August 04, 2011, 4:45 PM EDT

The Nixon Shock

How Nixon stopped backing the dollar with gold and changed global finance, a 40-year-old decision that still echoes in Greece, Ireland, and the U.S.

By Roger Lowenstein

“Inauguration Day was cloudy, grim,” wrote Arthur Burns in his diary on Jan. 20, 1969. As he watched President-elect Richard Nixon, Burns—an immigrant from Galicia, the son of a housepainter who had risen to become the foremost expert on U.S. economic cycles and chief economist to Dwight Eisenhower—saw a man with “a look of exaltation about him.” It was not a feeling Burns shared. “I would have felt better if his head were bowed and his body trembled some.”

Nixon was inheriting an overheated economy—inflation was already a concern. Burns, 64, would be joining the Administration as a uniquely trusted adviser. In 1960, when then Vice-President Nixon was seeking the White House, Burns had warned him that if the Federal Reserve tightened interest rates, it could damage Nixon’s chances. It had played out just so: The Fed tightened, the economy suffered a recession, and Nixon lost to John F. Kennedy. Nixon never forgot the power of the Fed, and he remembered Burns as an economist with political savvy.

So it was that a year into his term, with the economy faltering, Nixon tapped Burns to replace William McChesney Martin Jr., the Fed chief who had dashed his hopes in 1960. According to Burns biographer Wyatt Wells, Nixon issued his appointee some blunt instructions: “You see to it,” Nixon said. “No recession.”

Burns had more to address than a faltering economy and a famously meddlesome patron. By December 1969, inflation had topped 6 percent—its highest level since the Korean War.
Inflation had disturbing international implications because, in the system known as Bretton Woods that had prevailed since the end of World War II, the U.S. was committed to backing every dollar overseas with gold. Thus, foreign countries had the right to exchange their greenbacks at the rate of $35 per ounce. The other currencies were fixed to the dollar, and the dollar—the sun in the monetary sky—was pegged to gold.

For the first years after World War II, Bretton Woods (named for the New Hampshire resort where delegates from 44 Allied nations met in 1944) worked perfectly. Japan and Europe were still rebuilding, and foreigners were eager for dollars they could spend on American cars, steel, and machinery. Even as they accumulated currency reserves, America’s trading partners were content to park them in interest-bearing dollars rather than in inert metal. And since the U.S. owned over half the world’s official gold reserves—574 million ounces at the end of World War II—the system seemed secure.

But from 1950 to 1969, as Germany and Japan recovered, the U.S. share of the world’s economic output fell decisively, from 35 percent to 27 percent. Other nations had less need for dollars and more for deutsche marks, yen, and francs. Also, U.S. spending on Vietnam and domestic programs flooded the world with dollars. Bit by bit, America’s allies began to ask for gold.

The official charged with monitoring gold and other international exchanges was the Undersecretary for Monetary Affairs, a gruff, 6-foot, 7-inch banker named Paul Volcker. He had been worried about the gold market for quite some time. Although the U.S. fixed the official gold price, a market existed in London, in which, in effect, companies sold metal to jewelers and dentists, with central banks sopping up the surplus. Generally, the banks kept the price near to $35. One day in 1960, when Volcker was working at Chase Manhattan, someone burst into his office with news: Gold was at $40. Volcker couldn’t believe it. The price receded, but it was a worrisome foretaste. Jitters in the gold market were an early symptom of domestic inflation.

By the time Nixon took office, officials knew they were sitting on a powder keg. As Volcker, then 41, recalls, he warned incoming Treasury Secretary David M. Kennedy that they had two years to save the dollar. America’s balance of payments deficit in 1969 had reached $7 billion—small by today’s standards but scary then. This meant more dollars accumulating in London, Bonn, and Tokyo. Volcker pressed the Europeans to revalue their currencies; if Americans had to pay more for French wine, fewer dollars would pile up overseas. Germany modestly revalued; others refused. The Europeans, as well as Japan, were caught in a trap: They were reluctant to hold dollars, but unwilling to give up their dependence on exporting goods to America.

Nixon had minimal patience for the details of international finance. When an aide informed him of monetary problems in Rome, Nixon snapped, “I don’t give a s— about the lira.” What he did care about was the domestic economy, especially the politically sensitive unemployment number. And despite his instructions to Burns, in 1970 the U.S. suffered a recession, triggering a rise in unemployment to 6 percent, its highest mark in a decade.

Nixon was furious with Burns. He began taking economic cues from George Shultz, the Labor Secretary and then Budget Director. Shultz argued that Burns had erred by limiting the expansion of the money supply, which over the course of 1970 was less than 4 percent. Shultz, a former business school dean at Chicago, was echoing the theories of his close friend, Milton Friedman, the architect of the Chicago School. To Friedman, money supply was the single key tool at the Fed’s disposal. Friedman viewed money in terms of supply and demand: If the Fed printed more dollars, then money would be worth less and goods would cost more, i.e. inflation. But he also saw overly tight money as having worsened the Great Depression.

Burns, only eight years older than Friedman, had taught Friedman at Rutgers and been a mentor to him since. The two maintained a close friendship, and their families summered at nearby homes in Vermont. However, Burns didn’t share the rigid Friedman-Shultz belief that the money supply was everything. Burns distrusted single-answer diagnoses and blamed inflation partially on other factors, such as the growing power of labor unions. When even the 1970 recession failed to curb inflation, Burns was stumped. “What the boys around the White House fail to see,” Burns scribbled in his diary, “is that the country now faces an entirely new problem—sizable inflation in the midst of recession.” As Burns would tell a congressional committee, “The rules of economics are not working the way they used to.” Prices were going up even when factories stood idle—a seeming refutation of the economic rules.

Despite the galloping inflation, Nixon pressured Burns to loosen monetary policy. White House aides, violating the central bank’s supposed independence, inundated the Fed with memos on the need to lower rates. “The pressure that Nixon exerted was unbelievable,” says Joseph Burns, the late Fed chief’s son. Volcker agrees that it got “very rough.”

As the economy shifted into a tepid expansion in ’71, Burns allowed the money supply to expand at an annual rate of 8 percent in the first quarter, 10 percent in the next. This was wildly expansionary. Allan Meltzer, a Fed historian, says Burns’s policy was partly attributable to honest miscalculations. (Determining the rate of money supply growth is fiendishly difficult.)
But Meltzer says Burns was also influenced by Nixon’s bullying. The President alternately flattered Burns and excluded him, and Burns careened between feisty shows of independence and toadying displays of loyalty. In his diary, Burns assures the President that “his friendship was one of the three that has counted most in my life”; a few months later he is recoiling at Nixon’s “cruelty” and, still later, at his anti-Semitic outbursts. He feared the consequence of higher unemployment, yet was committed to the success of the Nixon Administration. This conflict led Burns to a dramatic about-face. In 1970, the Democratic-led Congress had authorized the President to impose wage and price controls. Nixon, who had played a small role in administering war-time price controls while working for the Office of Price Administration, thought they wouldn’t work. The issue became a political football. Then, at the end of 1970, Burns gave a speech advocating a wage and price review board that would issue guidelines and try to restrain inflation through suasion and public statements. Milton Friedman regarded it as an endorsement of centralized planning—and a personal betrayal. He stayed up all night writing his mentor what, he said later, was an overly harsh letter; Burns and Friedman were never friends again.

