The Next Liberal Order
The Age of Contagion Demands More Internationalism, Not Less
Crises can drive change, but sometimes it takes two crises to cement a transformation. Alone, the Great Depression ushered in the New Deal, roughly tripling U.S. federal spending as a share of output. But it took World War II to push federal spending much higher, solidifying the role of the state in the U.S. economy. If federal interventions such as the creation of the interstate highway system felt natural by the mid-1950s, it was the result of two compounding shocks, not a single one.
American history offers many such examples. Alone, the Vietnam War might have triggered a decline of trust in the government. It took the compounding shock of Watergate to make that decline precipitous. Alone, the collapse of the Soviet Union would have enhanced U.S. power. It took the strong performance of the U.S. economy in the 1990s to spark talk of a “unipolar moment.” Alone, technological advances would have fueled inequality in the first decade of this century. Globalization reinforced that fracturing.
Today, the United States and other advanced countries are experiencing the second wave of an especially powerful twin shock. Taken individually, either the global financial crisis of 2008 or the global pandemic of 2020 would have been enough to change public finances, driving governments to create and borrow money freely. Combined, these two crises are set to transform the spending power of the state. A new era of assertive and expansive government beckons. Call it the age of magic money.
The twin shocks will change the balance of power in the world, because their effects will vary across countries, depending on the credibility and cohesion of each country’s economic institutions. Japan, with a long history of low inflation and a competent national central bank, has already shown that it can borrow and spend far more than one might have predicted given its already high levels of public debt. The United Kingdom, which has a worrisome trade deficit but strong traditions of public finance, should be able to manage an expansion of government spending without adverse consequences. The eurozone, an ungainly cross between an economic federation and a bickering assemblage of proud nation-states, will be slower to exploit the new opportunities. Meanwhile, emerging economies, which weathered the 2008 crisis, will enter a hard phase. Weaker states will succumb to debt crises.
The new era will present the biggest potential rewards—and also the greatest risks—to the United States. As the issuer of the world’s most trusted financial assets, the United States will be able to use (and maybe abuse) the new financial powers most ambitiously. Thanks partly to the dollar’s entrenched position as the world’s reserve currency, the United States will be able to sustain an expansion in government spending on priorities as varied as scientific research, education, and national security. At the same time, the U.S. national debt will swell, and its management will depend crucially on the credibility of the Federal Reserve. In times of high national debt, U.S. presidents since Harry Truman have tried to subjugate the central bank. If the Fed loses its independence, the age of magic money could end in catastrophe.
The financial crisis of 2008 left its mark on the world by magnifying the power of central banks in the advanced economies. In the days immediately after Lehman Brothers filed for bankruptcy, in September of that year, Ben Bernanke, the U.S. Federal Reserve chair, offered an early glimpse of the economy’s new rules by pumping $85 billion of public funds into the American International Group (AIG), an insurer. When Representative Barney Frank, Democrat of Massachusetts, was informed of this plan, he skeptically inquired whether the Fed had as much as $85 billion on hand. “We have $800 billion,” Bernanke answered simply. Armed with the nation’s printing press, Bernanke was saying, the Fed can conjure as many dollars as it wants. The iron law of scarcity need not apply to central bankers.
The AIG rescue was only the beginning. The Fed scooped toxic assets off the balance sheets of a long list of failing lenders in order to stabilize them. It embraced the new tool of “quantitative easing,” which involves creating money to buy long-term bonds, thus suppressing long-term interest rates and stimulating the economy. By the end of 2008, the Fed had pumped $1.3 trillion into the economy, a sum equivalent to one-third of the annual federal budget. The central bank’s traditional toolkit, involving the manipulation of short-term interest rates, had been dramatically expanded.
The Fed has emerged as the biggest agent of big government, a sort of economics superministry.
These ambitious moves were mirrored in other advanced economies. The Bank of England also embraced quantitative easing, buying bonds on the same scale as the Fed (adjusting for the size of the British economy). The Bank of Japan had experimented with quantitative easing since 2001, but following the financial crisis, it redoubled those efforts; since 2013, it has created more money relative to GDP than any other mature economy. The European Central Bank’s response was halting for many years, owing to resistance from Germany and other northern member states, but in 2015, it joined the party. Combined, these “big four” central banks injected about $13 trillion into their economies in the decade after the financial crisis.
