When will the music stop?

America regularly consumes more than it produces. That’s simply how our economy has been designed to work over the past half century. Part of this is about the power of the dollar in the global economy, which allows us to borrow more than we should. Part of it is about policy decisions made to prioritise the service sector over manufacturing (and the trade ramifications of that, which I cover in my latest column). All of it has been facilitated by the rise of dollar denominated assets over a long period of time. But as Swamp Notes readers will know, I believe that this era will eventually come to an end, as the financialisation of the US economy collides with the rise of China.

Michael Pettis, along with Matthew Klein, have written eloquently about how the dysfunctional trade and currency relationship between the US and China will eventually break in their book Trade Wars Are Class Wars. As they put it, China’s not to blame for America’s problems (or visa versa), but rather imbalances within the countries themselves that have created tension. Despite recent gains, China still doesn’t consume enough, Pettis pointed out in his recent FT opinion piece, which is one reason the country just reported its largest trade surplus in history.

China’s dual economy and common prosperity efforts are in part about changing that, creating a more equal balance of consumption and local production for the Chinese themselves, as well as the countries along the “One Belt, One Road” pathway that are in their economic orbit. I think this sort of economic regionalisation makes sense for many reasons, from economic to environmental. When there’s a price on carbon, long supply chains simply don’t make as much sense.

As I argued in this column, there are many lessons that the US can take from China’s efforts around debt reduction, corporate governance and inequality. The problem is that we don’t have anywhere near the long-term view about our economy that China has about its own. This has led us to a deeply dysfunctional place in which central bankers are propping up the economy with monetary policy alone. This has raised asset prices, but also encouraged overconsumption and inequality (for more on that, read Christopher Leonard’s book The Lords of Easy Money, which tracks former Kansas City Federal Reserve chief Thomas Hoenig, a rare and thoughtful Cassandra of easy money.

Watching the ups and downs of the market in recent weeks, I’ve become more preoccupied with the problem of how we get off the easy money train without a recession or even a depression. I had a catch-up conversation with Hoenig last week to discuss the topic. Like me, he wishes the Fed would have tightened a long time ago. Now, we both worry that tightening into a slowdown will mean higher unemployment, and also rock markets in ways that will become a big headwind to growth. This is actually the fundamental issue. We’ve become so dependent on asset price increases that we may not be able to grow strongly, at least in the short term, without them.

So where does this leave us? “I think over the next year, we are going to see-saw towards higher inflation,” Hoenig said, with the Fed possibly having to move back and forth on tightening depending on what happens in the market. Longer term, he says, “we must encourage more savings”, as well as domestic production, to rebalance the economy. But Americans aren’t used to this kind of austerity. As I wrote back in April 2020, the last time American savings rates went up significantly from nearly zero was back in the 1930s and 1940s.

Consumers are certainly in better shape than they were before the 2008 crisis. But we are nowhere near double-digit savings rates. And yet, as this McKinsey Global Institute study shows, of the 45 episodes of deleveraging in mature economies since 1930, half involved sustained periods of austerity.

Of course, if we save, interest rates have to go up. Consumption has to go down. Ultimately, production must increase. This is a wholesale change in the economy of the sort that the Biden administration has tried to articulate in some ways, by encouraging domestic manufacturing and more training to raise wages and productivity together. But it’s not a quick shift, and even if it can be done, it requires central bankers and policymakers working hand in hand, over a long period of time. It also may lead to painful dollar market corrections in the short term.

I don’t want to say that America doesn’t have the capacity to do this, because frankly, I’m sick of that kind of easy, boring defeatism, from pundits in particular. But it does seem to call for another Paul Volcker-type personality at the Fed, and a president who can articulate the painful truth — that our half-century party of financialisation is coming to an end, and we have harder years ahead of us to get to a better place.

Ed, how does a political leader even articulate a message like this today? When was the last time you heard a political figure in any country articulate a hard truth, and then act on it in a way that made things better? As you can see, I’m desperately looking for some illustrative lessons from history here and invite not only Ed, but readers, to submit them.

Edward Luce responds

Rana, I don’t want to be that pundit who exhibits “easy, boring defeatism”, so I’ll suppress my worries about what a Paul Volcker-style dose of tightening would do to US politics. But I doubt it would be joyful for Democrats. Happily, I don’t think inflation is nearly as baked into the US system today as it was when Jimmy Carter appointed Volcker to the Fed in 1979. It was the harsh medicine that Volcker applied, more than the Iran hostage crisis, that helped pave the way for Carter’s defeat and Ronald Reagan’s victory. That was when the financialisation of the US economy really began to take off. With a little luck, and the Fed’s belated withdrawal of quantitative easing, US inflation will moderate over the next year and the recovery will not be derailed. But it will require good fortune, which hasn’t been in high supply in recent months.

Your larger question is about how the US definancialises its economy. I don’t think this is purely linked to the dollar’s reserve currency status. If that were the case then the UK’s economy would not be even more financialised than America’s — a century after the pound lost its reserve currency status. I am also sceptical about the train of thought that says higher interest rates would induce higher domestic savings, which would lead to a narrowing current account deficit and, in turn, lead to greater consumption of domestically produced goods. I suspect that would be a very high price to pay for a very uncertain outcome. Who is to say those surplus savings would be invested in the US economy, rather than overseas? The risk is that such hair-shirt economics would leave the US consumer worse off in the long run as well as in the short run. Lots of pain for no certain gain.

My preference would be for radical microeconomic reforms. The US tax system incentivises debt financing, rewards shares buybacks, punishes patient capital, and underinvests in its people and workforce. You cited Mancur Olson in the last note. What I would like to see is a grand fiscal bargain that would scrap these perverse incentives, eliminate the vast warren of corporate loopholes in the system, and raise new revenues to invest in people and better social safety protections. The great strength of US capitalism is its ability to reinvent itself and innovate. US capitalism’s great sin is to punish the numerous left-behinds for their plight. It is not only possible but urgently desirable to confront the system’s gross human inequities and inefficiencies without sacrificing the innovation. I would like to see politicians talk more in these terms.

Also, a reminder: as I mentioned in the last Swamp Notes, I’m taking six weeks of book research leave from the FT. My colleagues Peter Spiegel, Gideon Rachman and Richard Waters will kindly be standing in for me.

Your feedback

And now a word from our Swampians . . .

In response to ‘Oh what a lovely pandemic — for the rich’:

“Perhaps we can make this really simple. Take out a higher slice of consumer spending at the front end so the public sector gets it. Raise sales taxes (over here that’s VAT) — slowly, over a period of years. Make business a bit less profitable, so dial down a bit on rentier capitalism for the few. Sure, it’s regressive, so some fiscal readjustment needed around those lower incomes. A bit like carbon tax and dividend. Just broader.” — Mike Clark, Oxfordshire, England

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