In the first half of 1971, unions representing copper, steel, and telephone workers negotiated wage increases of more than 30 percent over three years, in addition to cost-of-living adjustments. To modern readers, it may seem odd that the chairman of the Federal Reserve was reluctant to raise interest rates in the teeth of double-digit inflation, but the modern view that only the Fed can control inflation was not widely accepted. Balanced budgets were thought to be of equal importance. And, as Meltzer notes, few Americans thought inflation was worth sacrificing jobs for. That summer, Time magazine opined that, “once an inflation starts, no government could accept the severe recession and unemployment needed to stop it cold.” This was the conventional view—that the Fed was powerless.

Friedman argued that it was better to snuff out inflation because, in the long run, inflation (which merely amounted to printing money) wouldn’t truly create jobs. Friedman’s position was later to become gospel. At the time, though, many economists believed that by adding to the money supply, the central bank could spur growth. Burns, therefore, urged the White House to curb inflation by non-monetary means. He encouraged the President to “jawbone” industries to show restraint and to form a council of wise men who would publish guidelines. Nixon feared guidelines were a step toward controls; his solution was to bring inflation down without a recession, by working toward a balanced budget. Herbert Stein, his economic adviser, told him flatly it wouldn’t work. Burns chafed: “I am convinced that the President will do anything to be reelected.”

Rampant domestic inflation was mirrored, franc for franc, in markets overseas. Foreign governments intervened to buy dollars to shore up America’s currency (and their export trade). This left their central banks swollen with greenbacks. “Foreigners buying dollars caused a monetary expansion, similar to today,” says Ronald McKinnon, an economist at Stanford University. Meanwhile, America’s gold stock had dwindled to $10 billion, half its 1960 level. The gold standard now existed only in name, for foreign banks held far more dollars than the U.S. held gold. This left the U.S. vulnerable to a run.

With shrewd timing, in early 1971, Nixon appointed a new Treasury Secretary, John Connally, a hulking former Texas governor, who saw these various financial trials—inflation, the pressure on the dollar, the mounting trade deficit—as affronts to the national honor. It was the peak of the Vietnam protest movement, and Connally felt the U.S. had absorbed enough humiliations. He had no abiding economic philosophy; as he proclaimed to Nixon, “I can play it square, I can play it round, just tell me how you want me to play it.” What he brought to the Nixon team was enormous ego, force of personality, and a political intuition that economic reforms, which appeared imminent, had to be presented in a program acceptable to ordinary Americans. That Connally lacked financial expertise bothered him not a whit. “I can add,” he said upon taking the job. His role, as he saw it, was to pull together the competing recommendations of Shultz, Burns, and Volcker into a policy suggesting coherence.

Burns continued to back a wage council; he also thought the U.S. should devalue against gold (that is, raise the gold price above $35). Volcker believed this would be ineffectual, as other countries would simply devalue their currencies by the same percentage. To Volcker, the key to restoring balance was a 10 percent-to-15 percent devaluation of the dollar against the yen and the European currencies. Even if America’s allies refused to budge, Volcker thought the U.S. could force the issue by temporarily halting gold-dollar convertibility.

The pressure intensified that spring. In April and into May, as speculators sold dollars and hoarded deutsche marks, Germany was forced to purchase $5 billion to stabilize the exchange rate. This was a huge sum in an era in which hedge fund goliaths did not exist. On May 5, Germany caved to the upward pressure on its currency and let the deutsche mark float. This brought the West a step closer to Friedman’s dream of freely trading currencies, but it did not alleviate the crisis.

The gold exodus continued and, to make matters worse, the U.S. began running a substantial trade deficit, a politically charged issue given that unemployment remained at 6 percent. Nixon had to act, but his advisers were split. Volcker, as well as Shultz, wanted to close the gold window. Burns was vehemently opposed. Severing the gold link would turn money into  paper.
If the government no longer had to preserve the dollar’s value in metal, how could the Administration claim, with any credibility, to be countering inflation?

This question prompted officials to give controls a second look. No one in the Administration, from Nixon down, believed in controls in an economic sense. They were Sovietized economics, an attempt to force markets where they didn’t want to go. But the economics didn’t matter to Connally; what counted was a forceful display of power. Over the summer, Connally, with Nixon present, briefed Shultz—essentially so the latter could air his objections and then get behind the program. Secrecy was imperative. “Don’t tell your wife,” Nixon warned Shultz.

The intent was to move after Labor Day, but on Aug. 12, a Thursday, Britain stunned the U.S. by demanding that it guarantee the value of $750 million. On Friday, Nixon summoned 15 advisers to Camp David; he insisted no outsiders be told. Volcker wisely took exception and briefed a colleague in the State Dept. and also the Japanese. Stein, the economic adviser, told William Safire, the speechwriter, that they were embarking on the most momentous economic decision since March 1933. “[Are] We closing the banks?” Safire asked. Stein said no, but the gold window might be disappearing. “What a tragedy for mankind,” wrote Burns in his diary.

The plan, presented by Connally, had three key points. First, America would stop converting dollars to gold. Second, to combat the potential inflationary effects, wages and prices would be frozen for 90 days. And third, the U.S. would impose an import surcharge of 10 percent. Connally’s idea was to use the surcharge as a cudgel, to pressure other countries to renegotiate their exchange rates.

The Camp David weekend was intended for Connally to get everyone’s support before the program was announced. People slept two to a cabin (the bed was too short for Volcker) and convened in the dining room. Nixon remained cloistered in his cabin, the Aspen Lodge, but called anxiously for updates. Burns spent an evening pacing the grounds with Volcker, wringing his hands over the gold standard. Burns alone was invited to the President’s cabin for a private audience. Although Nixon regarded the pipe-smoking Fed chairman as pompous and long-winded, he knew Burns was trusted by the public, and he needed his support. Otherwise, it was Connally’s show.

