Robert Z. Aliber’s research while affiliated with University of Chicago and other places

The lockdowns in Shanghai and other Chinese cities that President Xi adopted to prevent the spread of the pandemic has tripped the country’s economic growth by interrupting the purchases of apartments. The irony is that the virus that began in Wuhan has triggered a sharp decline in China’s rate of economic growth. Suddenly, many of the books and articles about the country’s challenge to U.S. hegemony appear outdated. The implicit assumption in these books and articles is that China will continue to achieve an economic growth rate of 4–5 percent a year. The irony in applying the Thucydides metaphor is that China is now aging more rapidly than the United States because of the belated impacts of the one-child policy that it adopted in the early 1980s. President Xi Jinping now faces “a perfect storm”; its other elements include a financial implosion as apartment prices cascade downward, the loss of its international competitive advantage to Vietnam and to Bangladesh and to other countries that have much lower wage rates, and the departure of the multinational firms that provided the brand names that made it easy to sell goods produced in China in foreign markets. The 2020 decade for China will be similar to the 1990s in Japan, when its growth rate fell below 1 percent in response to the implosion of the massive asset price bubble that had developed in the second half of the 1980s.

This paper asks whether the policy of benign neglect that the United States (U.S.) government adopted in the 1970s toward foreign purchases of U.S. dollar securities and the price of the U.S. dollar has advanced the ability of the U.S. to achieve its employment, price level, growth, and national security objectives. The dominant objective of some members of the U.S. team at Camp David in August 1971 was to secure an increase in the U.S. trade surplus. One choice for the U.S. government was to increase the U.S. dollar price of gold to $100 or$140 an ounce, much like the increase to $35 an ounce in 1934. The competing choice was to close the gold window. Some members of this team believed that this choice would facilitate the move to a flexible exchange rate arrangement and that the U.S. trade surplus would increase as the price of the U.S. dollar fell. The price of the U.S. dollar has increased since the late 1970s and the purchase of U.S. dollar securities by foreign central banks, sovereign wealth funds, mutual funds, insurance companies, pension funds, and families have meant that U.S. exports of securities have displaced U.S. exports of goods. The U.S. trade surplus morphed into a U.S. trade deficit in the early 1980s, which has increased secularly, and now is nearly four percent of U.S. GDP. U.S manufacturing employment declined from 20 million in 1980 to 13 million in 2020. The increasingly large U.S. trade deficit led to the loss of three million U.S. manufacturing jobs (ball park estimate). Hundreds of factory towns in the Northeast and Midwest were decimated by the increase in the U.S. trade deficit.

Within an economy, euphoria often spreads from one market to another. Property and stock markets stimulate each other in various ways. Higher wealth in one stimulates spending and faster growth, which raises the price of the other. Investors respond to a rise in the price of one by diversifying into the other. Higher property prices increase the value of the collateral that banks hold against loans, and banks increase the supply of credit. In 1980s Japan, banks held lots of shares, so the stock boom directly boosted the supply of bank credit, inflating the bubble spectacularly. Stock market and property may show ‘twin peaks’ on the way up, but on the way down stocks tend to fall faster than property. Speculators in real estate tend to borrow on extended terms and can hang on in hope.

Bitcoin and other cryptocoins have drawn tens of millions of investors, made billionaires, and reached $3 trillion in aggregate value in late 2021 before falling sharply. Yet crypto promises no cash flow and provides little financial service. Like Ponzi schemes, late investors provide any profit for early investors. Unlike a Ponzi, crypto cannot collapse in a run (although crypto exchanges and crypto lenders/borrowers can and have). And unlike zero-sum Ponzi schemes, bitcoin is a negative sum game: mining new coins consumes electricity and computers. Bitcoin is more akin to a decentralized pump and dump scheme with a negative sum. The end game for bitcoin and its ilk could see investor revulsion at the abuses of the centralized institutions that have sprung up to trade it, including exchanges and near monies, so-called stablecoins.

Financial crises tend to be international, either running parallel from country to country or spreading by one means or another from the centers where they originate to other countries. Boom, distress, and panic are transmitted through a variety of channels. Arbitrage keeps prices of commodities and securities in line, but so can marking up or down prices in one market when they change in another, without any actual buying and selling. Movements of money can take various forms: specie, bank deposits, and bills of exchange. Cooperation among central banks can play a role. Investor psychology is easy to neglect, especially in the linkage of securities that are not traded internationally and therefore are not subject to arbitrage.

With no world government and no world central bank, the question of where international last resort lending comes from is crucial. The historical record points to the country that serves as the world’s leading financial center, often assisted by other countries. The International Monetary Fund is not suited to the task owing to its limited, slow, and conditional lending. The swap arrangements between central banks worked out at the Bank for International Settlements starting in the 1960s better fit the bill. A division of labor developed among advanced economies: if central bank swaps could not be reversed within months, the borrower would refinance with the IMF with policy strings attached. IMF credit took center stage for emerging market countries, buttressed at times by central bank pressure on banks to increase or to maintain their lending.

Speculative manias gain momentum through the expansion of credit. Most increases in the supply of credit do not lead to a mania, but nearly every mania has been enabled by a rapid growth in the supply of credit to eager borrowers. In the last hundred years, increases in the supply of credit have come in part from banks, in part from new intermediaries and instruments, and in part from cross-border investment flows. Some prescribe the control of money—mostly bank deposits—to prevent a speculative mania. However, this prescription ignores the tendency of new channels of credit and new substitutes for money to develop during a mania. Banks can fund credit with non-deposit liabilities, including by tapping the elastic funding on offer in the international banking market.

In the crisis of 2008, central bank swaps played a role that had precedents but under circumstances without precedent, and in a size without precedent. The Fed extended unlimited dollar credit to non-US banks through swaps with central banks both to make its monetary policy effective and to meet runs on non-US banks. Central bank swaps during the pandemic crisis in March 2020 confirmed their role as backstops to global dollar banking, as well as ensuring the transmission of Fed policy to key private rates. In addition, the Fed’s new role as buyer of last resort in the US bond market in spring 2020 supported the global market for dollar bonds, including those issued outside the United States by non-US borrowers.

The propensities to swindle and to be swindled run parallel to the propensity to speculate during a boom. Some bubbles are swindles; many are not. Fraud and swindles grow with euphoria; demand from those who fear missing out and falling behind creates its own supply. Financial distress leads to more fraud as credit tightens, and prices stop rising and begin to decline. When a swindle or embezzlement is revealed, distress is increased, sometimes precipitating panic. Panic and crash, with their motto of every man for himself, induce still more to cheat by dumping losses onto others in order to save themselves. Panic can also lead to a scramble for cash that reveals a long-running scam like Bernie Madoff’s, which might otherwise have continued even longer.

Does it after all make a difference if there is no international lender of last resort? Based on a handful of cases before the Second World War, the absence of the lender of last resort does seem to make for a longer and deeper economic downturn after a crisis. However, the presence of the lender of last resort does not seem to forestall the crisis. Looking forward, the international lender of last resort faces challenges from the increasing weight of bond markets, and from politics. If central banks need to intervene jointly in bond markets, can they adapt the swap lines to this purpose? Can central banks continue to reconcile the politically possible and the economically stabilizing in a fracturing world?