How to Get the History of the Financial Order All Wrong – Foreign Policy

The past few decades have not been kind to the democracies of the North Atlantic. Deindustrialization, financial crises, mass unemployment, chaos in the Middle East, and rising inequality have shortened life expectancies, undermined social stability, and opened the door to demagogues and authoritarians. And that was before the pandemic killed tens of millions of people and Russian President Vladimir Putins brutal invasion of Ukraine displaced millions more and upended global commodity markets.

Could the West have realistically avoided any of this? Or was it always going to be helpless in the face of structurally driven shocks, the effects of which have cascaded from one place to another and between the geopolitical, economic, and domestic political spheres, as University of Cambridge professor Helen Thompson puts it in Disorder: Hard Times in the 21st Century?

The question matters. If specific politicians and technocratsand the intellectuals who influence themmake mistakes, then there is hope. The world has the potential to learn from their choices and do better in the futureor at least make new, different mistakes. If not, then the most it can aim for is the peace of mind that comes from understanding that there are no alternatives.

Thompson believes that the troubles of the 21st century have their roots in 1970, when the United States oil self-sufficiency transformed into import dependence and energy poverty. This fundamental change, in Thompsons telling, made it impossible to sustain the post-World War II geopolitical, financial, and social order.

That, in turn, accelerated what Thompson believes is the natural tendency of democracies to descend into mob rule or, more often, oligarchic corruption. Welfare states were rolled back while democracies became increasingly unresponsive to democratic demands for economic reforms that would increase the return to labour. The consequences have varied across societies, but they include the growth of far-right parties across the European continent, the United Kingdoms departure from the European Union, and the U.S. presidential election of Donald Trumpas well as his supporters violent attempt to overturn the election of his successor on Jan. 6, 2021.

It is a complex argument that has Thompson covering subjects varying from historians Polybius and Niccol Machiavellis analyses of the Roman Republic to former British Prime Minister Winston Churchills pre-World War I views on the best way to fuel the British Royal Navy. Disorder is filled with many fascinating observations relevant to the current momentespecially the passages covering the geopolitical dynamics involving Western Europe, Russia, Ukraine, Turkey, the Middle East, and the U.S. shale sector.

Unfortunately, Thompson makes her case harder to follow than it should be. The book is structured around three concurrent histories: geopolitics, economy, and democratic politics. As a result, many of the same events are described two or even three times but many pages apart. And although the first and third sections are well written and worth reading on their own for their many insights, the weaknesses of the central economy chapters raise serious questions about the entire project.

Echoing the language of many of the technocrats who set policy for much of this period, Thompson seems to believe that elected governments are powerless against vast and impersonal financial markets. But financial markets are just people trying to make moneyor avoid losing itwhile following the leads of regulators, legislators, and central bankers. Downplaying the agency of these political actors leads to unsatisfying explanations and a few outright errors.

Thus, while Thompsons account of the formation of the euro is full of details about negotiations among various government officials, it fails to address basic questions, such as: Was the euro a good idea, and were the countries that joined better or worse off than those that didnt? (She gives a hint when describing the costs of accession for Italybut roughly 100 pages later.)

Instead, it is taken as given that France had no choice but to tie its currency to Germanys one way or another. The United Kingdoms inability to remain within the European Exchange Rate Mechanism that preceded the euro is presented mainly as a story about the eventual inevitability of Brexit rather than as a chance to consider whether the U.K. and other major non-euro economies, such as Poland and Sweden, had significant advantages or disadvantages compared to their neighbors.

Coming to the crisis itself, Thompson writes, A Eurozone in which the [European Central Bank (ECB)] set monetary policy and elected member state governments decided on the rest of economic policy was a Eurozone heading towards its death. For her, the central bank could never end the financial panics of 2010 to 2012 unless Europeans first gave up democratic control over taxes, spending, and labor market regulations. To be fair, that is what many European elites believed at the time and in retrospect. But their view only makes sense if there actually was an inherent conflict between the policies that the ECB and national governments should have been pursuing.

The tragedy of Europes post-2008 experience is that there was no such conflict. Until the war in Ukraine, inflation in Europe had consistently been slower than the central banks target, thanks in large part to economic weakness caused by the euro crisis itself. The German government may have been led by scolds who practiced pedagogical imperialism, in the words of Der Spiegel, but ordinary Germans failed to benefit from its austerity. They may have done better than the millions of Spaniards who lost their jobs, but they nevertheless suffered from meager wage growth and degraded public services.