Connally brilliantly packaged the program not as America abandoning its commitment to the gold standard but as America taking charge. He turned the dollar’s collapse, which could have appeared shameful, into a moment of hubris. The emphasis would be on righting America’s trade balance, as well as minor points such as a 5 percent cut in foreign aid. An aide to William P. Rogers, the Secretary of State, called and interjected, “You can’t cut foreign aid.” Connally said, “Tell him if he doesn’t shut up we’ll make the cuts 15 percent.” Shultz muzzled his disquiet over price controls; even Burns joined ranks. The group feverishly debated whether Nixon should address the country on Sunday night, which would mean preempting the popular Gunsmoke. The public relations aspect was paramount. Stein wrote later that the discussion at Camp David assumed “the attitude of scriptwriters preparing a TV special.” No one pretended to know how controls would work; the question was scarcely debated.
Addressing the nation on Sunday, Nixon blamed currency speculators and “unfair” exchange rates rather than U.S. monetary policy. Politically, he hit the jackpot. Monday’s nearly 33-point rise in the Dow was the biggest ever to that point. Nixon’s “New Economic Policy” drew raves from the press. “We unhesitatingly applaud the boldness with which the President has moved,” read the New York Times editorial. In the present era, America’s inability to repair its fiscal problems has tarnished its credibility and hampered its currency negotiations with China. The Nixon Shock showed the U.S. taking action. That December, Shultz and Volcker successfully negotiated a broad revaluation of exchange rates.

Volcker envisioned that once exchange rates were modified, Bretton Woods would be restored, perhaps with a more flexible mechanism for adjusting rates. He tirelessly negotiated with Europe and Japan, but Bretton Woods could not be put back together. The gold window stayed shut. More devaluations followed, and by 1973, currencies were freely floating.

Friedman’s prediction that, left to the market, currencies would regulate themselves with only gradual adjustments proved wildly incorrect. The dollar plunged by a third during the ’70s, and currency volatility has threatened several national economies since; in 1997, Asian and Latin American countries were wrecked by currency runs. To this day, Volcker regrets that Bretton Woods was abandoned. “Nobody’s in charge,” he says. “The Europeans couldn’t live with the uncertainty and made their own currency and now that’s in trouble.” The effect on America’s domestic economy was even worse. As Shultz says, “Price controls gave the illusion of doing something about inflation.” They further liberated Nixon from concern for the normal rules. Late in 1971, he wrote to the Fed chief, “You have given me absolute assurance that money supply growth will be adequate to maintain growth.” Burns scrawled in the margin, “Never gave him absolute assurance. What nonsense!” But Burns, intentionally or not, delivered on Nixon’s demand for an expansionary monetary policy.

Controls had the desired short-term effect; inflation was quiescent through the end of 1972, when Nixon easily won reelection. The controls, however, proved difficult to end. The 90-day freeze begat a more complicated wage and price regime, a Phase II, followed by a Phase III, lasting into ’74. And Burns’s easy money fostered a monetary steam cooker that controls could not suppress. By August ’74, when Nixon resigned, inflation had topped 11 percent. Soon it would go even higher. Expectations of rising prices became embedded in the system.

The Nixon Shock was a central cause of the Great Inflation. It also spelled the end of the fixed relationships that had governed the financial universe. Previously, people took out mortgages for set periods and at fixed rates. They had virtually no options for saving money other than in banks, and the interest rates that banks could pay were capped. Floating currencies unleashed a new world of risk and instability. For the first time, investors could bet on the direction of interest rates or the Swiss franc. New financial instruments, new speculative tools, proliferated.
The world gravitated from the certainties of Bretton Woods to the dizzying market cycles we’ve lived with since. Donald Kohn, who joined the Fed in 1970 and retired last year as vice-chairman, thinks Bretton Woods was doomed. But bankers have yet to find as rigorous a standard as gold. And they have become ever more apt to please politicians, deferring recessions at the risk of inflating asset bubbles.

Burns was replaced by Jimmy Carter in 1978. The following year, with inflation rocketing toward 15 percent, Burns delivered a keynote speech, “The Anguish of Central Banking,” in which he argued that central bankers around the world were failing because elected leaders were unwilling to risk displeasing constituents. The new Fed chief, Volcker, did tame inflation; unlike Burns, he had the fortitude to subject the country to a brutal recession. But the dilemma faced by Burns—how to withstand the demands of the public for limitless monetary expansion—did not go away. We see it now in the troubles of nations from Greece to Ireland to the U.S. And the anguish that Burns felt is Ben Bernanke’s unfortunate inheritance.

Lowenstein is a columnist for Bloomberg News.

A Net Assessment of East Asia

By George Friedman

June 16, 2015 | 08:00 GMT

When I began this series a month ago, I pointed out that the most significant feature of the global system currently is the ongoing destabilization of the Eurasian land mass, from the Atlantic to the Pacific, from the Arctic to the Arabian Sea. One important aspect of this is that the destabilization isn't, at this point, a single systemic crisis, but a series of relatively self-contained disorders. Thus the European, Russian and Middle Eastern systems have different dynamics, and while they touch on each other, they have not yet reached the point of having merged into a single crisis.

It is in this context that I turn to the question of East Asia. Asia is so vast and diverse and geographically fragmented that it is impossible to speak of Asia as a whole. East Asia is that part of Asia east of the Central Asian deserts that extend deep into China, and north of the Himalayas and hilly jungles east of the Himalayas. It consists of two main parts: One is the mainland, the region between the southern barriers and Siberia, which is Han China and its subordinate states, Tibet, Xinjiang, Inner Mongolia and Manchuria. The other is the East Asian archipelago, a string of islands and peninsulas stretching from the Aleutians to the Malay Peninsula-Java interface. Of particular importance to an East Asian net assessment are Taiwan, the Philippines and Japan. One additional feature is noteworthy: the Korean Peninsula, wedged between China and the archipelago. In the simplest terms, at this moment, the critical question is the dynamic in the northeast, involving China, Japan, the Koreas and, of course, the global power, the United States.

East Asia shares one major feature with the rest of Eurasia. It was part of World War II, which both transformed the region and defined it. In East Asia, World War II involved two issues:
The first was Japan's ability to access raw materials and manpower from the Asian mainland and the rest of the archipelago. The second was the military balance between the two major Pacific powers, Japan and the United States. The two issues became intertwined.

Economic Development in Japan and Korea

Japan is an island group almost completely bereft of raw materials. When European and American imperialism goaded it into becoming an industrial power, Japan immediately developed dependence on sources of raw materials (and on manpower to support its industrial expansion without immigration). Japan's enormous success at industrializing in the early 20th century made Tokyo insecure about access to these resources and therefore aggressive in trying to secure them. The United States, historically concerned about maritime defense of its coasts, saw Japan's increasing power and insecurity as a threat to U.S. control of the Pacific, which Washington saw as essential to protection of the West Coast.

The United States sought to limit Japan's control and even access to necessary resources in order to control its behavior. The Japanese saw this as an American plan to permanently subordinate Japan to the United States. When the Germans overran France and the Netherlands, the status of Indochina and today's Indonesia became murky, and Japan's ability to secure the resources it historically obtained from these places was uncertain. Japan moved to secure these areas, but doing so required securing the Philippines lest the sea-lanes from the south remain insecure. The Philippines was an American protectorate, so securing it meant war with the United States. This dynamic led to Pearl Harbor, which ultimately led to the catastrophic defeat of Japan.

