The Morning After

The next president will inherit an economic mess. Where to begin the cleanup.
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In the summer of 1998, during the Asian financial crisis, I went to Japan with Larry Summers, the Harvard economist who was then deputy secretary of the Treasury. Back then, American politicians often flew around the world telling other countries how to manage their economies, a task Summers, who often referred to "the power of the American idea," took to with gusto. Shortly before Summers arrived in Tokyo, the Japanese government had asked the United States for assistance in propping up the yen. Vanloads of reporters followed him around town, in part because he didn't refrain from telling his hosts that, in return for American help, they needed to overhaul their antiquated financial system: make it more competitive, more modern, more freewheeling, and-he didn't use this precise phrase; he didn't have to-more American. When I put it to him that he sounded like a triumphalist, he retreated into academic jargon but didn't deny the charge. Summers, like most of his compatriots, took it as self-evident that the American model represented the best way to organize an economy-and the proof was the fact that the U.S. had emerged as the sole economic superpower.

Ten and a half years later, American economic hegemony looks much less secure. The U.S. economy is suffering through a serious slump, the second in a decade; many American families face eviction from their homes; American workers haven't received a decent pay raise in almost 10 years; and U.S. taxpayers are being railroaded into committing the better part of a trillion dollars to bail out feckless Wall Street institutions. The Iranian president isn't the only one hailing the end of the American era. Take, for example, this passage from George Soros' latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means: "I contend that it means the end of a long period of relative stability based on the United States as the dominant power and the dollar as the main international reserve currency. I foresee a period of political and financial instability, hopefully to be followed by the emergence of a new world order."

Is Soros right? Up to a point, he is. Three pillars of American economic supremacy have been badly dented: the unrivaled power of Wall Street, our ability to dictate policy to other countries, and the appeal of the dollar. With the U.S. government heavily dependent on foreigners' purchases of Treasurys to finance its deficit, American officials, when they visit places like China and Japan, are already less arrogant than they used to be. In the future, they will surely be even more reluctant to sound off, which is just as well. Today, many Japanese and Chinese officials would struggle to keep a straight face upon hearing an American policymaker dispensing economic advice.

But the humbling of the U.S. doesn't mean that the Asians and Europeans are going to be bossing us around the way we used to boss them. The U.S. may no longer be the bully on the block, but its economy is still by far the biggest in the world, and even now it attracts money and talent from around the globe. After a punishing period of wealth destruction and rising unemployment, the financial markets will stabilize and growth will resume. America will be a bruised giant, but a giant it will remain.

One of my first assignments in journalism was covering the Big Bang-the deregulation of Britain's financial markets-which took place in October 1986. All too aware that the City of London was slipping behind Wall Street, Margaret Thatcher's government abolished the regulations that had prevented foreign investment firms from competing with the snooty, undercapitalized British banks that had dominated Britain for centuries. Within a few years, the titans of Wall Street-Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers-had barged into town, buying out many local outfits and eliminating many venerable British customs such as the three-hour liquid lunch.

In today's City, cocktails at noon are a thing of the past, but so too is the cocky American investment banker. Lehman is bankrupt; Merrill is a subsidiary of Bank of America; Morgan and Goldman, fearful they were about to become subsidiaries of the People's Republic of China or perhaps even meet the same fate as Lehman, have converted themselves into commercial banks; and Goldman has sold a chunk of itself to Warren Buffett. Washington Mutual is gone. Citi, another big player in London, is referred to in some circles as the Bank of Arabia. (Following the firm's latest mishaps, Arab investors own about 20 percent of its equity.)

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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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