The crisis brought on by the novel coronavirus has emboldened central banks still further. Before the pandemic, economists worried that quantitative easing would soon cease to be effective or politically acceptable. There were additional concerns that post-2008 legislation had constrained the power of the Fed to conduct rescues. “The government enjoys even less emergency authority than it did before the crisis,” former Treasury Secretary Timothy Geithner wrote in these pages in 2017. But as soon as the pandemic hit, such fears were dispelled. “I was among many who were worried a month ago about the limited scope of the Fed arsenal,” the respected investor Howard Marks confessed recently. “Now we see the vast extent of the Fed’s potential toolkit.”
The Fed rode into battle in March, promising that the range of its actions would be effectively limitless. “When it comes to lending, we are not going to run out of ammunition,” declared Jerome Powell, the Fed chair. Whereas the Fed’s first two rounds of quantitative easing, launched in 2008 and 2010, had involved a preannounced quantity of purchases, Powell’s stance was deliberately open ended. In this, he was following the precedent set in 2012 by Mario Draghi, then the president of the European Central Bank, who pledged to do “whatever it takes” to contain Europe’s debt crisis. But Draghi’s promise was an inspired bluff, since the willingness of northern European states to support limitless intervention was uncertain. In contrast, nobody today doubts that the Fed has the backing of the U.S. president and Congress to deliver on its maximalist rhetoric. This is “whatever it takes” on steroids.
The Fed’s muscular promises have been matched with immediate actions. During March and the first half of April, the Fed pumped more than $2 trillion into the economy, an intervention almost twice as vigorous as it delivered in the six weeks after the fall of Lehman Brothers. Meanwhile, market economists project that the central bank will buy more than $5 trillion of additional debt by the end of 2021, dwarfing its combined purchases from 2008 to 2015. Other central banks are following the same path, albeit not on the same scale. As of the end of April, the European Central Bank was on track for $3.4 trillion of easing, and Japan and the United Kingdom had promised a combined $1.5 trillion.
The design of the Fed’s programs is leading it into new territory. After Lehman’s failure, the Fed was leery of bailing out nonfinancial companies whose stability was marginal to the functioning of the financial system. Today, the Fed is buying corporate bonds—including risky junk bonds—to ensure that companies can borrow. It is also working with the Treasury Department and Congress to get loans to small and medium-sized businesses. The Fed has emerged as the lender of last resort not just to Wall Street but also to Main Street.
As the Fed expands its reach, it is jeopardizing its traditional claim to be a narrow, technocratic agency standing outside politics. In the past, the Fed steered clear of Main Street lending precisely because it had no wish to decide which companies deserved bailouts and which should hit the wall. Such invidious choices were best left to democratically elected politicians, who had a mandate to set social priorities. But the old demarcation between monetary technicians and budgetary politics has blurred. The Fed has emerged as the biggest agent of big government, a sort of economics superministry.
This leads to the second expansion of governments’ financial power resulting from the coronavirus crisis. The pandemic has shown that central banks are not the only ones that can conjure money out of thin air; finance ministries can also perform a derivative magic of their own. If authorized by lawmakers and backed by central banks, national treasuries can borrow and spend without practical limit, mocking the normal laws of economic gravity.
The key to this new power lies in the strange disappearance of inflation. Since the 2008 crisis, prices in the advanced economies have risen by less than the desired target of about two percent annually. As a result, one of the main risks of budget deficits has vanished, at least for the moment. In the pre-2008 world, governments that spent more than they collected in taxes were creating a risk of inflation, which often forced central banks to raise interest rates: as a form of stimulus, budget deficits were therefore viewed as self-defeating. But in the post-2008 world, with inflation quiescent, budget authorities can deliver stimulatory deficits without fear that central banks will counteract them. Increased inequality has moved wealth into the hands of citizens who are more likely to save than to spend. Reduced competition has allowed companies with market power to get away with spending less on investments and wages. Cloud computing and digital marketplaces have made it possible to spend less on equipment and hiring when launching companies. Thanks to these factors and perhaps others, demand has not outgrown supply, so inflation has been minimal.
Despite a perception of U.S. decline, almost two-thirds of central bank reserves are still composed of dollars.
Whatever the precise reasons, the disappearance of inflation has allowed central banks to not merely tolerate budget deficits but also facilitate them. Governments are cutting taxes and boosting spending, financing the resulting deficits by issuing bonds. Those bonds are then bought from market investors by central banks as part of their quantitative easing. Because of these central bank purchases, the interest rate governments must pay to borrow goes down. Moreover, because central banks generally remit their profits back to government treasuries, these low interest payments are even lower than they seem, since they will be partially rebated. A finance ministry that sells debt to its national central bank is, roughly speaking, borrowing from itself. Just as central bankers are blurring the line between monetary policy and budgetary policy, so, too, are budgetary authorities acquiring some of the alchemical power of central bankers.