Two dimensions of this defeat were interesting: The first was that the Japanese industrial plant, and therefore the Japanese economy, was wrecked. The second was that in spite of defeat and disaster, Japanese society maintained its cohesion. In addition, the Americans needed Japan to revive its industry and use its social cohesion and human capital to produce equipment that the United States needed for the Korean War. The destruction of Japan's industrial base, the maintenance of social cohesion, and the American need for Japanese production created a dynamic that has been crucial in shaping East Asia since 1945.

Historically, global capitalism has relied on certain regions providing inexpensive manufacturing. This produced low-wage, high-growth countries like the United States at the end of the 19th century. World War II reset the Japanese and German economies so that they could become low-wage, high-growth engines that were particularly efficient because of the social discipline in these countries.

Japan's postwar recovery depended on the country playing this role, which it did for four decades.

Such economies can both build an economic infrastructure and foster rising standards of living.

However, a focus on growth rather than on rates of return on capital inevitably undermines profitability. In the end, growth can be maintained only by repressing wages or, when that is no longer viable, by slashing profit margins in order to compete with other low-wage countries. In due course, the country reaches a climax that results in a financial crisis, built around the fact that profitability has been sacrificed for growth. In Japan, this climax occurred between 1989 and 1991, between the last surge of Japanese exports, a crisis with the United States over Japanese export policy, and a banking crisis.

In the wake of its financial crisis, Japan became a much lower-growth country, less dependent on exports and more on domestic consumption. Moreover, to maintain social stability, Japan focused on maintaining full employment, not only by sacrificing profits but also by increasing debt. But another way to put this is that Japan managed the transition from a low-wage, high-growth country to a more stable economic platform without social unrest. Given their imperative, the Japanese did well.

South Korea also went through this process, reaching its climax in the 1997 East Asian financial crisis. Unlike Japan, it did experience social unrest, and unlike Japan it never managed a dramatic reduction of dependence on exports. It has straddled contradictions, but it has managed to maintain a relatively coherent social-economic policy that is still heavily export-oriented but less dependent on low wages.

China Enters the Next Economic Phase

China is the third wave of this process in East Asia. During World War II, China was both a victim and a battleground. In large part this was because of China's fragmentation before the war. This fragmentation was caused by China's forced integration into the international economic system. The vast majority of China's population lives in the interior, where transport is difficult. Western interaction with the Chinese economy tended to focus on relations with coastal Chinese. This created a fundamental schism. The coastal cities were oriented toward the Western powers. Their economic interests aligned more with the Europeans' and the Americans' than with those of the Chinese central government. Thus, when the communists tried to spark an uprising in Shanghai in the 1920s, Mao Zedong failed and took the "Long March" into the interior, where he raised a peasant army. The split between coast and interior was institutionalized, and splits between coastal interests emerged as well. The result was a highly fragmented society at first exploited by Japanese interests, then caught between Japan and the United States.

After the war, Mao defeated the pro-Western factions, closed off China to most international trade, and sought to create national unity by excluding foreign influences. The result was internal repression. China did not come close to fulfilling its potential. When Mao died, the Chinese had to choose between this situation and reopening to the global economy. It chose the latter and assumed its place as the low-wage, high-growth country of its generation. And like Japan before it, when China's customers stopped buying after 2008, Beijing's attempts at maintaining social stability through employment at the cost of profitability led to inflation. This inflation was not massive, but as competition in the class of products China excelled in intensified, and as new players with much lower wage rates entered the game, even limited levels of wage inflation caused China to lose market share. In fact, even Chinese companies began to seek out labor in lower-wage countries. China experienced both the loss of global competiveness based on low wages and a complex financial problem that was more endemic than a crisis. China is now shifting to a post-low wage, post-high growth economy to a more sustainable one.

It should be remembered that the culmination phase in Japan and South Korea was characterized by massive capital flight, which the West saw as evidence of the Asian countries' economic power rather than as a vote of no confidence in their own economies. Recall the Japanese purchase of American real estate in the late 1980s or Korean purchases of business in the 1990s. These were not particularly successful, nor were they meant to be. They were designed to reduce the Japanese and Koreans' exposure at home. The same can be said with China's current propensity for foreign investment. It is driven, at least in part, by a lack of confidence among those within China who really understand the country's situation. Much of it is state capital flowing out. Some is state capital flowing outward and becoming private capital.

Other funds are private capital. The types and patterns vary, but the flow has continued.

Managing Economic Change

A major difference between China and Japan is social cohesiveness. The economic dysfunction was managed socially in Japan. Given that the majority of the Chinese public participated in this process only marginally, the inability to sustain this model has caused significant fragmentation, as before.

The first priority for the Chinese is retaining the power of the Communist Party and the central government in Beijing. Thus, the Chinese are engaging in political repression and purges in order to maintain the political system while the country transitions to a new economic system.

It is important to note the sequential enthusiasm Westerners have had to Japan's and China's economic development. Both were seen not as they were — simply a phase of the Asian countries' history — but as a permanent process that would cause each country to rapidly surpass the rest of the world. Westerners did not recognize that this process had inherent limits that would assert themselves in due course. Therefore, the lingering perception in the West about East Asia — or, in its current phase, of China — is that it is likely to become a singularly powerful international player.

The Chinese have severe limits on their ability to engage in international adventure. The People's Liberation Army is physically blocked from large-scale military operations by terrain.

The Chinese navy is similarly limited, blocked as it is in the South China Sea and the East China Sea by the East Asian archipelago. It can exert pressure within these confined spaces until and unless the United States intervenes. Even with its anti-ship missiles, which can be destroyed by air campaigns, China cannot yet risk facing the U.S. Navy. It therefore probes below the threshold of triggering action.

The same can be said about North Korea, a fascinating case of a country whose significance is far less than the impression of importance it has created. Its ultimate goal is regime preservation. The position of "not quite ready to use nuclear weapons" aids in this. Passing the threshold to being ready or to actually use them would defeat the North Koreans' primary goal.

Nothing would assure regime destruction more certainly than excessive aggression. Its actions have to be carefully calibrated and have been for well over a decade.

What all of this shows is that East Asia is transitioning from a period in which it — or each of its major components in sequence — played a critical role in the global system. Each has now climaxed, and both Japan and China are now playing a much more normal role in the system.

This is the result of success and not failure, but it is also the result of the fact that while their previous economic models could exist for decades, at a certain point a shift is necessary.

As they shift, they experience different internal patterns. The Japanese have accepted low and no growth in return for social cohesion. The South Koreans went through spasmodic unrest followed by a shift not in export dependence but in the type of product exported and its position on the value chain. The Chinese are focused on maintaining centrifugal forces.

