There are two dimensions to the crisis — immediate crisis managment and long-term systemic reform. 

On the first, both stock market and credit market responses to the seemingly endless string of “fixes” have been uniformly negative. Why? Because the leadership of the Treasury and Fed appeared panicked in warning of immense danger if something is not done immediately. But then when given the authority and money to act, the US Treasury does not act. “We’ll be ready in a few weeks.”  Hardly reassuring.  Were they incapable of forward planning?  In the meantime, the original scare talk coming from Washington has made investors predisposed to believe the worst and nothing has happened to alleviate that concern.  Lesson: Don’t say the sky is falling without acquiring a sturdy umbrella — and then opening it.

 The second is the important issue of what happens after the crisis simmers down, which it eventually will.  There are two diametrically opposite points of view, call them the Greenspan doctrine and the Volcker view. The Greenspan doctrine is that free markets overshoot and there is nothing anybody can do about that. But the good that they do during booms in creating new businesses, houses, etc. outweighs the damage done in the crashes.  So don’t re-regulate the financial system.

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What does the current economic turmoil portend for globalization in general? Since we are now, by common consent, in the midst of the worst financial crisis since the Great Depression, and since that event put an end to the efforts of the 1920s to reconstruct pre-World War I globalization, it is perhaps worth asking whether history is poised to repeat itself on this score. On this point two observations seem worth making.

First, free-market globalization was vulnerable last time around because, among other reasons, plausible alternatives were on offer: the centrally planned economic system that the Bolsheviks had created in the former tsarist empire that seemed immune to the plagues that struck the rest of the world; and the system of (with apologies to the twentieth century’s greatest economist) military Keynesianism that the Nazis installed in Germany that lifted that country out of the Depression earlier than the other European countries managed to escape it. Subsequent events, however, have thoroughly discredited both, and neither is a candidate for a comeback. (World War II demonstrated that while manufacturing weapons can increase productive economic activity, actually using them has the opposite effect.) As Mrs. Thatcher might put it, where some form of globalization is concerned there is no alternative. To the Asian financial crises of the 1990s the afflicted governments responded with policies — the accumulation of reserves most prominently — that modified but did not fundamentally change their economic approaches. A similar response seems likely when the current storm passes.

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I side with those (from Nye to Setser) who say this is not the end of US relative power, and that fiscal constraints will not be hugely binding.

Regarding the latter, what Japan’s actions in the 1990s show us is that fiscal policy when properly used can be effective, that running up debt in what is clearly a temporary situation is not automatically inflationary (note that yen also had a sustained major depreciation and Japan had neither rising interest rate nor inflation), and that it is net debt, not gross public debt that matters (see the work of Broda and Weinstein).

What I am much more concerned about is the US having lost the intellectual or “model setting” leadership in the global economic community. This is in large part deserved because we did get sloppy with our regulation and supervision, we were too arrogant to others, and we did too little to submit our own policies to international institutions (even under Clinton, though obviously much worse under Bush).

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To Sebastian’s original forum question: is there a relationship between the financial turmoil and US power. The answer has to be yes – for both internal and external reasons.

The internal reasons are more obvious: a strong economy is critical to the ability of the US to lead, to fund national security needs, and to generate public support for any truly necessary engagement abroad to protect national security interests. This crisis has a ways to play out with consequences to the US economy ranging from bad to catastrophic (with other countries now facing similar prophesies). A home-first bias will temper foreign aid programs, just at a time when a cash rich beneficiaries of this decade’s wealth transfer out of the US are able to use financial clout for foreign aid programs or even as outright foreign policy tools. Heading deeper into debt (increasing dependence on Chinese, Japanese, Russian… reserves) could potentially limit our foreign objectives as well (see Brad’s excellent Sovereign Wealth piece).

The external impact of this crisis on US power has yet to play out, but early warning signals are not good. Over the past few years, one could count on Putin to rave about revising the world’s financial architecture (US at the center) to benefit the emerging world economic powers. We counted on a rising China buying into a legacy system it benefited from and not rocking the boat. Now we hear from friends and foes that the time to rebuild the entire financial and monetary system of the world has come. Today we focus on saving the global banking system, but after the dust settles, real questions will emerge about free-market capitalism and the role of the state (not least of which will be because the UST will rival ADIA in assets under management). It would be naïve to write this one off as a bubble born of a perfectly fine free market system – back to business as usual in a year – in the eyes of the rest of the world.

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Nick Eberstadt’s post invites comments on the relative nature of US power. I’ve contributed a few thoughts there, but would also like to build on a question raised by Desmond Lachman in his Forum comment last week. Where does this turmoil leave globalization?

Even before the financial crisis, globalization faced a long list of challenges.
-The American political system appears to be allergic to further tariff-cutting efforts. A likely shift to the Democrats in the next Congress may not help matters, though there is a counter-argument that says Democrats elected in Republican-leaning districts may be more open to trade liberalization.
-Soveriegn wealth funds and post 9/11 fears have created a drift toward investment protectionism, as documented in a recent Council on Foreign Relations report by David Marchik and Matthew Slaughter.
-Climate negotiations are likely to create a fight over green tariffs, with potential to trigger more protectionism.
-The food price spike earlier this year triggered a widespread loss of faith in global markets as providers of food security. Several countries lunged for an autarkic response by imposing export controls, and the Doha Round stalled largely because China joined India in the view that protecting domestic farmers is vital.
-Rising prices for other commodities in the past several years has produced a scramble to lock up supplies. Rather than believe that they can secure needed raw materials by buying them on world markets, China and others have taken the view that they need to buy mines, oil wells, and so on. Resource nationalism has emerged as a challenge to the liberal international order.

Against this difficult background, the world now faces a painful recession that will be blamed, with some justification, on globalized capital markets. Already, the policy response has involved more assertion of control by national governments and less faith in international markets. In some cases, the expansion of the role of the state has been unavoidable: The US government had no choice but to take-over Bear, AIG and Fannie and Freddie. In other cases, the state has flexed its muscles too much: The Irish elimination by fiat of all bank credit risk and the bans on short selling of stocks fall into this category.

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