hydrocarbons are great, but they are much better than coal as a way of not generation CO2. In some ways, it gives these economies a generation of breathing room. We now have this way of developing this kind of energy. Can we now make investments so, 50 years from now, we're actually on a more sustainable path?

The Chinese recognize that environmental problems were a major source of political instability in the former Communist countries, so they have an incentive to tamp that down. Obviously through repressive means, but also in more direct ways to alleviate the environmental problem.

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