On the whole, it can be argued that this region is inherently stable. This is true of Japan and, depending on North Korea, true of the South. But China has not yet demonstrated that it can make the transition without internal fragmentation or intense repression. History would seem to argue that either is more likely than a return to the past decades. Mao was minimally aggressive after the lessons of the Korean War, where Chinese losses were extensive, so a strategy of regime preservation would tend to turn China inward. If China fragments and the coastal region draws in foreign powers to protect mutual interests, as happened in the 19th century, that would be another story. But this is not the 19th century, and such action from the coastal region is not highly probable.

The U.S. Role

In spite of the U.S. rhetoric about a pivot to Asia, East Asia is not the United States' top priority in Asia. Washington's main concerns remain the Middle East and the borderland between Russia and the European Peninsula. Unless East Asia undergoes a fundamental redefinition, the United States has few interests that involve military intervention. South Korea's concern is preventing the collapse of the North Korean regime, but the price West Germany paid to integrate East Germany is not something the South is eager to bear. And China, for all its posturing, is more than content to not have to face the United States at sea.

The country that appears most content is Japan, but it is the wild card. South Korea's power is limited on a broader scale. China can sustain itself, on some level at least, even cut off from the world. Japan is the world's third-largest economy, yet it is the most vulnerable industrial power in the world. It has few industrial resources, and if it loses access to international sources — if only because of chaos among the sources — its industrial ability would wither with extraordinary speed. That the third-largest economy in the world depends completely on imports of raw materials and is incapable of securing those materials by itself is the underlying tension within the region and the global system.

The United States guarantees Japan access to its raw materials. But Tokyo sees the American concern in Russia and the Middle East as potentially dangerous to Japan's ability to access what it needs. A war that closes the Strait of Hormuz would cut Japan off from its supply of oil.

Washington, from the Japanese point of view, is prepared to take risks that are minor to the United States but potentially disastrous to Japan. Tokyo's fear is that the United States will act not against Japan, but against a country on the road to a country Japan needs, heedless of the consequences to Japan.

The Japanese are quite aware of the problem, as well as that there is no way to limit this risk apart from staying close to the United States. Tokyo is also aware that the more problems the United States has with China, the more thoughtful Washington will be with Japan. But the United States has a queue of problems, and China, rhetoric aside, is not one of them. Whether it gets there will have less to do with what Beijing intends than with Beijing losing power over parts of China. That would draw the United States in and give Japan the leverage it needs.

But that is, as I have argued, a possibility for the future. The internal evolution of China is, in fact, the key to the region. China has moved from limited liberality to increasingly intense authoritarianism.

The evolution of this government is at the heart of the East Asian dynamic. North Korean nukes, Chinese aggressiveness at sea and American threats are all secondary.

June 16, 2015 5:56 pm

Divorce in haste, repent at leisure

Martin Wolf

Neither Greeks nor their partners should imagine a clean break if they leave the euro

Illustration by Ingram Pinn

The outbreak of the first world war was, we are told, greeted with confidence and jubilation by the peoples of Europe. Something similar seems to be happening after years of economic crisis and political turmoil in Greece. A growing number of people feel that enough is now enough.
The strident views expressed in these pages by the Italian economist, Francesco Giavazzi, are shared by many in high office. Meanwhile, Alexis Tsipras, the Greek prime minister, accuses Greece’s creditors of “pillaging” his country.
Olivier Blanchard, the International Monetary Fund’s sober chief economist, indicates that a deal might still be reached. But many are beginning to long to see the knot cut. Whatever game the Greeks thought they were playing, their government may now just desire an end to the humiliation. Similarly, whatever game the eurogroup may have been playing, it may now just want an end to the frustration. If so, Greek default, exit and devaluation could be fairly close.
Would euphoria then last? I fear not. The assumption of some in the eurozone is not only that the Greek case is unique, but that the disaster those sinners so deserve would improve the behaviour of everybody else. But the currency union would also no longer be irrevocable. New crises will occur. When they do, confidence in the union would be less than complete after a Greek exit. The programme of Outright Monetary Transactions, announced by the European Central Bank in 2012, might need to be implemented, to calm nerves. But it could fail. Self-fulfilling speculation could force even more divorces.
Some argue that Greece at least would be far better off after a default and exit. It is indeed theoretically possible that a default to its public creditors, combined with introduction of a new currency, a big devaluation (accompanied by sound monetary and fiscal policies), maintenance of an open economy, structural reforms and institutional improvements would mark a turn for the better. Far more likely is a period of chaos and, at worst, emergence of a failed state. A Greece that could manage exit well would have also avoided today’s plight.

Neither side should underestimate the risks. It is also crucial to avoid the contempt so characteristic of the frayed nerves caused by failing negotiations.

Fecklessness may be a grievous fault, but grievously have the Greeks answered it. As the Irish economist, Karl Whelan, points out in a blistering response to Mr Giavazzi, the Greek economy has suffered a staggering collapse. From peak to trough, aggregate real gross domestic product fell by 27 per cent, while real spending in the economy fell by a third. The cyclically-adjusted fiscal balance improved by 20 per cent of GDP between 2009 and 2014 and the current account balance improved by 16 per cent of GDP between 2008 and 2014. The unemployment rate reached 28 per cent in 2013, while government employment fell by 30 per cent between 2009 and 2014. Such a brutal adjustment would have shredded the politics of any country. (See charts.)
Martin Wolf 1
Europeans are now dealing with Syriza because of this calamity. But they are also dealing with Syriza because of the refusal to write down more of the debt in 2010. This was a huge error, made far worse by the subsequent collapse of the Greek economy. Indeed, the vast bulk of the official loans to Greece were not made for its benefit at all, but for that of its feckless private creditors. Creditors, too, have a duty to take care. If they are careless, they risk big losses. If governments want to save them, their own taxpayers should be told to pay up.
Greece has also already made significant reforms, including to its pension arrangements and business environment. But backtracking on such reforms would indeed be a huge mistake, as the eurogroup and IMF argue.

Martin Wolf 2

Given all this, it is tragic that the breakdown might occur now, after so much pain has already been suffered. It is not too late to reach agreements aimed at promoting reform, minimising additional austerity and making debt manageable. That would also be in everybody’s long-term interest. The parameters of such a deal are also clear: a small primary surplus in the short run, a decision by the eurozone to pay off the IMF and the ECB, accompanied by long-term debt relief, and a strong commitment to bold structural reforms by the Greek government.

Whether it likes it or not (understandably, it does not) the European Central Bank is a central player. It will have to decide when it can no longer treat the credit of the Greek government as collateral against emergency liquidity assistance to Greek banks. If Greece cannot reach a deal on the release of funds, the ECB seems likely to cut the banks off. That would then trigger controls on withdrawals. This might be accompanied by a scheme for circulation of deposit receipts, or ultimately by messy introduction of a new currency.
Martin Wolf 3

Right now, however, the aim must still be to cool down and secure a deal. Yet, in the current mood of anger and recrimination, reaching one now seems ever more unlikely. That would not be the end of the story, however. Europeans will be unable to walk away. Whether Greece stays inside the euro or leaves, much the same challenges will arise. The Europeans would still have to admit that they would not get much of their money back; and they would still have to help avoid a Greek collapse.

