The Morning After

The eclipse of Wall Street is mirrored in the demise of the Washington Consensus, an interrelated set of free-market policies that the U.S., often operating through the World Bank and the International Monetary Fund, once imposed on less developed nations. Stripped to its basics, the American recipe for economic success had three elements: open markets, deregulation, and macroeconomic stability-all of which have now been called into question.

Even Summers, who in many ways embodied the Washington Consensus, today opposes elements of it. Summers recently advocated a more restrained approach to future trade treaties, since previous agreements, such as Nafta, had failed to benefit American workers. In an interview with Lloyd Grove on Portfolio.com, Summers also questioned the wisdom of excessive financial deregulation. Comparing the Asian crisis, which decimated the banking system in countries such as Korea, Taiwan, and Thailand, with what the U.S. is now experiencing, he said, "Some of the very same mistakes-excessive budget deficits, failure to regulate financial institutions, excessive leverage-that led to those problems are what led to our problems."

With the Treasury Department taking over Fannie Mae and Freddie Mac, the two biggest mortgage firms in the country, the Federal Reserve purchasing 80 percent of the biggest insurance firm in the country, and Congress grappling with possible bailout plans, it hardly needs pointing out that the U.S. is no longer in a position to lecture others on the virtues of laissez-faire and sound economic management.

The demise of the Washington Consensus undercuts America's ability to use what Joseph Nye, the Harvard political scientist, refers to as "soft power"-or economic heft-rather than military might, to exert its influence. One way the U.S. did this was by relying on the attractiveness of the American ideal to shape the preferences and beliefs of people around the world. When countries in economic transition, such as Poland and Vietnam, opened their markets to McDonald's and Budweiser and Microsoft, they did so not because their leaders were kowtowing to powerful American multinationals but because their citizens demanded it. "Soft power uses a different type of currency-not force, not money-to engender cooperation," Nye wrote in a 2004 article. "It uses an attraction to shared values and the justness and duty of contributing to the achievement of those values."

Today, the images of America being broadcast around the world often feature desperate homeowners, failing banks, and panicked policymakers-none of which are likely to inspire confidence in, or affection for, Uncle Sam. On the Monday after Treasury Secretary Hank Paulson announced his bailout plan, the dollar suffered its biggest fall against the euro in almost a decade. Currency traders know an overstretched government when they see one, and the sight of the U.S. Treasury taking on what looked, at first glance, to be the financial equivalent of another Iraq war sent them fleeing from the greenback. "What's weighing on the dollar is the question of how [the bailout] will ultimately be financed," Sue Trinh, a currency strategist at RBC Capital Markets, told Reuters.

In nationalizing Fannie Mae and Freddie Mac, the U.S. government had already added $5.3 trillion to the national debt. Much of this debt is owed to foreign central banks, particularly the Bank of Japan and the Bank of China, which have both announced plans to diversify their reserves. To be sure, Japan and China have a strong interest in preventing a precipitous decline in the U.S. currency, which would devalue their existing holdings. Still, the spectacle of Paulson asking Congress for a blank check, and the Federal Reserve asking the Treasury to issue bonds on its behalf, must give those countries pause about buying yet more dollars, which is what is required if the U.S. is to finance its vast trade deficit and regain its currency's privileged status.

With the chairman of Standard & Poor's rating committee having recently stated that the U.S. government didn't have a "god-given gift" of a triple-A rating, some longtime dollar bears foresee the moment when foreigners will no longer lend to the U.S. at modest rates of interest and the Fed will thus be presented with the awful choice of either hiking the funds rate to maintain the inflow of foreign capital or letting the dollar collapse and beginning the process of monetizing the country's debts. A more likely scenario, in my opinion, involves foreign central banks gradually diversifying their portfolios, shifting some of their reserves into euros and other currencies. The demand for Treasurys won't collapse overnight, but the days of the U.S. merrily borrowing from abroad in virtually unlimited amounts, as it has been doing in recent years, would come to an end. And who knows? In 20 or 30 years, the euro or the yuan could replace the dollar as the favored currency of Russian gangsters and Arab oil sheiks.

Having said all that, for all the weaknesses in the U.S. model that the housing crisis has revealed, America still has many underlying economic strengths, including its enormous physical and human capital resources, its technological leadership, its entrepreneurial bent, and its ability to bolster the output of its patchy education system with a steady influx of highly skilled immigrants.

It is important not to conflate the financial sector with the economy as a whole. In terms of productivity-G.D.P. per worker-the U.S. economy still leads other developed countries by a wide margin. Of the world's 500 biggest public companies, as ranked by the Financial Times, 169 are in the U.S.-more than are in Japan, the United Kingdom, France, China, Germany, and Russia combined. Even in the battered financial sector, Bank of America and Citigroup remain the two biggest banks on the planet when ranked by market capitalization.

Then there are the growth industries of the future: high tech, entertainment and leisure, consulting, health care, biotechnology, environmental products, and, sadly, defense. In all of these areas, U.S. companies have a commanding presence. Of course, other countries could cut into this lead, but in places like Silicon Valley, Hollywood, Boston's medical research centers-and, yes, Wall Street-the U.S. has clusters of expertise that are extremely difficult to replicate.

Most important of all, the U.S. economy retains an enviable capacity to re-create itself. In one way, the unfolding of the credit crunch reads like a left-wing conspiracy theory: Rich Wall Street bankers concoct an explosive brew of exotic mortgage securities that bubbles over and blows up the financial system, or large parts of it. Amid the carnage, the government-the executive committee of the capitalist class, as Marx called it-offers to bail out the bankers at the taxpayers' expense. But from another perspective, that of Austrian economist Joseph Schumpeter, the subprime catastrophe can be seen as the inevitable by-product of a crucial and ultimately beneficial innovation: the securitization of illiquid assets such as mortgages, credit-card debt, and auto loans. Whenever something exciting and new comes along, Schumpeter pointed out, entrepreneurs and investors gear up to take advantage of it, which can easily lead to the emergence of "reckless" finance. It happened with the building of the railroads of the mid-19th century, the development of radio and television in the 1920s, and the commercialization of the internet in the 1990s.

As a longtime critic of financial deregulation and the Greenspan-Bernanke policy of stoking asset-price booms, I don't totally buy into the Schumpeterian story, but neither do I buy the argument that American capitalism is collapsing under the weight of its internal contradictions. A period of living within its means, behaving less arrogantly toward other countries, and relying for its prosperity on creativity and honest toil rather than speculative bubbles would be good for the U.S. It might well make it more popular; it could certainly make it stronger.

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