Europes problem was that too many of the technocrats and politicians simply misunderstood what was happening and what was needed, preferring cheap ethnic stereotypes over serious economic analyses. Ordinary Europeans paid the price. By the eve of the pandemic, consumer spending and public and private investment in Greece, Italy, and Spain were still well below pre-crisis levels while living standards in Cyprus, Portugal, and Slovenia had just barely returned to where they were in 2008 after more than a decade of misery. Shifting blame was easier for Europes elites than confronting the consequences of their own choices.

Thompsons explanation for the 2016 Brexit referendum suffers from similar flaws. That referendum, it must be remembered, was decided in a close vote that was only held because the Tories won an unexpected parliamentary majority the year before. And that election, it should also be recalled, was one in which European issues played almost no part. Instead, the supposed threat of Scottish independence was the decisive issue in key English constituencies. Moreover, according to the 2016 British Social Attitudes survey, only 22 percent of U.K. citizens wanted to leave the EU in 2015. But instead of treating the outcome as a fluke that needs to be explained by contingent circumstances, Thompson believes that it was a fundamental consequence of the United Kingdoms place outside the euro.

First, she argues that by growing faster than much of the euro area, Britain became a haven for European migrants looking for work, supposedly boosting the political fortunes of British nativists. Second, Thompson writes that the United Kingdoms status as an out marginalized it within Europe and limited its ability to protect its core interests. Thus, she attributes elite support for Brexit to the U.K. governments failure to secure regulatory protections for London-based financial services during the EUs debt negotiations of 2011 and 2012.

These are interesting arguments, but they are not persuasive. Britain did much worse than France from 2007 to 2013 and substantially underperformed Germany, Sweden, and Switzerland ever since the global financial crisis. (Switzerland is not in the EU, but it nevertheless allows full freedom of movement for EU nationals.) The United Kingdom may have done better than Spain or Greece, but it did not do well. Besides, the people who voted for Britain to leave the EU lived in the places with the fewest migrants. And although the U.K. government may not have won all of its battles over euro-denominated clearing while it was inside the EU, it clearly has had far less negotiating leverage with the rest of the European Union after it decided to leave.

The alternative explanation, made convincingly by economist Thiemo Fetzer, is that the U.K.s self-imposed austerity measures after 2010 created fertile ground for bigots and opportunists. And since the EU has always been a convenient bogeyman for national politicians in all of Europes member states, those voluntary budget cuts were decisive in shaping the outcome of a referendum that most people never expected would happen. But nobody forced former British Prime Minister David Cameron, former British Chancellor of the Exchequer George Osborne, and the rest of the Conservative-Liberal Democrat coalition government to pursue their ideologically motivated program. It was their choice.

More generally, Thompsons explanation of both the broader global financial crisis and the euro crisis would have benefited from a deeper understanding of the links between trade and financial imbalances. The normal way to pay for imports is to export more, and the standard reward for exporting more is being able to afford more imports. The unusual feature of recent decades is that this did not always happen, with massive imbalances arising among several major economies.

This omission has important implications. Thompson attributes this turmoil chiefly to the interaction between rising oil prices and the excesses of European banks. Higher oil prices squeezed discretionary incomes and limited the ability to service debt. Meanwhile, the creation of the euro led to a surge in bank lending within Europe, and many of those same banks also expanded their U.S. operations, borrowing dollars in the short term from U.S. money market funds to make long-term loans, especially dubious mortgages. For Thompson, the central problem was that the ECB, the Bank of England, and the Swiss National Bank had insufficient dollar reserves they could use to support their banks if U.S. money funds ever pulled their financing. Thus, when the crisis struck, the U.S. Federal Reserve had to step in and provide trillions of dollars in emergency loans.

None of this is wrong, but it is incomplete. It is not possible to understand why some places had debt booms and busts while others did not without also understanding how underconsumption and underinvestment were transmitted abroad through trade surpluses and deficits. Yet in her view, accounts that root the global crisis in this sort of balance of payments analysis are misleading.

Higher oil prices did not have to squeeze growth in either the 1970s or the 2000s. It was only because the exporters chose to hoard their windfalls by purchasing financial assets rather than using their newfound purchasing power to buy more goods and services that the rise in oil prices forced consumers to choose between cutting their spending and going into debt. If oil producers had simply let their living standards rise, workers elsewhere could have responded by making and selling more exports.

Similarly, the emergence of China as a major manufacturing power was so traumatic to the workers of the industrialized world only because the party state ensured that Chinese consumers were unable to spend the money they should have been paid on the goods and services they wanted. China did not practice export-led growth but rather wage suppression and financial repression that held down imports. That choice was bad for people in China, but it was also costly for everyone outside China who lost income because they couldnt sell enough to Chinese customers.

Thompson correctly notes that the boom in bank lending within Europe was motivated by the creation of the single currency and consequent reduction in the perceived risk of currency devaluation. But it is telling that she shows little interest in the reason German banks were particularly prolific in finding questionable assets abroadnamely, that there was such little borrowing and spending at home. And this underconsumption and underinvestment had its own origins in the choices of Germanys policy and business elites.

Most troubling is that Thompsons desire to emphasize the importance of oil and Eurodollars (a term for dollar-denominated lending that occurs outside the United States) in her narrative pushes her to make repeated factual errors.

Former U.S. Federal Reserve chair Alan Greenspan and his colleagues did not decide to move away from targeting the money supply because Eurodollar markets undermined national interest rates, as Thompson would have it. After all, interest rates are prices, which means that they are affected by changes in both money supply and money demand. There will never be a stable relationship between interest rates and the money supply as long as households and businesses change how much they want to hold in bank accounts relative to retirement funds, housing, and other asset classes. Instead, Fed officialslike central bankers in much of the rest of the worldrealized that money supply measures were inherently disconnected from what they cared about. The quantity of money that the private sector needs to grow without excessive inflation is constantly changing in unpredictable ways, which is why the Fed and other central banks stopped taking it seriously decades ago.

And although oil prices matter, the Federal Reserve did not begin raising overnight interest rates in June 2004 in response to what it feared might be the inflationary effects of rising oil prices. In fact, the transcript from the policy meeting makes clear that both the staff forecasters and many of the key policymakers believed that oil prices would fallor at least stay flat around $37 per barrel. Instead, Fed officials were simply trying to normalize short-term interest rates to keep pace with the broader economic recovery following the downturn of the early 2000s.

Even as oil prices kept rising, the Fed stopped raising interest rates in 2006and lowered them in 2007 and 2008because officials were consistently focused on underlying domestic U.S. economic and financial conditions. That is also why the Fed kept its cool during the commodity price spikes of 2011. The European Central Bank reacted differently both in 2007 and 2008 as well as in 2011, as Thompson notes, but that was a choice made by people with specific (and wrong) views about inflations outlook rather than the inevitable consequence of the ECBs legal mandate to prioritize price stability over growth.

Chinas troubles with capital flight began in 2012 with the start of its anti-corruption crackdown, not in 2015 when the Federal Reserve was preparing to raise interest rates. China never faced any dollar constraints because the minuscule dollar-denominated debts incurred by Chinese businesses had always been dwarfed by the hoard of reserves held by the Peoples Bank of China.

Most egregiously, the slowdown in Chinas growth rate that began in 2011 had nothing to do with the ongoing risks around dollar shortage problems in Eurodollar markets. Instead, it was a deliberate policy choice by Chinese officials who wanted to curtail the unnecessary and environmentally destructive construction projects that were launched in response to the global financial crisis. Thompson writes Chinese leaders were worried that Chinas dollar debt vulnerability had trapped the country in a lower growth paradigm. Yet she cites a Peoples Daily article from 2016 that warned against another yuan-denominated borrowing surge and welcomed slower growth because China has to make a choice between quantity and quality.

These kinds of errors unfortunately cast doubt on other parts of the book.

Why should the world believe grand assertions that democracies are fundamentally challenged by the problem of political time in ways that autocracies, presumably, are not? Why should a global switch to green energy intensify Sino-American rivalry if it reduces the zero-sum competition for fossil fuel resources? And if the United States succeeds in breaking its dependency on Chinese manufacturing supply chains while China expands its domestic markets to compensate, why would that necessitate conflict, as opposed to restoring the amicable relations that preceded the dislocations of the 2000s?

Policymakers may be constrained by the material and social circumstances in which they operate, with oil and gas playing especially important roles, as Thompson convincingly argues. But as Putin has reminded the world so vividly this year, individual choices can still make a differencefor better and for worse.

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How to Get the History of the Financial Order All Wrong - Foreign Policy