It might be a relief to divorce a difficult partner. But the partner will still exist, even after this monetary marriage is over. Greece will remain strategically located and even inside the EU.

Neither the Greeks nor their partners should imagine a clean break. The relationship will continue. It will just be poisonous. If, tragically, that fate cannot be avoided, it will have to be managed for a very long time.


Europe Asks if Greece Could Default Without Exiting Euro

With no deal in sight, some look for ways to avoid potential chaos of a ‘Grexit’

By Gabriele Steinhauser

Updated June 15, 2015 8:00 p.m. ET

   To enlarge graph click here

BRUSSELS—As the bailout standoff between Athens and its creditors escalates, some European officials are suggesting something that was once unthinkable: Let Greece keep the euro currency even if it defaults on its rescue loans.

This idea breaks with the conventional wisdom of more than five years of debt crisis, where the shock of a default has been seen as sending Greece down an inexorable path of bank runs, capital controls and, finally, exit from the eurozone.

Yet, with the risk of nonpayment higher than ever, finding a way to avoid the chaos of a Greek currency switch is looking more attractive. Proponents say it could spare Europe the embarrassment of one of its members crashing out of the eurozone, damp some of the market panic that would likely follow a default, and avoid setting a precedent that would undermine confidence in those still inside.

The idea of keeping Greece in the euro despite a default was briefly discussed by senior officials from eurozone finance ministries last week, although many of them harbor serious doubts about if it would work, according to people familiar with the talks.

“It is not so much a plan, but an evolution in the thinking,” says one person familiar with the discussions among Greece’s creditors.

Proponents of a default-without-exit scenario largely fall into two camps: those who believe the shock of a temporary default would compel Prime Minister Alexis Tsipras to finally seal a financing deal with the creditors; and those who believe that an immediate ejection from the euro would trigger chaos in Greece and beyond.

“Greece lacks the capacity for launching a new currency and [organizing a] ‘Grexit,’ ” an official familiar with last week’s discussion said, using a popular term for describing Greece’s departure from the eurozone.

Any scenario where Greece fails to secure new funds from its international creditors would likely see the government issue a sort of parallel currency to pay wages and government contractors for some time, even as it keeps the euro as its legal tender, experts say.

“It’s the simple answer when you run out of cash,” says Harold James, a professor at Princeton who specializes in Europe’s financial history.

Parallel currencies have been around for centuries. In the late Middle Ages, merchants in Florence and the Netherlands paid local laborers and suppliers in silver coins while settling bigger transactions in gold—without a fixed exchange rate between the two.

In a world where foreign-exchange trades are conducted in split seconds, managing two separate currencies would pose more challenges.

Like in California, which issued IOUs in 2009 when a budget impasse left it unable to pay tax refunds, vendors and local governments, Greece’s parallel currency would likely take the form of debt issued to its own citizens.

They're Coming to Take Away Your Cash

By: Keith Weiner

Tuesday, June 16, 2015

The stories are all over the Internet. Governments are forcing us into a cashless society.

Supposedly the pretext is terrorism, and the real reason is to take more control. No doubt more power appeals to politicians, and banning cash seems like the next step after mandatory reporting of cash transactions. However, I think there is a more serious driver than simple power lust.

A more compelling case is that cash banning is the logical follow up to bail-ins. Most people think a bail-in is when banks steal your deposit. So it seems to make sense that governments want to force people to keep their cash in the bank. Then they are easy meat for the next bail-in.

However, a bail-in isn't theft by your bank. There's theft, alright, but the culprit is upstream.

For example, in the case of Cyprus, the theft occurred in plain sight. The thief was Greece. That country sold instruments which it fraudulently called bonds, but it had neither means, nor the intent to repay.

Those bonds are bogus paper. The Greek government stole the money, in the guise of borrowing it.

The Cypriot banks invested considerable deposits in Greek bonds. When depositors realized this, they began to withdraw their cash -- a run on the banks. The banks were insolvent, so someone had to take losses. A bail-in shifts the losses from bondholders and other creditors to depositors.

It's an example of how a corrupt monetary system causes corruption in banking. If government bonds are defined as the risk-free asset, then banks must hand depositors' funds over to governments to spend. That can't end well.

An honest bank will shut down operations before it burns through so much capital as to harm depositors. However, regulation obliges banks to buy government bonds (typically using short-term deposits). Thus the bail-in was devised to protect banks, though it violates law developed over centuries.

Neither control for its own sake, nor bail-ins, are the primary drivers of going cashless. Central banks don't care about regulating the people, though they do support this new war on cash.

Bail-ins are not a consideration in the US yet, though already American economists and bankers have expressed support for cash banning. So what's really going on?

Citi's Willem Buiter and Harvard economist Kenneth Rogoff are quite explicit. Central banks are grappling with the limit to their planning. As they push down the interest rate, more people withdraw their cash. This squeezes the banks, which make money by borrowing from depositors and lending at higher interest. Banks cannot pay a positive rate in order to earn a negative rate. If the interest rate on the government bond is negative, then the bank must set the interest on deposits at an even lower negative rate.

For some odd reason, depositors don't like paying the bank to deposit their cash. It's weird, I know. Instead, they withdraw their deposits. Withdrawals reduce bank funding, forcing banks to sell bonds. This pushes interest up, contrary to the plans of the central bank. It's worth noting that bank runs and interest rate pressure are the reasons why President Roosevelt outlawed gold in 1933.

This simple preference not to lose money is dangerous to central banks. It threatens the monetary system to its foundations, because it's an escape hatch allowing people to opt out of the central plan.

If central banks don't respond, then they accept a hard limit to their power over people.

They're stymied in their desire to set negative interest.

Thus they're coming to take away your cash. However, they had better be careful. People will react to the central bank response, which forces another policy response, to which people will react, and so on. Central banks risk the destruction of their currencies.

