Wednesday, September 24, 2008

The End of 'Chimerica'

NIALL FERGUSON, Standpoint, September 2008

Shortly before the anniversary of the great Western credit crunch, I paid a visit to its antithesis: the great Eastern savings splurge. Nowhere better embodies the breakneck economic expansion of China than the city of Chongqing. Far up the River Yangtze, it is the fastest growing city in the world today. I had seen some spectacular feats of construction in previous visits to China, but this put even Shanghai and Shenzhen into the shade. There was something truly awe-inspiring about the countless tower blocks under construction, the innumerable cranes perched on the city’s hills, the gleaming new highways, the brand-new enterprise zones, the ubiquitous smog. I felt I was witnessing an industrial revolution several orders of magnitude larger than the Industrial Revolution that once filled the cities of the West – of the British Isles and North America – with similar noxious fumes.

Yet in some ways Chongqing also reminded me, eerily, of the Soviet Union in the 1930s. Because it is, unmistakably, a product of a planned economy. The reason that Chongqing is growing so fast has little or nothing to do with market forces, and everything to do with a decision taken in Beijing to turn Chongqinq into the biggest financial and manufacturing centre in western China. As local officials told me about the 30 bridges they were building, the 10 light railways and the millions of square meters of residential and office space, I find myself thinking: this is the reincarnated spirit of early Stalinism. There is the same sense of limitless possibilities, the same sense that state-led industrialisation can take you to the moon and beyond. But there is also the same sense that the negative externalities of growth are being ignored. As in the Soviet case, in China today there is little evidence that the factors of production are being accurately priced; little evidence that the pollution of air, soil and water is being properly accounted for. China’s industrial take-off may have begun with foreign direct investment and an export drive aimed at Western markets. Today it has become domestically driven, both in terms of the sources of investment and the sources of demand. The state is in the driving seat.

And so I came away from Chongqing thinking differently about China. In particular, I came away convinced that we are living through the end of something Moritz Schularick and I christened “Chimerica”. In our view, the most important thing to understand about the world economy over the past 10 years has been the relationship between China and America. If you think of it as one economy called Chimerica that relationship accounts for around 13 per cent of the world’s land surface, a quarter of its population, about a third of its gross domestic product and somewhere over half of economic growth in the past six years.

For a time, it was a symbiotic relationship that seemed almost perfect. To put it very simply, one half did the saving and the other half did the spending. Comparing net national savings as a proportion of gross national income, American savings declined from above 5 per cent in the mid 1990s to virtually zero by 2005, while Chinese savings surged from below 30 per cent to nearly 45 per cent. This divergence in saving allowed a tremendous explosion of debt in the United States because one effect of what Ben Bernanke, chairman of the US Federal Reserve, called the Asian “savings glut” was to make it very much cheaper for households to borrow money – and to a lesser extent for the government to borrow money – than would otherwise have been the case.

Needless to say, it was not just the United States that was borrowing, and it was not just the Chinese who were lending. All over the English-speaking world, as well as in countries like Spain, household indebtedness increased and conventional forms of saving were abandoned in favor of leveraged plays on real estate markets. Meanwhile, not only China but other Asian economies adopted currency pegs and accumulated international reserves, thereby financing Anglosphere deficits as well as keeping their exports affordable. Middle Eastern and other energy exporters also found themselves running surpluses and recycling petrodollars to the Anglosphere and its satellites. But it was Chimerica that was the real engine of the world economy.
As this tremendous expansion in borrowing was taking place, many Panglossian economists tried to rationalise what was going on. Some argued that this was “Bretton Woods II”, a kind of system of international exchange rate management. Others called it a “stable disequilibrium”, something that could be counted on to continue for some considerable time. What went wrong, as is now well known, is that a crisis in the subprime mortgage market in the United States sent a shockwave through the western financial system. Was this a black swan in Nassim Taleb’s sense of an event beyond the power of markets to predict? No. It was eminently predictable.

