Philadelphia Reflections

Macroeconomics of The 2007 Collapse

Sudden wealth creation, whether from the discovery of gold or oil, the conversion of poverty into useful cheap labor, or the sudden abundance of cheap credit, is of course a good thing. Sudden wealth creation can be compared with a stone thrown into a pond, causing a splash, and ripples, but leaving a somewhat higher water level after things calm down. The globalization of trade and finance in the past fifty years has caused 150 such disturbances, mostly confined to a primitive developing country and its neighbors. Only the 2007 disruption has been large enough to upset the biggest economies. It remains to be seen whether a disorder to the whole world will result in a revised world monetary arrangement. One hopes so, but national currencies, tightly controlled by local governments, have been successful in the past in confining the damage. This time, the challenge is to breach the dikes somewhat, without letting destructive tidal waves sweep past them. Many will resist this idea, claiming instead it would be better to have higher dikes.

It is the suddenness of new wealth creation in a particular region which upsets existing currency arrangements. Large economies "float" their currencies in response to the fluxes of trade, smaller economies can be permitted to "peg" their currencies to larger ones, with only infrequent readjustments. Even the floating nations "cheat" a little, in response to the political needs of the governing party, or, to stimulate and depress their economies as locally thought best. All politicians in all countries, therefore, fear a strictly honest floating system, and their negotiations about revising the present system will surely be guilty of finding loopholes for each other; the search for flexible floating will, therefore, claim to seek an arrangement which is "workable".

In thousands of years of governments, they have invariably sought ways to substitute inflated currency for unpopular taxes. The heart of any international payment system is to find ways to resist local inflation strategies. Aside from using gunboats, only two methods have proven successful. The most time-honored is to link currencies to gold or other precious substances, which has the main handicap of inflexibility in response to economic fluctuations. After breaking the link to gold in 1971, central banks regulated the supply of national currency in response to national inflation, so-called "inflation targeting". It worked far better than many feared, apparently allowing twenty years without a recession. It remains to be investigated whether the substitution of foreign currency defeated the system, and therefore whether the system can be repaired by improving the precision of universal floating, or tightening the obedience to targets, or both. These mildest of measures involve a certain surrender of national sovereignty; stronger methods would require even more draconian external force. The worse it gets, the more likely it could be enforced only by military threat. Even the Roman Empire required gold and precious metals to enforce a world currency. The use of the International Monetary Fund (IMF) implies attempts to dominate the politics of the IMF. So it comes to the same thing: this crisis will have to get a lot worse, maybe with some rioting and revolutions, before we can expect anything more satisfactory than a rickety negotiated international arrangement, riddled with embarrassing "earmarks". Economic recovery will be slow and gradual unless this arrangement is better, or social upheavals worse, that would presently appear likely.

Originally published: Thursday, March 12, 2009; most-recently modified: Sunday, July 21, 2019