Tipping Point in Transit

By Farhad Manjoo

June 10, 2015 6:32 pm

Credit Bob Scott

One sunny morning a few weeks ago, I slipped into the inviting cockpit of a Mercedes-Benz S550 sedan, a ride equipped with massaging front seats, reclining back seats, a heads-up display worthy of a fighter jet and more speakers than a political convention. At $136,000, this was a car fit for a rap star or a European Union functionary, of which I am neither (yet).
Instead, I write about the future, and embedded in the S550 are a host of technologies that roughly approximate the future of automobile transportation — already available, for a high price, on the road today.
For decades, pundits and theorists have been expecting a future in which cars drive themselves, and companies like Google have been testing advanced versions of these systems for several years.
But the S550 — some of whose self-driving features can be found in other luxury automobiles, including Cadillacs, Volvos and soon the Tesla Model S — shows that in many ways, the future of transportation is already here, and it is evolving at a pace that would surprise even the most optimistic enthusiasts.
And today’s semiautonomous road car isn’t the only sign that transportation is changing quickly. Because of on-demand services like Uber, the very idea of owning a car is being undermined.
Observers say that advances in transportation may be especially apparent in cities, where technology is creating an emerging multitude of options, from app-powered car sharing and car-pooling to new modes of driving and parking to novel forms of short-distance travel and private jitney buses with seats allocated by phone.
Communication systems and sensors installed in streets and cars are creating the possibility of intelligent roads, while newer energy systems like solar power are altering the environmental costs of getting around. Technology is also creating new transportation options for short distances, like energy-efficient electric-powered bikes and scooters, or motorcycles that can’t tip over.
“Cars and transportation will change more in the next 20 years than they’ve changed in the last 75 years,” said M. Bart Herring, the head of product management at Mercedes-Benz USA.
“What we were doing 10 years ago wasn’t that much different from what we were doing 50 years ago. The cars got more comfortable, but for the most part we were putting gas in the cars and going where we wanted to go. What’s going to happen in the next 20 years is the equivalent of the moon landing.”
Mr. Herring is one of many in the industry who say that we are on the verge of a tipping point in transportation. Soon, getting around may be cheaper and more convenient than it is today, and possibly safer and more environmentally friendly, too.
Kuka robots at work on Tesla Model S cars, which will be equipped with a self-driving feature called Autopilot this year.Credit Jeff Chiu/Associated Press

But the transportation system of the near future may also be more legally complex and, given the increasing use of private systems to get around, more socially unequal. And, as in much of the rest of the tech industry, the moves toward tomorrow’s transportation system may be occurring more rapidly than regulators and social norms can adjust to them.
“All the things that we think will happen tomorrow, like fully autonomous cars, may take a very long time,” said Bryant Walker Smith, an assistant professor at the University of South Carolina School of Law who studies emerging transportation systems. “But it’s the things we don’t even expect that will happen really fast.”
A step toward that future is something that Mercedes calls, clunkily, Distronic Plus with Steering Assist, a kind of advanced cruise control that lets a vehicle basically drive itself on freeways. Using radar and cameras, the S550 can center itself within a lane, remain a safe distance from the vehicle ahead and automatically brake and steer to keep pace with traffic.
But that didn’t mean that I could exactly doze off on the road. The self-driving system, for example, can’t handle sharp turns. Both the car and the company warned me not to see the car’s abilities as permission to distract myself, which is a bit like warning the fox to exercise some self-control around that newfangled self-guarding henhouse. The Mercedes issues an alarm when you’ve taken your hands off the wheel for more than 10 seconds.
Still, the car lulled me: With the S550 making most major decisions, I could safely look at incoming Twitter messages while jammed in bumper-to-bumper traffic. The car even promises to respond to emergency situations, like if it senses that you’re veering off the road into the median, or if the vehicle ahead of you suddenly jams on the brakes.
Thankfully, I didn’t get a chance to test those features.
High I.Q. Commuting
The technologies pushing rapid changes in transportation are similar to those altering much of the rest of the world: sensors, smartphones and software.
The sensors help cars, roads and other elements of modern infrastructure become aware, letting vehicles keep track of other vehicles and the roads around them. And smartphones keep track of people. They help companies like Uber take payments and route drivers and riders efficiently.
And they enable companies like Leap Transit, one of several app-powered luxury private bus services operating in San Francisco, to measure demand on its routes. Finally, the software ties the sensors and the smartphones together.
When the entire transportation system has been wired, powerful software operating within cars, on phones and in the computing cloud will analyze all the incoming data to constantly reallocate resources, watch for any emergencies and prompt action as soon as they happen.
“You’re adding intelligence to every step of the system,” said Stefan Heck, a research fellow at Stanford University who explored the benefits of smart transportation last year in “Resource Revolution,” a book he wrote with Matt Rogers, a management consultant at McKinsey.
Like many who’ve studied the issue, the pair argue that autonomous driving, intelligent roads and other advances would make transportation far safer and more efficient than it is now.
Every year, more than 30,000 Americans are killed in cars, and traffic crashes cost society at least $300 billion a year, according to a study by AAA. Most accidents are caused by human error that could, in theory, be mitigated or avoided by artificial intelligence.
Reducing fatalities on American roads by the tens of thousands is within the realm of the plausible, according to experts and automakers. In 2008, Volvo even set a goal for itself: By 2020, the Swedish carmaker hopes that “nobody shall be seriously injured or killed in a new Volvo.” It is a vision that rests in large part, it says, on increasing automation.
A roof-mounted camera on a Google autonomous car.Credit Jason Henry for The New York Times

Efficiency gains are also likely. Today, most cars spend most of their time idle, and even when they’re moving, they frequently carry a single person, a tremendously inefficient allocation of resources. That could change not just through smartphone-enabled car-pooling and reduced vehicle ownership, but also because automation would change driving itself.
Cars that couldn’t crash could be made lighter, and they could pack closer together on freeways and travel in platoons, reducing congestion and, eventually, the amount of space cities devote to roads. Intelligent roads, Mr. Heck and Mr. Rogers argue, could save untold numbers of lives and hundreds of billions of dollars.
That’s the dream. But the path to full automation isn’t likely to be smooth or quick. Although Google recently announced that it would soon begin test-driving self-driving cars, many experts said they believed that fully autonomous cars for the public were at least a decade away.
More than technical limitations, price hampers vehicles with this capability. Prototype self-driving cars of the sort that Google uses are usually equipped with a high-end laser sensor known as Lidar, a comical device that sits on the car’s roof and spins like a windmill, detecting obstacles in all directions. Google has said that the Lidar units on its prototypes cost as much as $85,000 each.
Though costs are expected to come down, the devices are too expensive for today’s production cars.
Many carmakers plan to start testing their autonomous vehicles over the next five years, but none have offered any date for selling them to the wider public.
But if full automation is still years away, what car companies call “semiautonomous” features are already here — and they’re getting better, cheaper and more widely available every year.
The semiautonomous features found in luxury cars use ordinary sensors that are largely invisible to the outside world. Among these are radar, often powered by units mounted in the grille or the top of the windshield. There are also cameras and ultrasonic systems positioned around the car that allow it to detect objects and pedestrians at close range.
Together, these sensors let the car see pretty much everything a human driver can see, and a whole lot that a driver would most likely miss, like a sudden slowdown by the vehicle two cars ahead.
Some cars now or may soon take advantage of so-called telemetry data, like mapping information that describes the bend of a curve or an emerging traffic jam. Manufacturers say it wouldn’t take too much work for such data to be integrated into the semiautonomous systems in today’s cars.
In practice, these could lead to a driving experience that very closely mimics self-driving in certain conditions. Tesla, which plans to introduce a self-driving feature called Autopilot as a software update to its Model S sedan this year, has said that on highways, its cars will be able to steer into turns steeper than mere gentle bends.
“We can basically go between San Francisco and Seattle without the driver doing anything,” Elon Musk, Tesla’s chief executive, told reporters in March.
There are early signs that certain semiautonomous features will improve safety. The Highway Loss Data Institute, which tracks insurance loss statistics on vehicles, has found that Volvo’s forward-collision avoidance system, which slows or stops the car if it senses an imminent crash, has reduced claims of bodily injury by at least 18 percent.
The Volvo XC90 comes with a variety of technology-based safety features. The Swedish carmaker has vowed that by 2020, “nobody shall be seriously injured or killed in a new Volvo.”Credit

