Threats to American Economic Preeminence?
J. Bradford DeLong
Last night Richard Cooper talked about economic power in the sense of "controlling influence." He said that--by and large--there was no such thing. Rare are cases like ECA Administrator Paul Hoffman using the threat of aid cutoffs to scale back the nationalization plans of Britain's post-WWII Labour government.
This morning I want to talk about something softer: American economic preeminence and its uses.
Reality and Perception
There are three types of threats to American economic preeminence. The first is a threat to the growth of America's economic prosperity: a slowdown in productivity and real income growth, and an end to improvements in the standard of living. A prolonged period of near-stagnation would leave the American economy performing much more poorly than it could have. There would be secondary consequences of such a failure of the economy to deliver sustained growth: perhaps a shift in American politics in an unfravorable direction, and surely a--correct--foreign belief that the American economy was not a good model. But the most important consequence would be the lowering of living standards and productivity levels.
The second is a threat to the America's relative economic preeminence because of a speed-up of growth elsewhere. This would be regretted: it would be the sign that our institutions were not doing their job at innovating. But other things equal we benefit from richer trading partners: they sell us good stuff more cheaply.
The third type of threat to American economic preeminence is a matter not of economic reality--not of productivity and real living standards--but of perception. From an economist's point of view, an inaccurate perception of America's economic strength is unimportant. After all, an economy is prosperous and its citizens are wealthy and powerful if its productive power is great, whether or not outsiders perceive economic strength. The most important thing is high and growing real productivity and real income, for "no society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable..." And there is a great deal to be said for the economist's point of view. Not only does absolute productivity matter, but a focus on relative productivity is dangerous--it leads governments to start playing zero or negative-sum games.
Nevertheless, the economist's point of view is not the only point of view.
Remember that it was not a German reactionary but a German liberal--the great turn-of-the-last-century social scientist Max Weber--who curtly dismissed the "... vulgar conception of political economy... that it consists in devising recipes for universal happiness... adding to the 'balance of pleasure' in human existence." Instead "processes of economic development are power struggles too"--struggles over "the power to determine the character of world culture in the future." For a country to be perceived to be, in Leon Trotsky's words, "the furnace where the future is forged" has powerful cultural, political, and social consequences.
The country that is perceived to be the most economically powerful is the country that will be emulated--culturally, socially, and politically. Leaders and citizens in other countries will look to it to see the image of their own future. And they will believe that its institutions and orientations are to be copied if they in their turn want to become rich, and powerful.
Weber's principal political goal was for Germany to play a role in shaping the people of the future, giving them those German "characteristics which we think of as constituting the human greatness and nobility of our nature." We, by contrast, think that the world is more prosperous, more free, and less dangerous because the cultural, social, political, and military power of what Weber dismissed as "English speaking 'society'" proved greater.
Delivering a world-class standard of living to our citizens requires a strong and healthy economy. Providing the material base so the government can raise the resources to act with a global reach requires a strong and healthy economy. But being the center of attention and the focus of emulation by others requires an economy that appears to be strong and healthy. And maintaining the perception of economic strength may well turn out to be harder than maintaining the reality.
So let me run through these threats to America's relative economic preeminence in reverse order.
Threats to Perceived Power I: Financial Crisis
The first potential threat to the perceived economic power of the United States is a full-blown financial crisis: a collapse of the stock market accompanied by a massive outflow of capital from the U.S. and a steep decline in the exchange value of the dollar. Such a full-blown financial crisis is surely possible, for we have already gone through the three preliminary stages that Charles Kindleberger described as needed to set the stage for a financial crisis. First comes a displacement, a change in fundamental values that leads to a fully-rational and fully-justified increase in asset prices. Second comes an increased flow of money into financial markets and an increasd use of leverage in response to the initial displacement, which leads to further rises in asset prices. Third comes an increasing use of positive-feedback investment strategies--buy when prices rise and sell when prices fall--by an additional wave of investors attracted by the profits already earned.
We have already clearly had all three of these stages in the U.S. stock market: the $6.0 trillion of wealth in the NASDAQ currently has a trailing P/E ratio of 400. We may have had all three stages in the foreign exchange market: the past year has seen the dollar appreciate by twenty percent against the euro, and since 1994 the real value of the dollar has risen by fifteen percent against the yen. Foreign exchange markets may be the ones in which trend- and momentum-chsing traders are most common. And a current account balance of minus four percent of GDP suggests that the dollar is substantially overvalued unless foreigners are willing to increase the dollar-denominated share of their portfolios without end.
Should a justified climb-down of asset markets from their current stock and exchange market valuations turn into a large-scale panic and outflow of capital from U.S. stock markets and from dollar-denominated assets, it need not have any significant impact on the fundamentals of U.S. economic prosperity. The Federal Reserve has ample room to cut interest rates--as it did in 1987--to ensure that a stock market decline has little effect on total demand. Full employment could be maintained. The U.S. is not so open an economy that currency value declines would produce a large ouburst of inflation that would keep the price system from performing its resource-allocation function. Lower stock market values would not choke off investment if interest rates came down. And the improvements in productive technology and other innovations would keep coming.
Strong American economic growth could continue through a full-fledged financial crisis, just as the 1992 British financial crisis was accompanied by a surge in economic growth. Such a crisis would reduce the standard of living of those of us who consume imports in large quantities, But--since the U.S.'s international debt is largely denominated in dollars--it would look like an increase in the real wealth of the rest of us, a partial expropriation of America's creditors.
However, such a large-scale financal crisis and permanent decline in the exchange value of the dollar could well have disastrous effects on foreigners' perceptions of the strength of the American economy.
Threats to Perceived Power II: Loss of the Dollar's Unit-of-Account Role
A second--but slower--threat to perceived power would be a slow, gradual loss by the dollar of its reserve currency and its unit-of-account role to the euro. Once again this need not have any significant effect on the real economic prosperity of America: it would entail a small decline in American terms of trade and the loss of perhaps $25 billion a year in seigniorage. But once again it might have a serious effect on the extent to which foreigners view the U.S. model as worth emulating.
Moreover, the loss of the dollar's unit-of-account role could interact with a standard international financial crisis to make such a crisis truly a danger to the fundamentals of American prosperity. The principal reason that the United States--now a net debtor country, indebted to the rest of the world to the tune of $2 trillion or so--can look with relative equanimity at the prospect of a declining dollar is that a decline in the value of the dollar does not increase the real indebtedness of American firms or governments. The dollar's role as unit of account does give the U.S. policy options foreclosed to many other countries that have borrowed on international capital markets--another aspect of the "exorbitant privilege," to use Charles de Gaulle's words, that the U.S. gains by having its currency be the key currency in the international monetary system.
How much is it worth sacrificing other objectives to guard against a large-scale devaluation of the dollar in the context of an international financial crisis? How much is it worth sacrificing other objectives to keep the dollar more attractive as a unit of account and reserve currency of choice than the euro?
I don't know. I'm just a simple-minded economist.
But I can say that they are worth worrying about--especially because in combination these two factors could harm not just the appearance but the reality of American economic prosperity because they would remove our relative insulation from the most damaging consequences of financial crisis.
On the other hand, as Larry Summers says, it is remarkable that we have the luxury of worrying not about problems, but about situations that might develop into problems.
Threats to Productivity
Over the past two decades there have been four potential threats to America's economic strength. First, there was the threat that the inflation of the late 1970s would get sufficiently out of control to disrupt the functioning of the price system as a resource allocation mechanism. Second, there was the threat of the return of deep recessions: the recessions of 1973-1975 and 1980-1983 were the deepest since the Great Depression. Third, there was the threat of institutional sclerosis in American business management: the fact that in the 1970s and early 1980s it was clear that the center of innovations in business organization was not the United States but Japan, and thus that America's business managers were falling behind and making American economic productivity significantly lower than it could have been. Fourth, there was the threat of the uncontrolled deficit sucking away capital that would have been used for investment, retarding the capital-output ratio and the spread of new capital-embodied technologies.
All these threats are now gone. Barring major mistakes in macroeconomic policy, all these threats will remain distant for decades.
The inflation of the 1970s is gone, and is very unlikely to return. Recessions today appear small, and rare. We do have a better Federal Reserve that is doing, and looks likely to continue to do, a better job. The budget deficit of the 1980s is gone, and with it the prospect that the federal government's financing needs will strangle capital formation. And American firms today are, if not the first, at least a fast second in adopting innovations in all forms of technology. The Japanese export sector taught many American businesses a painful lesson in the 1980s. But American businesses learned from these lessons.
Moreover, we today look forward to a future in which the U.S.'s advantages as the center of technological innovation appear nearly insurmountable. At the end of the last decade East Asian factories looked to be more efficient producers of semiconductors, and the communications protocols that now underpin the world wide web were developed at a pan-European research institute. Yet the core of the network economy is in Silicon Valley and appears likely to stay in Silicon Valley.
Thus threats to any of the four underpinnings of real economic prosperity--price stability, full employment, investment, and innovation--are distant and appear unlikely in the absence of significant failures of macroeconomic policymaking.
Of course, we could always make our economic policies better. But I have already talked for more than long enough.