If low inflation and quantitative easing have made budget deficits cheap, the legacy of 2008 has also made them more desirable. In the wake of the financial crisis, quantitative easing helped the economy recover, but it also had drawbacks. Holding down long-term interest rates has the effect of boosting equity and bond prices, which makes it cheaper for companies to raise capital to invest. But it also delivers a handout to holders of financial assets—hardly the most deserving recipients of government assistance. It would therefore be better to rouse the economy with lower taxes and additional budgetary spending, since these can be targeted at citizens who need the help. The rise of populism since 2008 underscores the case for stimulus tools that are sensitive to inequality.
Because budget deficits appear less costly and more desirable than before, governments in the advanced economies have embraced them with gusto. Again, the United States has led the way. In the wake of the financial crisis, in 2009, the country ran a federal budget deficit of 9.8 percent of GDP. Today, that number has roughly doubled. Other countries have followed the United States’ “don’t tax, just spend” policies, but less aggressively. At the end of April, Morgan Stanley estimated that Japan will run a deficit of 8.5 percent of GDP this year, less than half the U.S. ratio. The eurozone will be at 9.5 percent, and the United Kingdom, at 11.5 percent. China’s government, which led the world in the size of its stimulus after 2008, will not come close to rivaling the United States this time. It is likely to end up with a 2020 deficit of 12.3 percent, according to Morgan Stanley.
As the world’s strong economies borrow heavily to combat the coronavirus slump, fragile ones are finding that this option is off-limits. Far from increasing their borrowing, they have difficulty in maintaining their existing levels of debt, because their creditors refuse to roll over their loans at the first hint of a crisis. During the first two months of the pandemic, $100 billion of investment capital fled developing countries, according to the International Monetary Fund, and more than 90 countries have petitioned the IMF for assistance. In much of the developing world, there is no magic, only austerity.
Since the start of the pandemic, the United States has unleashed the world’s biggest monetary stimulus and the world’s biggest budgetary stimulus. Miraculously, it has been able to do this at virtually no cost. The pandemic has stimulated a flight to the relative safety of U.S. assets, and the Fed’s purchases have bid up the price of U.S. Treasury bonds. As the price of Treasuries rises, their interest yield goes down—in the first four months of this year, the yield on the ten-year bond fell by more than a full percentage point, dropping below one percent for the first time ever. Consequently, even though the stimulus has caused U.S. government debt to soar, the cost of servicing that debt has remained stable. Projections suggest that federal debt payments as a share of GDP will be the same as they would have been without the crisis. This may be the closest thing to a free lunch in economics.
The world’s top economies have all enjoyed some version of this windfall, but the U.S. experience remains distinctive. Nominal ten-year government interest rates are lower in Canada, France, Germany, Japan, and the United Kingdom than in the United States, but only Germany’s is lower after adjusting for inflation. Moreover, the rate in the United States has adjusted the most since the pandemic began. Germany’s ten-year government rate, to cite one contrasting example, is negative but has come down only marginally since the start of February—and has actually risen since last September. Likewise, China’s ten-year bond rate has come down since the start of this year but by half as much as the U.S. rate. Meanwhile, some emerging economies have seen their borrowing costs move in the opposite direction. Between mid-February and the end of April, Indonesia’s rate rose from around 6.5 percent to just under eight percent, and South Africa’s jumped from under nine percent to over 12 percent, although that increase has since subsided.
The United States’ ability to borrow safely and cheaply from global savers reflects the dollar’s status as the world’s reserve currency. In the wake of the 2008 crisis, when the failures of U.S. financial regulation and monetary policy destabilized the world, there was much talk that the dollar’s dominance might end, and China made a concerted effort to spread the use of the yuan beyond its borders. A decade or so later, China has built up its government-bond market, making it the second largest in the world. But foreigners must still contend with China’s capital controls, and the offshore market for yuan-denominated bonds, which Beijing promoted with much fanfare a decade ago, has failed to gain traction. As a result, the yuan accounts for just two percent of global central bank reserves. Private savers are starting to hold Chinese bonds, but these still represent a tiny fraction of their portfolios.
Today, finance has more sway over countries and people than ever before.
As China struggles to internationalize the yuan, the dollar remains the currency that savers covet. Despite the financial crisis and the widespread perception that U.S. influence in the world has declined, almost two-thirds of central bank reserves are still composed of dollars. Nor has the frequent U.S. resort to financial sanctions changed the picture, even though such sanctions create an incentive for countries such as Iran to develop ways around the dollar-based financial system. Issuing the global reserve currency turns out to be a highly sustainable source of power. The dollar continues to rally in times of uncertainty, even when erratic U.S. policies add to that uncertainty—hence the appreciation of the dollar since the start of the pandemic.
The dollar’s preeminence endures because of powerful network effects. Savers all over the world want dollars for the same reason that schoolchildren all over the world learn English: a currency or a language is useful to the extent that others choose it. Just under half of all international debt securities are denominated in dollars, so savers need dollars to buy these financial instruments. The converse is also true: because savers are accustomed to transacting in dollars, issuers of securities find it attractive to sell equities or bonds into the dollar market. So long as global capital markets operate mainly in dollars, the dollar will be at the center of financial crises—failing banks and businesses will have to be rescued with dollars, since that will be the currency in which they have borrowed. As a result, prudent central banks will hold large dollar reserves. These network effects are likely to protect the status of the dollar for the foreseeable future.
In the age of magic money, this advantage will prove potent. At moments of stress, the United States will experience capital inflows even as the Federal Reserve pushes dollar interest rates down, rendering capital plentiful and inexpensive. Meanwhile, other countries will be treated less generously by the bond markets, and some will be penalized by borrowing costs that rise at the least opportune moment.
A strong financial system has always given great powers an edge: a bit over two centuries ago, the United Kingdom’s superior access to loans helped it defeat Napoleon. Today, finance has more sway over countries and people than ever before. But even as it bolsters U.S. power, finance has become riskier. The risk is evident in the ballooning U.S. federal debt burden. As recently as 2001, the federal debt held by the public amounted to just 31 percent of GDP. After the financial crisis, the ratio more than doubled. Now, thanks to the second of the twin shocks, federal debt held by the public will soon match the 106 percent record set at the end of World War II.
Whether this debt triggers a crisis will depend on the behavior of interest rates. Before the pandemic, the Congressional Budget Office expected the average interest rate on the debt to hover around 2.5 percent. The Fed’s aggressive bond buying has pulled U.S. rates lower—hence the free lunch. But even if interest rates went back to what they were before, the debt would still be sustainable: higher than the average of 1.5 percent of GDP that the country has experienced over the past two decades but still lower than the peak of 3.2 percent of GDP that the country reached at the start of the 1990s.
Another way of gauging debt sustainability is to compare debt payments with the growth outlook. If nominal growth—real growth plus inflation—outstrips debt payments, a country can usually grow out of its problem. In the United States, estimates of real sustainable growth range from 1.7 percent to 2.0 percent; estimates of future inflation range from the 1.5 percent expected by the markets to the Fed’s official target of 2.0 percent. Putting these together, U.S. nominal growth is likely to average around 3.6 percent. If debt service payments are 2.5 percent of GDP, and if the government meets those obligations by borrowing and so expanding the debt stock, nominal growth of 3.6 percent implies that the federal government can run a modest deficit in the rest of its budget and still whittle away at the debt-to-GDP ratio.
Japan’s experience reinforces the point that high levels of debt can be surprisingly sustainable. The country’s central government debt passed 100 percent of GDP in 2000, and the ratio has since almost doubled, to nearly 200 percent. Yet Japan has not experienced a debt crisis. Instead, interest rates have declined, keeping the cost of servicing the debt at an affordable level. Japan’s track record also disproves the notion that high levels of debt impede vigorous emergency spending. The country’s pandemic stimulus is large, especially relative to the scale of its health challenge.
In short, the recent prevalence of low interest rates across the rich world encourages the view that U.S. debt levels will be manageable, even if they expand further. The more central banks embrace quantitative easing, the lower interest rates are likely to remain: the rock-bottom yields on Japan’s government debt reflect the fact that the Bank of Japan has vacuumed up more than a third of it. In this environment of durably low interest rates, governments enter a looking-glass world: by taking on more debt, they can reduce the burden of the debt, since their debt-financed investments offset the debt by boosting GDP. Based on this logic, the age of magic money may usher in expanded federal investments in a wide range of sectors. When investors the world over clamor for U.S. government bonds, why not seize the opportunity?
The question is whether Tokyo’s experience—rising debt offset by falling interest rates—anticipates Washington’s future. For the moment, the two countries have one critical feature in common: a central bank that is eagerly engaged in quantitative easing. But that eagerness depends on quiescent inflation. Because of a strong tradition of saving, Japan has experienced outright deflation in 13 of the past 25 years, whereas the United States has experienced deflation in only one year over that period. The danger down the road is that the United States will face an unexpected price surge that in turn forces up interest rates faster than nominal GDP, rendering its debt unsustainable.
To see how this could work, think back to 1990. That year, the Fed’s favorite measure of inflation, the consumer price index, rose to 5.2 percent after having fallen to 1.6 percent four years earlier—thus proving that inflation reversals do happen. As inflation built, the Fed pushed up borrowing costs; rates on ten-year Treasury bonds went from about seven percent in late 1986 to over nine percent in 1988, and they hovered above eight percent in 1990. If a reversal of that sort occurred today, it could spell disaster. If long-term interest rates rose by two percentage points, the United States would face debt payments worth 4.5 percent of GDP rather than 2.5 percent. The burden of the national debt would hit a record.
That would have significant political consequences. In 1990, the unsustainable debt trajectory forced the adoption of a painful deficit-cutting package, causing President George H. W. Bush to renege on his “no new taxes” campaign pledge, arguably costing him the 1992 election. Given today’s political cynicism, it seems unwise to count on a repeat of such self-sacrifice. It is therefore worth recalling the other debt-management tactic that Bush’s administration attempted. By attacking the Fed chair, Alan Greenspan, with whispered slanders and open scolding, Bush’s advisers tried to bully the central bank into cutting interest rates. The way they saw things, lower rates, faster growth, and higher inflation would combine to solve the debt problem.
Greenspan stood his ground, and Bush was not reckless enough to get rid of him. But if a future president were more desperate, the Fed could be saddled with a leader who prioritized the stability of the national debt over the stability of prices. Considering the Fed’s recent business bailouts, it would be a small step to argue that the central bank also has a duty to protect citizens from budget austerity. Given its undershooting of the inflation target over the past few years, it would be easy to suggest that a bit of overshooting would be harmless. Unfortunately, if not checked fairly quickly, this seductive logic could open the way to a repeat of the 1970s, when U.S. financial mismanagement allowed inflation to reach double digits and the dollar came closer than ever in the postwar period to losing its privileged status.
The age of magic money heralds both opportunity and peril. The twin shocks of 2008 and 2020 have unleashed the spending power of rich-world governments, particularly in the United States. They have made it possible to imagine public investments that might speed growth, soften inequality, and tackle environmental challenges. But too much of a good thing could trigger a dollar crisis that would spread worldwide. As U.S. Treasury Secretary John Connally put it to his European counterparts in 1971, “The dollar is our currency but your problem.”
Nobody is sure why inflation disappeared or when it might return again. A supply disruption resulting from post-pandemic deglobalization could cause bottlenecks and a price surge; a rebound in the cost of energy, recently at absurd lows, is another plausible trigger. Honest observers will admit that there are too many unknowns to make forecasting dependable. Yet precisely because the future is uncertain and contingent, a different kind of prediction seems safe. If inflation does break out, the choices of a handful of individuals will determine whether finance goes over the precipice.
The United States experienced an analogous moment in 1950. China had sent 300,000 infantry across the frozen Yalu River, which marked its border with Korea; they swarmed U.S. soldiers sleeping on the frigid ground, stabbing them to death through their sleeping bags. The following month, with the fate of the Cold War as uncertain as it would ever be, U.S. President Harry Truman called Thomas McCabe, the Fed chair, at home and insisted that the interest rate on ten-year bonds stay capped at 2.5 percent. If the Fed failed to buy enough bonds to keep the interest rate at that level, “that is exactly what Mr. Stalin wants,” the president lectured. In a time of escalating war, the government’s borrowing capacity had to be safeguarded.
This presented the Fed with the kind of dilemma that it may confront again in the future. On the one hand, the nation was in peril. On the other hand, inflation was accelerating. The Fed had to choose between solving an embattled president’s problem and stabilizing prices. To Truman’s fury, McCabe resolved to put the fight against inflation first; when the president replaced McCabe with William McChesney Martin, a Treasury official Truman expected would be loyal, he was even more shocked to find that his own man defied him. In his first speech after taking office, Martin declared that inflation was “an even more serious threat to the vitality of our country than the more spectacular aggressions of enemies outside our borders.” Price stability should not be sacrificed, even if the president had other priorities.
Years later, Truman encountered Martin on a street in New York City. “Traitor,” he said, and then walked off. Before the age of magic money comes to an end, the United States might find itself in need of more such traitors.
A Real-Life Experiment in Hyper-Keynesianism