In essence, the rest of the world’s savings helped inflate a real estate bubble in the United States. Easy money was, as is nearly always the case, accompanied by lax lending standards. As invariably happens in bubbles, euphoria eventually gave way to distress and then panic. It began in the subprime market because it was there that house prices were least sustainable; it was there that defaults were most likely to happen. But the housing crisis in the United States is far from over. According to figures produced earlier this summer by Credit Suisse, a total of 6.5m loans could ultimately fall into foreclosure. That could throw as many as 13 per cent of US homeowners with mortgages out of their homes. At the time of writing, no one knows where the floor is for US property prices. Not since the Great Depression have we seen house prices declining at annual rates above 10 per cent.

What is more, the negative effects of this housing crisis on the American financial system have not yet fully manifested themselves. If the total losses on risky debt can be estimated at more than $1 trillion, yet only something like $400bn of writedowns has been acknowledged, and barely $300bn of new capital has been raised by western banks, there is a hole of at least $100bn in the financial system. Because of the way our credit system works, that implies a 10-fold contraction in bank balance sheets in the foreseeable future. Potentially, this could be a “great contraction” comparable with the one described by Milton Friedman and Anna Schwartz in their famous Monetary History of the United States.
I say “potentially” because Ben Bernanke and his colleagues at the Federal Reserve have been striving manfully to avert such a monetary meltdown. Indeed, you could have predicted nearly every move the Fed has made over the past year, simply by assuming that it would do the opposite of what the Fed did during the Great Depression. It has done everything to prevent large-scale banking failure from taking the economy down. It has pumped liquidity into the financial system by cutting rates and targeting funds. It has risked its own credibility in doing so. It has arguably overstepped its statutory powers. It has been a wonderful exercise in the application of historical knowledge – just what one would have expected from a Fed chairman who did the lion's share of his academic work on the Great Depression.

Yet it is not immediately clear that the Fed – or for that matter the European Central Bank, which has been equally open-handed – has the capability entirely to offset this contraction. Friedman and Schwartz assumed that if the Fed had only been more enlightened between 1929 and 1933, the Depression could somehow have been avoided, or at least mitigated. We are now testing their theory that a central bank, if it is sufficiently expansionary, can avert a full-scale banking crisis. The test is not yet over. If, as seems inevitable, there is a recession in the United States, there will be corporate defaults. And when these corporate defaults increase, we will find out just what credit default swaps really are. Are they a wonderful, flexible insurance policy? Have they allowed risk to be allocated optimally as never before? Perhaps. But that is what they used to say about collateralised debt obligations, the key financial instruments used to turn “toxic waste” mortgages into “investment-grade” securities.

During the Depression – notably in 1931 – the Fed tightened monetary policy to avoid a drain on its reserves following the devaluation of sterling. This time around, we can be confident that Bernanke will tighten only if there is a clear domestic inflationary threat. He has been – and seems certain to remain – more or less indifferent to the exchange rate of the dollar per se. That is one reason why one of the consequences of Fed policy has been a significant depreciation of the dollar in terms of other currencies around the world.

This has its benefits for the United States. Increased net exports are the principal reason why the most recent GDP growth statistics are still in positive territory. However, what makes the weakening of the dollar doubly significant is that it has coincided with a time of real tightness in nearly all commodity markets.

We have lived through a succession of years in which the growth of world GDP has significantly exceeded the growth of oil production. In the same period, the supply of food has been in some measure constrained, while demand, particularly in emerging Asia, has been anything but constrained. The results have been predictable. The price of oil has surged, at one time exceeding $143-plus a barrel. But it is not just oil that has gone up. Nearly all commodities have been affected, including (to name just a few) gold, copper, aluminum, coal, oil, sugar and wheat.

Contrary to popular belief, this is not like the 1970s. Then, only two commodities really spiked in this way: oil and gold. The rest did not experience the same correlated upward surge. In fact, the last time that commodities experienced this kind of really substantial correlated upward surge was the early 1940s. The really interesting thing about recent trends in commodity prices, in other words, is that it looks as if we are in the middle of a world war. Except, there is no war. Or is there? 

Now, it is true that the so-called War on Terror has produced quite small wars by 20th-century standards. What has happened in Afghanistan and what has happened in Iraq amount to little more than a couple of colonial policing operations. But these small wars are having big economic effects because they are coinciding with another war – the one I call China’s War on Nature.

If the United States has a War on Terror, China has a War on Nature, by which I mean that the environmental effects of China’s breakneck industrialisation resemble an unprecedented assault on the natural world. And it does feel a little bit like a War on Nature when you visit China. I was in Beijing not long after the Sichuan earthquake happened, on the day of that extraordinary and universally observed public silence. It reminded me strongly of the atmosphere in the United States after the terrorist attacks of 9/11. But who was the enemy? All the extraordinary, formidable devices of the government's propaganda machine were deployed to extol the virtues of the rescue workers and to emphasise the suffering of the victims. But there was no enemy except nature. It is nature, I suspect, that will resist China's industrialisation far more effectively than anything else. But until environmental constraints begin to bite, Chinese growth represents a huge challenge to the world's ability to produce commodities and extract fuels. That is the main reason why commodity prices look as if there is a war on.

What are the geopolitical implications of all this? One is that the great reconvergence between East and West is speeding up. If you go back to the very first “BRICs” – Brazil, Russia, India, China – report that Jim O'Neill and his colleagues at Goldman Sachs produced in 2003, China was projected to overtake the United States in terms of gross domestic product in 2040. But in more recent reports, that has been brought forward to 2027. And maybe that makes sense. One logical consequence of the credit crunch is that the United States will grow more slowly for the foreseeable future. Whether this is a short recession or a long recession, a deep one or a shallow one, is beside the point. The point is that there is simply no way the United States can grow at 4 per cent per annum over the next five years. It is more likely to be closer to 2 per cent. By contrast, China's planned economy seems unlikely to be significantly affected by that slowdown because net exports are no longer the key driver of China's growth. The only true constraint on China’s planned economy, as I have said, is environmental.

The second geopolitical implication of the current crisis is that the days when the dollar was the sole international reserve currency are coming to an end. Reserve currencies do not last forever, as the case of the British pound makes clear. Once upon a time, sterling was the world’s number one currency, the unit of account in which most financial transactions were done. It died a slow, long, lingering death, sliding from $4.86 in 1930 to very nearly parity with the dollar at the nadir in the early 1980s. “When exactly did sterling stop being the world's number one currency?” is an interesting question. Some historians would say it was as early as 1915, which was the first time that the British government had to issue dollar-denominated debt in New York. Others would say it was in 1931, when the pound went off gold. It certainly was clear by the 1950s that the pound could no longer be the financial anchor it had been in the previous century. The principal reason for that was debt: the huge debts that Britain had run up to fight the world wars. The second reason was lower growth. Britain's economy was the under-performer of the developed world in the postwar decades, right down to the early 1980s.

History’s lesson is clear: the combination of high indebtedness and low growth is lethal to reserve currency status, provided there is an alternative. The last time the dollar weakened significantly, there was no alternative. There is an alternative now. It is perfectly plausible to imagine a world economy in which the euro is at least equivalent to, if not superior to, the dollar. Already, statistics produced by the Bank for International Settlements show that more bonds are issued in euros than in dollars.

A third geopolitical consequence of the crisis we are living through is that troublemakers get richer. The effect on gross domestic product of an increase in the price of oil from $50 to $100 a barrel was a 16 per cent gain for Russia, a 24 per cent gain for Iran and a 33 per cent gain for Venezuela. High energy prices would not matter if there were more Norways or Canadas among the energy exporters, or if significant new sources of energy could be found in the United States itself. But this is not going to happen any time soon, even if restrictions on exploration and drilling in the US are lifted. The biggest increases in oil production in recent years have been in countries like Azerbaijan and Angola.

As those names suggest, a striking feature of the current chase for commodities is that it is taking the commodity importers to ever more exotic locations. A hundred years ago, of course, the scramble for Africa had more or less reached its climax. But back then, many empires were scrambling for African resources. Now there is only one. China's scramble for resources in Africa is one of the most extraordinary phenomena of our times. It is almost as if we are witnessing the genesis of a new empire. And it is happening in the traditional way.

You decide you want resources from a certain place. You feel uneasy about simply relying on market forces to get those resources. So you say “we'll own the infrastructure”. You start to build the roads, the port facilities, to upgrade the mines. And then you discover something awkward about the countries in question: they are politically unstable, particularly at a time of high food prices. So what do you do? “Well, we have to secure our assets. We’d better have a few people with guns there.” Gradually the number of armed Chinese in the vicinity of Chinese assets in Africa increases.

The great geopolitical and economic shift from West to East that we are living through is no recent phenomenon. It began over a century ago, when Japan mounted the first effective Asian challenge to rampant European imperialism. Among other things, this great shift implies that a larger and larger proportion of global industrial production is being located in a more dangerous part of the world than previously. Even if there is no such thing as global warming – even if the climate change story is a complete fantasy – there is still a problem, simply because Asia is already much more vulnerable to natural disasters than the West. (Consider the death toll attributable to natural disasters in 2007: 47 dead in North America, 13,748 dead in Asia.) If the East becomes the workshop of the world, that workshop will suffer more typhoons, more earthquakes and more floods than when it was located in and around Dusseldorf or Detroit.

The first Industrial Revolution, the one that began in the late 18th century in Britain, was essentially a northwestern phenomenon. It did not initially affect a substantial proportion of the world’s population. It depended on two things: access to cheap coal, which was very conveniently located in places like the north of England, central Scotland and Belgium; and the ability to import cheap food and other agricultural raw materials, like cotton, from the rest of the world. In this first Industrial Revolution, fossil fuels were plentiful. It was money that was scarce. And money was scarce because the monetary system of the world was based on gold, a very scarce commodity indeed, no matter what you do. Compare that to the Industrial Revolution of our times, which is affecting a vastly larger proportion of humanity. Today, paper money is plentiful. There is no physical limit to the number of dollars that can be printed or otherwise created. It is commodities that are scarce.

The geopolitical dimension of the first Industrial Revolution was that when a power came along that was capable of matching Britain's industrial capacity, it could credibly challenge Britain as the dominant global power simply by cutting off its food supply – the core of German strategy against Britain in two world wars. Today, the key question of geopolitics is whether or not China will one day mount an analogous challenge to American primacy.

Is it likely that a China that feels it must grow at 10 per cent per annum – and therefore a China that insatiably needs to import commodities of every kind – is going to coexist peacefully with the United States for the foreseeable future? Only, it might be thought, if the United States grows so slowly in the wake of the credit crunch that it no longer feels itself to be in competition for those commodities.

Back in 2006 Chinese state television broadcast a 12-part documentary entitled The Rise of the Great Powers which charted the experience of nine empires, beginning with the Portuguese empire and including the United States. The remarkable thing about this series was that it was not a series of polemics against Western imperialism. On the contrary, an official statement that accompanied that broadcast declared: “China should study the experiences of empires it once condemned as aggressors bent on exploitation.” And the lessons were fascinating: the crucial importance of maritime power, the vital need for political unity.

All of this leads me to ask a question that was always implicit in the word, Chimerica, which was a pun from the outset. Could it be that Chimerica – the relationship between China and America that has been so crucial over the past decade – is now merely . . . a chimera?

Niall Ferguson is a Professor at Harvard University and Harvard Business School, a Fellow of Jesus College, Oxford, and a Senior Fellow of the Hoover Institution, Stanford