Radar and cameras are such old tech, and are produced at such large scale, that they don’t add much cost to vehicles. Many manufacturers sell their semiautonomous systems as an upgrade for about $3,000 or less, and several carmakers said they could envision autonomous features becoming standard features across a wide range of vehicles. If they continue to show safety and efficiency gains, they may one day even be mandated by the government.
“There is not a fundamentally expensive technology involved in any part of this,” Erik Coelingh, who runs Volvo’s safety technology program, said of the semiautonomous features coming to cars.
Unequal and the Unknown
Not all coming advances may be democratically allocated. Though the prices charged by car-hailing apps like Uber have fallen sharply because of huge scale, they are not as cheap as many public transportation options.
And other privatized transportation technologies like the Leap bus service or Shuddle, a car-sharing app for driving children to school, are starting with high prices that may fall as the services grow larger, though it’s far from clear that will happen. Even optimists concede these difficulties of access. “Not all of this will make everyone better off,” said Mr. Heck of Stanford.
The bigger problem may be the way the culture, laws and our brains respond to improvements in transportation. One worry about technology that makes commuting less of a headache is that it will lead people to move farther away from their jobs, which will in turn increase sprawl and drive up demand for cars, eliminating any overall benefit from the advances.
Another is a well-known paradox of safety called the “offset hypothesis.” If we make cars safer, won’t people then just act more dangerously, offsetting any benefit?
I noticed this effect during my days with the Mercedes. With the car steering for me, and promising to take care of emergencies, I felt much safer fiddling with the stereo, the GPS navigator and even my phone while driving 75 miles an hour down the highway.
“Here is a technology that will significantly reduce the kinds of crashes that we know about. But at the same time, it will lead to different behaviors, and it could lead to new crashes,” said Mr. Smith, the University of South Carolina law professor. He added that automakers would have to spend years fine-tuning the design of their autonomous and semiautonomous systems so it became clear to drivers what the capabilities and shortcomings of the technologies were and to push drivers away from risky behavior.
“The solution is saying, we have to accept that humans are imperfect, and design accordingly,” he said.

June 14, 2015 6:39 pm

A setback to American leadership on trade

Lawrence Summers

We do not need more globalisation, but to make sure the globalisation we have works for all citizens

The Senate’s rejection of Pre­sident Woodrow Wilson’s commitment that the US would join the League Of Nations was the greatest setback to American global leadership of the last century. While not remotely as consequential, the House votes last week that, unless revisited, would doom the Trans-Pacific Partnership, send a similarly negative signal regarding US willingness to take responsibility at a critical time for the global system.
Repudiation of the TPP by Congress would neuter the presidency for the next 19 months. It would reinforce concerns that the vicissitudes of domestic politics are rendering the US a less reliable ally. Coming on top of US failure to stop or join the Asian Infrastructure Investment Bank, it would signal a lack of US commitment to Asia at a time when China is flexing its muscles. And it would strengthen companies overseas at the expense of US businesses.

Both the House and Senate have delivered majorities for the trade promotion authority necessary to complete TPP. The problem is with the complementary trade adjustment assistance programme, designed to assist American workers, which most Republicans do not support and Democrats are opposing in order to bring down the TPP. It is to be fervently hoped that a way through will be found to avoid a catastrophe for US economic leadership.

Perhaps success can be achieved if its advocates can acknowledge that rather than being a model for future trade agreements, the TPP debate should lead to careful reflection on the role of trade agreements in America’s international economic strategy.

Four points seem salient. First, the era of agreements that achieve freer trade in the classical sense is over. The world’s remaining tariff and quota barriers are small, and often result from deeply held cultural values, such as Japan’s attachment to rice farming. What we call trade agreements are in fact deals on the protection of investment and on achieving regulatory harmonisation and establishment of standards in areas such as intellectual property. There may be substantial potential gains from such agreements, but their merits must be considered case by case. No reflexive presumption in favour of free trade should be used to justify further agreements.

Second, there must be a balancing of the political cost of legislating trade agreements. If just a fraction of the US political capital expended on the TPP had been devoted to supporting reform of the International Monetary Fund and ad­equate funding for international fin­ancial institutions and the UN, those objectives could have been attained, with greater benefit. Trade deals are of­ten defended on the grounds that commerce builds ties to other nations. A rebalancing by the US towards backing multilateral institutions that provide support for other countries, and away from demands for changes to their domestic policies, would enhance US prestige and influence.

Next, there should be careful consideration of the ramifications of trade deals that include some countries but exclude others. Where the grouping is natural, as with the North American Free Trade Agreement, or it reflects a clear political strategy, the argument is stronger than where the criteria are not clear. In rec­ent weeks, political necessity has led ad­vocates of TPP to offer increasingly ag­gressive formulations about how it enables the US to gain ad­vantage at the expense of China. We may come to reg­ret such provocation. But it will become important down the road to consider possible Chinese membership of TPP on terms no different from those applied to others.

Last, the global economic challenge is profoundly different from a generation ago. Just after the cold war and the Latin American debt crisis, and with Asia’s China-led renaissance in its early stages, the challenge was to enable new mark­ets to emerge. Trade agreements that encouraged adoption of market institutions in developing economies and helped them access the industrial economies were crucial in creating a global economy. Today, we have such an economy, one that has supported the greatest economic progress in emerging markets. It works spectacularly well for capital and a cosmopolitan elite that moves effortlessly around the world.

But it presses down on the middle classes who lack the wherewithal to take advantage of new global markets and who do not want to compete with low-cost foreign labour. Our challenge now is not to create more globalisation, but to make sure the globalisation we have works for all our citizens.

Ultimately, trade diplomacy must be one component of a broader approach whose primary stakeholders are not just global companies but also those concerned with economic equity, the environment, opportunities for workers to migrate and financial stability. If the TPP is to be secured, there must be clear signs that international economic diplomacy will turn to these concerns.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary