china mortgaging america helen thompson conclusion

Conclusions By early 2009, the economic relationship between the United States and east Asia was first and foremost defined by the financial relationship between the United States and China. Putting together the holdings of the Chinese central bank, the state-owned banks, and China’s sovereign wealth fund, Brad Setser and Arpanda Pandey have estimated that in early 2009 China held foreign assets of about $2.3 trillion, the equivalent of more than 50 per cent of China’s GDP. Around 70 per cent of these assets were denominated in dollars.1 During 2008, China provided more than 50 per cent of the capital flows required to finance the American current account deficit, and by that year’s end China was holding about twice as many foreign exchange reserves as Japan.2 Whilst the general economic relationship between the United States and east Asia that developed after the Asian financial crisis initially satisfied a set of mutual interests, by 2009 the US-China financial relationship was one increasingly dominated by the risks produced by the consequences of past interdependence and the fear they induced. Today, China’s economy is far more exposed to its portfolios of dollar holdings than it was even in 2006 when the Chinese leadership had begun to accept some appreciation of the yuan. For its part, the American state is responsible for servicing far more debt than it was when the federal government’s borrowing last peaked. A large proportion of that debt had arisen because the American state was eventually forced to mop up the consequences of the vast flows of capital across the Pacific over much of the previous decade. The American state also now has direct responsibility 127 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 for two huge mortgage corporations around which the whole mortgage sector of the American economy depends, and these corporations have massive liabilities. When the Asian central banks forsook the debt of Fannie Mae and Freddie Mac, first the American government had to step in and guarantee those bonds and securities, and then the Federal Reserve had to take the medium- to longterm inflationary risk of buying up their debt. This did nothing to advance confidence in the east Asian states in the security of their dollar investments. As a result of this loss of east Asian faith, the still large American balance of payments deficit was primarily being financed by early 2009 on a precarious, short-term basis. Interdependence as fear: China’s burden The post-2008 economic relationship between the United States and China leaves each state vulnerable to rather different degrees. The Chinese leadership is self-consciously operating under a host of overt and acute international constraints. China’s fundamental problem is the sheer scale of its exposure to the risk of substantial depreciation of the American currency. This risk had already grown every year that China had added to its dollar’s portfolio, but the large increase in the American government’s borrowing in 2008 significantly exacerbated the risk because it is likely to put more medium- to long-term structural downward pressure on the dollar. On top of its near-certain future currency loss, China, by 2009, had lost billions of dollars on its reserves through its diversification into equities after it established the China Investment Corporation (CIC). The Chinese leadership was also badly burned by a set of misjudgements about how the American government would act towards China’s American investments. It had not expected the American government to take over Washington Mutual in which China’s State Administration of Foreign Exchange had invested.3 Reportedly, it was also dismayed by the Bush administration’s decision to let Lehman Brothers go, especially as the CIC had a $5.4 billion investment in a money-market fund that collapsed as a result of the investment bank’s bankruptcy. By early 2009, the Chinese government had decided that the various Chinese state investment agencies should stay away from dollar assets carrying even the semblance of risk. The investment agencies were now buying neither Fannie Mae and Freddie Mac’s securities nor other corporate bonds 128 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 and equities, nor long-term Treasury securities. In investing this way at a moment when American monetary policy was exceptionally expansive, China was left effectively purchasing only assets that yielded virtually no interest. Whilst the purchase of short-term Treasury bonds mitigated the risk of any immediate dollar crisis, and provides a quick exit option if and when one were to develop, it also ensured that China was left with nothing in the short term to compensate for its inevitable long-term currency losses. China’s chief gain from the economic relationship to the United States prior to the events of 2008 had been the support that it provided via the exchange rate for export-led growth. Yet the onset of the third phase of the financial crisis destroyed, at least in the short term, the trade opportunity that interdependence had hitherto sustained. In the final quarter of 2008, east Asian exports, including China’s, collapsed spectacularly. Between January 2008 and January 2009, South Korea’s exports fell by 33 per cent, and between December 2007 and December 2008, Taiwan’s fell by 42 per cent. Between February 2008 and February 2009, Japanese exports fell by nearly 50 per cent and China’s by 43 per cent. These falls precipitated large drops in east Asian industrial production and GDP. In the fourth quarter of 2008, GDP fell in Thailand by 22 per cent, in South Korea by 21 per cent, and in Japan by 12 per cent. By February 2009, Japan’s industrial production was falling at a year-on-year rate of 38 per cent. Whilst China’s economy continued to grow through the final quarter of 2008, it did so at a rate several points below that which the Chinese government has long considered safe for employment purposes. The fallout of the financial crisis for China’s exports also raised perhaps a more fundamental problem for China because it sharply exposed the general vulnerabilities of export-driven economies under conditions of interdependence. The falls in national growth in late 2008 and early 2009 across the world were considerably higher in east Asia than in the United States or much of Europe, and even within western Europe, the strongest-exporting economy, Germany, suffered a particularly deep decline. When the east Asian economies did begin to recover in the second quarter of 2009, they did so in response to large domestic fiscal stimuli rather than exports.4 This susceptibility of exports to a worldwide fall in demand reinforced the increasingly intractable dilemma China faced in choosing between the markedly conflicting international imperatives on the financial and trade issues Conclusions 129 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 that the economic relationship with the United States had created. Moreover, by 2009, the cost of evading any decisive choice between moving the burden of growth to domestic demand, and accepting future currency losses in doing so, and satisfying the immediate interests of export competitiveness was higher than ever before. The shock the financial crisis had wrought on export-dependent sectors of the economy left the Chinese government with every short-term reason to try to stop any yuan appreciation at all against the dollar to contain the damage to trade, but to do that the Chinese central bank was likely to have to purchase yet more assets that carried a significant mediumto long-term currency risk. In practice, the Chinese government tried to face both ways. By the end of 2008, it had restored an effective peg against the dollar to stop the yuan appreciating any further. It was also directing state-banks to lend more to exporters, providing tax rebates to the export sector, and preparing to provide credit support for exports. In December 2008, Li Yizhong, the minister of industry and information technology, publicly said that China would ‘resort to tariff and trade policies to facilitate export of labour-intensive and core technology-supported industries’.5 Meanwhile, the Chinese government was also looking for ways to shift the medium-term emphasis of its development strategy from export-led growth to domestic consumption.6 By the end of 2008, it had significantly increased expenditure on education, health, social security, and employment.7 When the Chinese economy, along with the others in east Asia, started to recover from the financial crisis in the second quarter of 2009, the increase in growth came entirely from domestic demand and exports continued to fall.8 Each approach had its limitations. The short-term, nationalist reaction to the problem was bound to antagonise Washington and, indeed, in December 2008, the American government filed a case at the World Trade Organisation, alleging that China was providing illegal subsidies to exporters. Nonetheless, to make a decisive strategic shift away from export-led growth would require accepting an appreciation of the yen and facing up to future currency losses sooner rather than later.9 Meanwhile, the Chinese leadership’s political difficulties with the economic relationship had become more overt. The fallout of the financial crisis produced a domestic political problem for the Chinese leadership. China’s losses on its American investments drew a string of criticism from influential economic commentators. One editorial in a government-owned newspaper pronounced that the ‘[United States] 130 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 should not expect [a] continuous inflow of more cheap foreign capital to fund its one-after-another massive bailouts’.10 In late 2008, a fast circulating internet essay attacked the Chinese central bank for ‘collud[ing] with Henry Paulson to buy US bonds, forc[ing] [yuan] appreciation, attach[ing] China’s economy to the U.S. and break[ing] China’s economic independence’.11 The ferocity of the domestic censure meant that the Chinese leadership could not simply deal in a practical and pragmatic way with the American government on the complex economic issues that existed between them. It rhetorically had to appease domestic critics in its public utterances on any aspect of the economic relationship with the United States whilst, at the same time, it had to try to ensure that in doing so it did not provoke the Americans into any new protectionist action. In February 2009, a senior official at China’s Banking Regulatory Commission was reported as saying: We hate you guys. Once you start issuing $1 trillion–$2 trillion … we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do. … Compared with gold or bonds issued by other countries and regions, US Treasury bonds are still an option [for China]. But if the US government issues a large amount of Treasury bonds amid efforts to deal with the economic crisis, all investors who hold US Treasuries will suffer losses.12 One month later, the Chinese Premier Wen Jiabo, in less dramatic language, urged the United States to take action to guarantee its ‘good credit’, saying he was worried about the ‘safety’ of China’s holdings of American government debt: We have lent huge amounts of money to the United States. Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.13 During the same month the Chinese central bank governor, Zhou Xiaochuan, published an essay arguing that the existing international monetary and financial order was fundamentally flawed: The outbreak of the current crisis and its spill-over in the world have confronted us with a long-existing but still unanswered Conclusions 131 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 question, ie what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth.14 He called for a new reserve currency to replace the dollar: The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies. … A super-sovereign reserve currency managed by a global institution could be used to both create and control the global liquidity. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will significantly reduce the risks of a future crisis and enhance crisis management capability.15 The Chinese central bank will certainly have known that American Presidents would not voluntarily accede to the eclipse of the dollar as the primary reserve currency in the world in this way. Even more importantly, during the first months of 2009, China appeared actually to increase its holdings of short-term Treasury bonds despite this confrontational rhetoric.16 Nonetheless, Zhou seemed to have wanted to make the American government understand the depth of the Chinese leadership’s unease at the position China had found itself and the domestic problem for China that each side’s actions have created. Given the fact that thus far China has not been prepared even to disclose information about the nature of its reserves to the International Monetary Fund (IMF), Zhou’s suggestion that China might be prepared to internationalise its dollar reserve problem indicated just how much of a burden the leadership believed the financial relationship with the United States now imposed: Compared with separate management of reserves by individual countries, the centralized management of part of the global reserve by a trustworthy international institution with a reasonable return to encourage participation will be more effective in deterring speculation and stabilizing financial markets. … With 132 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 its universal membership, its unique mandate of maintaining monetary and financial stability, and as an international ‘supervisor’ on the macroeconomic policies of its member countries, the IMF, equipped with its expertise, is endowed with a natural advantage to act as the manager of its member countries’ reserves. For its part, the United States faces fewer immediate constraints than China but, nonetheless, has less policy autonomy than it did earlier in the decade. Although, over the past few years, two Presidents and Congress have massively increased American government borrowing, it is not clear that the Obama administration at least perceives this debt as a constraint or something to fear. The President’s first draft budget in 2009, and the proposals that contained for future expenditure projects particularly on healthcare, would suggest that the Obama administration is not overly worried about a sharp increase in federal borrowing, despite lofty rhetoric to the contrary. A preliminary report from the Congressional Budget Office calculated that the deficit for 2009 would be 11.9 per cent based on existing fiscal commitments and 13.1 per cent if Obama’s draft budget were to be enacted whilst the cumulative deficit for the years 2010 to 2019 on the basis would be $9.3 trillion, more than twice the baseline projecting from 2008. Meanwhile, the Congressional Budget Office warned, the national debt would rise from 41 per cent of GDP in 2008 to 82 per cent in 2019 and the net interest payments would add $1 trillion to the deficit.17 Certainly, the United States’ dependence on China as a creditor for much of the past decade has alarmed some in the American Congress and prompted some domestic political discussion. In 2004, Robert Byrd, the Senate’s longest serving member declared: It’s great political rhetoric to claim that America doesn’t have to ask the permission of other nations to defend itself or do anything else for that matter, but when we rely so heavily on other nations to pay our way in the world, our haughty claims of independence are just so much bluff. Unfortunately the rest of the world knows what we will not admit. We are beholden to foreigners to pay our way.18 Meanwhile, on the night of the Wisconsin Democratic party primary in 2008, Hillary Clinton attacked the Bush administration for allowing Conclusions 133 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 the United States to become financially dependent on China and pronounced that dependency was now a constraint on American foreign policy: And while you pinch pennies to stay within your budget, the President blew the bank on tax breaks for his friends and no-bid contracts for his cronies, borrowing hundreds of billions of dollars from China to pay for it all. He has signed a sub-prime mortgage on America’s economic future and that’s your future. And so when people ask me ‘why can’t we get tough on China?’ well, when was the last time you got tough on your banker? And so we have to get back to fiscal responsibility in order to get tough on China because we shouldn’t be borrowing so much money from them.19 Looked at from a historical perspective, there are some reasons to suppose that rising government debt is likely to reduce the autonomy of the American state over time, not just economically but conceivably militarily too. Several previous great powers have been undone by the political fallout of borrowing, whether from domestic or foreign creditors, such that an internal debt crisis had led to external defeat or decline. The United Provinces, 17th century Spain, and ancien régime France are in many ways the classic cases of this historical pattern. At a general level, there are three possible difficult scenarios for indebted states: external creditors can use access to future credit as leverage for a political or military purpose against them; debtor states can find themselves in a fiscal position where they cannot repay; and creditors can lose confidence that the debtor state will repay in the future and, consequently, refuse to lend any more money. Internationally powerful states, like the United States, have historically proved more liable to run into the second and third of these problems than the first. However, they have done so not because of the absolute volume of their borrowing in any instance, but either because they have exhausted alternative creditors, or because they have been unable for domestic political reasons to service their debt at a moderate cost in interest. There is also no reason to suppose that rising government debt necessarily imposes constraints on internationally powerful states. The British state during the 18th and early 19th century borrowed 134 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 significantly more than the French state. It not only avoided a debtinduced political crisis like the one that afflicted France in the summer of 1789, but it used its borrowing to finance its rise to become the dominant European power in the first half of the 19th century. It was able to do this because it maintained its creditors’ confidence in its political capacity to raise future taxes to pay for the loans. Consequently, it could service its debt at half the rate of interest levied on France. By contrast, the United Provinces, Spain and ancien régime France all endured transformative debt crises because for domestic political reasons their debt became unserviceable. The government in the United Provinces provoked riots when, as its debt burden rose during war time, it tried to raise more taxes from its constituent provinces that enjoyed substantial fiscal autonomy. The Spanish crown’s attempts to tax more to sustain borrowing during the Thirty Years’ War produced similar revolts in Portugal and Catalonia. When the French crown needed new taxes to restore creditors’ confidence in 1789, it was forced to summon the Estates-General, prompting the political crisis that destroyed the ancien regime. Historically, whether large-scale borrowing is problematic for internationally powerful states has been dependent on domestic political circumstances and how governments manage the problems that the political conditions of procuring credit bring.20 Today, states face the same basic fiscal problems as older states did: to pay for their expenditure they must either raise immediate revenue in taxes, or borrow and levy taxes later. However, they also face new problems that arise out of the interaction of their own borrowing and those of other economic agents, and these are generated by the relationships between current accounts, exchange rates, and private short-term international capital flows. By the standards of the 17th and 18th century great powers, the American federal government’s debt is very low. Nonetheless, the future absolute burden of that debt is uncertain. The American Treasury is not in a position to know what the liabilities of the financial sector it is guaranteeing are, and it has never been capable of accurately calculating what they are likely to be in the future. Indeed, in the summer of 2007, the banks themselves had no idea just how badly damaged their balance sheets were and now governments everywhere have learned that those losses are on a scale that they would probably have thought inconceivable during the early months of the crisis. Conclusions 135 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 Paradoxically, in this instance this problem matters in the short term less for the debtor state than the creditor. The uncertainty about the scale of future American liabilities and the probable impact on the foreign exchange markets of the necessity of more federal borrowing can only damage further the confidence of the Chinese leadership about the wisdom of sustaining the present terms of the economic relationship with the United States. It leaves the Chinese leadership unable to judge how much lending China might have to do in the future to support the American fiscal position. Moreover, it adds to the future losses that China will have to incur when it does change its exchange rate policy because it increases the likelihood of future dollar depreciation. Neither beyond radically reversing fiscal policy is there much the United States can do to reassure China. In the 1970s, the United States was fiscally constrained by the weakness of the dollar. Then, the Carter administration decided to sell debt known as ‘Carter bonds’ denominated in German marks and Swiss francs to fund its borrowing at a moment when its foreign creditors had lost confidence in American policy towards the dollar. Yet in the circumstances of the present international economy, it is difficult to see how the Chinese government would want the Americans to try anything akin to ‘Carter bonds’ because such a move would almost certainly lead to exactly the kind of dollar crisis that such an act would be conceived to avoid. Nonetheless, that the United States is borrowing from a state that is not lending in its own currency is in the final instance a problem for the United States’ autonomy as well as China’s. The Chinese leadership does not have anything but an exceptionally painful way out if it were to lose confidence entirely in American creditworthiness. Nonetheless, the more uncertainty it has to navigate, the greater the risk for the United States that it will quite suddenly decide to change course and take the short-term hit on currency losses that it ultimately cannot avoid. Perhaps also the United States risks China beginning to look for more foreign policy leverage from its lending to compensate for its losses. Consequently, although the United States is significantly less constrained than most previous internationally powerful debtor states have been, no American government can afford to be that cavalier about what it expects China to absorb for the sake of an economic status quo that is hugely problematic as seen from Beijing. It is perhaps then not surprising that reports of the Strategic Economic Dialogue meeting in July 2009 between American and Chinese officials suggest 136 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 that the Obama administration eschewed raising the subject of China’s exchange rate policy, despite the fact that over the previous six months the yuan’s real-trade weighted value had fallen by 8 per cent.21 After a summit held between President Obama and the Chinese President, Hu Jintao, in Beijing in November 2009, Obama publicly expressed hope that China would move ‘a more market-oriented exchange rate over time’, but appeared to procure no practical concession from the Chinese leadership.22 Historical experience would suggest that the United States’ future external creditworthiness turns on whether there is the domestic political basis to sustain the American government’s present borrowing and, just as importantly, the judgement that the Chinese leadership makes about whether or not this is the case. This question goes beyond whether any President and Congress would be politically willing to increase taxes significantly in the medium term. It also matters whether the fact that American taxes will need to be raised to make interest payments specifically to China will in time become a politically contested issue. The Bush administration did succeed in acting to protect China and Japan’s interests as major creditors to Fannie Mae and Freddie Mac without provoking a political crisis, despite wiping out domestic shareholders of the two corporations. More generally, American citizens appear to have directed their political anger about the financial crisis at Wall Street rather than other states. However, the United States’ economic relationship with China has the potential to be politically very awkward for any President if contingently a dramatic issue rises to the surface at any time. In 2005, a vote in the House of Representatives forced a Chinese firm to withdraw its bid for a small American oil firm, and the remarks by Wen Jiabo in March 2009 might suggest that the Chinese leadership has some anxiety that there could be a repeat of such a scenario on a financial issue. Yet we can also turn the question that history generates around. The future of the US-China economic relationship is not just a question of whether the United States has the domestic politics to sustain its position as a debtor state, but whether China has the domestic politics to sustain its position as a large-scale creditor state lending in another state’s currency. Whether the Chinese leadership can make a decisive strategic shift away from the economic relationship with the United States in its present form may turn on how quickly it can create a more consumer-oriented economic culture so that domestic demand could be Conclusions 137 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 radically expanded. The domestic politics of both sides of the economic relationship between the United States and China now compound all the difficulties that were created by interdependence and the way it developed. The state, politics and the financial crisis By early 2009, the future of the economic relationship between the United States and east Asia, and China in particular, had come to turn on a set of fundamentally political questions that the problems of interdependence and the way it has been managed by governments have created. There is no economic resolution to China’s dilemma about what to do about its dollar holdings. There is only a political judgement to be made in Beijing about how to deal with the risks that China is running, and not an objective economic fix to be hit upon. The Chinese leadership must decide when the Chinese economy can absorb the short- and medium-term cost of reducing the state’s dollar portfolios to contain the long-term losses that its past decision-making have ensured are one day inevitable. Within the Chinese leadership, what to do, and when to do it, will be contested because the political fallout from the economic tumult that a radical shift in exchange rate policy will bring about is likely to be severe because of its consequences for employment. Meanwhile, in the United States there will eventually have to be a political debate about what to do about Fannie Mae and Freddie Mac and whether it is either desirable or sustainable for the American state to have responsibility for these two corporations. Whilst the resolution of that question matters a great deal economically for the future of the financial relationship between the United States and east Asia, that debate is as likely to be as much about the politics of home ownership as the fiscal cost to the American state of maintaining the conservatorship and guarantees to the corporations’ east Asian creditors. Yet there will also be nothing new in politics proving crucial to how the economic relationship between the United States and east Asia plays out, or its accompanying impact on the entire international economy. The political nature of the general financial crisis and its fallout has frequently been lost in much commentary and analysis. Much of the early political narrative around the financial crisis centred on the behaviour of financial markets and the greed of 138 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 the financial sector. Many assumed that the fundamental causes of the crisis lay in the primacy of markets over the state and politics, and that the state has now had to take responsibility for significant parts of financial sectors precisely because it was previously largely absent from any part of their operation. Although many financial corporations did behave in grossly reckless ways, the origins of the financial crisis in the Pacific economic relationship, and what that made possible, are also far more complex than this particular narrative suggested. Put simply, they were in significant part political and they involved the state in different ways. As Herman Schwartz and Leonard Seabrooke’s recently edited volume on the subject shows, the politics of housing and housing finance are crucial to understanding the present nature of the international economy.23 The sub-prime mortgage boom that lay at the centre of the crisis was as much the product of the drive by successive American Presidents and the Congress to expand home ownership as it was new financial derivatives devised on Wall Street. American politicians wanted more home ownership and by definition that meant that they wanted banks and other financial corporations to lend to people who previously had not been given mortgages. Since the question of whether these new customers were creditworthy was not easily separated from the fact that a disproportionately low number of African-Americans and Hispanics were home owners in the United States, and since increasing lending to these groups was a policy goal of two administrations, subprime lending was politically protected. Meanwhile, the sub-prime boom and the accompanying financial bubble in mortgage-backed securities was made possible because the east Asian governments, and China’s in particular, politically decided to arm themselves against currency speculators and also to stop short-term financial flows that if unchecked would have driven their exchange rates upwards against the dollar. The first decision came out of the east Asian government’s understanding of the political consequences of the Asian financial crisis as well as the economic. Capital flight had devastated much of the region economically, but so politically had exposure to the power of the United States through the conditionality on which the IMF had insisted. Moreover, in deciding to continue to accumulate reserves to protect a competitive exchange rate, the Chinese leadership was pursuing a development strategy that it saw as crucial to maintaining political order. Conclusions 139 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 In understanding the role of politics, the place of the state is crucial. On both sides of the economic relationship between the United States and east Asia, politics mattered in part because of the power of the state and what that power made possible. This is clearest on the east Asian side because there governments so overtly set out to use the power of state, via the accumulation of reserves and in China’s case the deployment of capital controls, to create outcomes contrary to the ones that the financial and foreign exchange markets would have produced. In doing so these states established the pool of capital that made cheap borrowing possible for the American government, Fannie Mae and Freddie Mac, and, indirectly, corporations across the housing sector. Nonetheless, the power of the state was important on the American side too. Certainly the American state’s reach in economic matters is fragmented and in some respects weak and, as Lawrence Jacobs and Desmond King have recently said, in the context of the financial crisis, ‘institutionally incoherent’.24 The Securities and Exchange Commission acquiesced easily to the pressure of the investment banks in 2004 to reduce the restrictions on their borrowing and the consequences of that decision went well beyond those corporations for whom the Commission was responsible. From the moment the first phase of the financial crisis began in the summer of 2007 through to fallout of the Lehman bankruptcy, the American Treasury had to rely on trying to co-ordinate other agencies and cajoling financial corporations into certain lines of action to do much. When, then, the whole financial sector was in danger of meltdown in the autumn of 2008, the American executive had to negotiate and compromise with Congress to get effective emergency powers for the Treasury to act in any way likely to avert disaster. However, as Kevin Gotham has argued, the American state had been a crucial player via federal legislation and the activities of regulatory agencies in the moves that integrated local housing markets into international financial flows in the first place.25 More particularly, Fannie Mae and Freddie Mac’s borrowing only happened because of the implicit political commitment that the American state could, and would, guarantee the debt that the two corporations issued and the confidence that gave investors, especially foreign central banks, to lend. That commitment existed because the American state had long been deeply involved in the American mortgage market. Over seven decades it had created incentives for financial 140 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 corporations to involve themselves in primary mortgage lending or the secondary mortgage market, and it had provided an effective guarantee to a considerable amount of financial activity around home ownership. The legacy of the state’s historical intervention mattered for the way the Clinton and Bush jnr administrations and Congress dealt with the issues around Fannie Mae and Freddie Mac. It was the reason why much of the political debate about the corporations took the substantive shape it did, and it was a significant part of the explanation as to why those who privileged home ownership over financial risk politically won the regulatory battle that took place in the middle of the decade even when, given the absence of accurate financial reporting from the two corporations, those risks were enormous. However, the existence of state-capability itself is not a sufficient explanation of the crisis around Fannie Mae and Freddie Mac. Politics also mattered because of what those with state power chose politically to do, or not do, with that power. The politics of the two corporations’ part in the mortgage boom was not pre-determined just because of the length, depth and historical difficulties of the American state’s involvement in home ownership. The American state did carry the weight of the discriminatory politics of the past, but that mattered because many members of Congress, and Democrats in particular, chose to privilege remedying the consequences of that over dispassionate analysis of the financial facts in their decision-making. The regulatory rules over Fannie Mae and Freddie Mac that were in place between the beginning of the housing boom and the summer of 2008, and which left the two corporations free to drive the final part of the sub-prime expansion, were the product of a political contest between competing sets of politicians, the two corporations themselves, and interest groups, in which the different actors wished to use the power of the state for very different reasons. One political position won and the other lost. But if the Bush administration had been able to create and maintain an across-the-board Republican party position on the issue in 2003 through 2004 and procured some modest Democrat support in the Senate, the corporations would have been placed under a tougher regulatory regime that would have restricted their borrowing and investment portfolios. Under this scenario, they would have not been able to operate as they did from the latter part of 2004 and the subprime boom would almost certainly have ended earlier and with less Conclusions 141 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 disastrous fallout for the world economy. In understanding why that counter-factual did not happen, we need to turn to the specific conditions of American domestic politics. That the Bush administration and the Republican reformers in Congress failed in their aims and were unable to check Fannie Mae and Freddie Mac was in significant part the consequence of the political fact that because of the structure of campaign finance and lobbying in the United States, the two corporations were able to direct political services to individual members of Congress. Just as significantly, other issues of financial regulation were also politically contested in the years leading up to the boom. On the regulation of derivatives, there was a battle within Congress, and then between the Treasury and the Federal Reserve Board on one side and the Commodity Futures Trading Commission on the other. Whilst there was rather less political support for regulating derivatives than there was for creating new rules for Fannie Mae and Freddie Mac, the absence of regulation was nonetheless a judgement made by those who dominated the institutional decision-making process at the expense of those who would have decided differently. In explaining these political outcomes, we also have to go beyond considering which material interests were practically served by the various political decisions that were made by American policy-makers and look at the way the issues at stake were politically constructed by different participants in the debates. Many American politicians were unwilling to confront the questions of financial risk around Fannie Mae and Freddie Mac because there was a high political price to accepting a narrative that might appear to question the sanctity of increasing the rate of home ownership among African-Americans and Hispanics. For many Democrats in Congress, the discourse of financial risk conceded too much general ground to their Republican opponents about the difficulties of changing the balance of opportunities for different social groups in such a conspicuously divided and unequal society. The consequence of the way in which home ownership had become framed as a policy issue in the United States was that the opponents of reform acted as if they were in denial about what was happening at Fannie Mae and Freddie Mac: since the problem was too politically awkward, therefore the problem could not exist. Interestingly, this mirrored the unwillingness of those acting in the financial markets to face up to the inherent risk of securitised sub-prime lending, in their case because there was short-term money to be made in 142 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 not doing so. In this sense, the dominant political perspective in the United States on the financial risk inherent to the sub-prime boom, and its accompanying financial derivatives, was rather similar to the one that prevailed in the financial markets. The actions of states also impact on economic interdependence through their international consequences. The way states politically deal with the opportunities and constraints of interdependence engenders further opportunities and constraints for other states. The growth strategy that the east Asian governments decided upon created the economic opportunity for the American sub-prime boom and the scale of Fannie Mae and Freddie Mac’s expansion and borrowing. The borrowing of the American government and its willingness to allow a burgeoning current account deficit provided an outlet for east Asia’s savings and made it possible for the east Asian governments to manage their exchange rates to support export-led growth. The constraints created by other states for the east Asian states were overt. The first rationale for the strategy of accumulating dollar reserves was a political response to those that had played out through the Asian financial crisis. The east Asian governments had to make choices about economic matters in the context of an international economy that they had not politically shaped and in which the United States could, through the IMF, make demands about the organisation of their economies and decision-making. Over time, for the Chinese leadership in particular, the external politics of the economic relationship with the United States created an ever-deeper constraint on its prudent policy options. From the start, it was left with no purchase on whether the American government acted, or not, to maintain the value of China’s dollar lending and investments, when that question was of immense significance for China’s future. Thereafter, unless and until it was willing to reverse its economic strategy, the Chinese leadership had no choice but to keep leaving itself ever further at the mercy of decisions made in Washington. As a result, any eventual reversal of policy will be that much more domestically costly for China. For the United States, the constraints generated by the Chinese state were certainly less immediately problematic. Nonetheless, American politicians and the Federal Reserve Board did have reason to fear that decisions made in Beijing could precipitate a large-scale crisis of foreign confidence in the dollar. Consequently, even on the American side there was at times some degree of external state constraint on Conclusions 143 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 what those responsible for economic policy could judiciously decide to do. The dollar weakness that was the central tension of the Pacific economic relationship after 2002 helped create the context in which the Federal Reserve tightened monetary policy from 2004 and the mortgage boom began to unravel. Most conspicuously, the American government was constrained by what the Chinese and Japanese governments could accept in how it could deal with the Fannie Mae and Freddie Mac crisis. Today, unsurprisingly, the constraints generated by other states on how governments can deal with the fallout of the financial crisis remain tighter on the east Asian side than the American. China is not only at risk to a policy move in Washington that precipitates a large fall in the dollar to an unprecedented degree, but the leadership would now have to deal with such a crisis during, or after, a period of significantly reduced growth. By contrast, the United States enjoyed huge monetary and fiscal discretion in the autumn of 2008 and continued to do so over the following months. The problems the Chinese government faces because of interdependence have thus far not proved a constraint on the Federal Reserve Board printing money or the American government hugely increasing its borrowing. Yet even on the American side of the relationship, the Chinese government’s domestic political response to the contingencies produced by American domestic politics could well become increasingly problematic looking to the future. In taking on the liabilities of Fannie Mae and Freddie Mac, the American state has become far more constrained by its internal politics around home ownership in how it can react to any eventual external imperative for retrenchment than it has hitherto. This is in part a practical question in that withdrawing the state’s support for this part of the mortgage sector would at any time be very likely to have deleterious market consequences. But it is also a matter of political expectations. When a state once takes responsibility in an area, it creates a presumption among its citizens that the politicians in office will use the power of the state to respond to moments of difficulty in that sphere, and any government usually cannot ignore those expectations without fighting a political battle to repudiate them. Meanwhile, the Chinese leadership has already become constrained by the domestic anger felt about the financial relationship with the United States, and would face a huge problem if the interests and passions at stake in American domestic politics produced a situation that created even the suggestion that the American government 144 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 could renege on its commitment to honour Fannie Mae and Freddie Mac’s debt. Even without such a scenario, the domestic anger in China is likely to rise further if and when the Chinese leadership accepts that it should begin to take the significant losses ahead and tries to retreat from its present commitment to the dollar. How the Chinese leadership manages this political problem will then become part of the external constraint that American policy-makers themselves will face in the future. American domestic politics and Chinese domestic politics will have serious consequences for the other state as will the way each government reacts to that problem. Recognising the place of politics in the way the dynamics of interdependence have played out in the economic relationship between the United States and China has important implications for the way in which international political economy is conceived as an academic subject. Despite the original aspiration of the subject to analyse the interaction of the economic and the political, the language of ‘globalisation’, which became commonplace in much analysis within the field over the past two decades, in itself effectively negated politics because its central premise was that globalising economic forces were reconstituting the world and subjugating political choices to international economic realities. Whilst many scholars have recognised that states were not as impotent economically as this discourse suggested,26 the actual contingencies of the particular domestic politics of individual states tended to be neglected in much of the literature beyond the recognition that more right-wing-oriented and more leftwing-oriented governments might wish to choose different macroeconomic policies.27 Yet, as the development of American policy towards Fannie Mae and Freddie Mac shows, the political actions of policy-makers consistently shape and reshape the consequences of economic interdependence and they do so from matters that go far beyond macro-economic policy. Since they do, we need tools of analysis that the study of the international economy conceived as a discrete academic subject cannot generate. As Nicola Philipps has argued, since specific states with their distinct features are ‘fundamentally constitutive’ of the international economy, international political economy cannot separate itself as a field of enquiry from comparative politics and comparative political economy.28 Whatever issues generated by the international economy we are analysing, we need to pay attention to political specifics and Conclusions 145 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 contingencies. In doing this, we need to avoid the trap of assuming that the economic is foundational and that the political is merely a response to the economic. Put simply, the political is part of the nature of economic interdependence itself.29 We also need to recognise that since relations between states as separate political actors also shape the political nature of economic interdependence, international political economy should not be analytically separated from international relations. The political relations that have developed between the United States and China cannot possibly be the same as those between the United States and Japan, however much the Japanese and Chinese states operate under similar economic constraints in relation to the dollar and American monetary policy, or pursue much the same policy over foreign exchange reserves. Neither can these different political relations between different states not have an impact upon the way that the dilemmas generated by economic interdependence are conceived by those who have to make policy decisions in the face of them. Since these specific political relations between states are themselves part of the opportunities and constraints of economic interdependence, they need to be analysed as such.30 The political limits of economic interdependence The development of the financial crisis and its aftermath have made certain things clear about the consequences of economic interdependence that were less apparent in the experiences of states over the previous two decades. The 1990s and early years of the 21st century had appeared to suggest, first, that open international capital flows created potentially severe problems primarily for developing-country and emerging-market states, and, second, that economies where governments had adapted their economic policies to the opportunities that trade openness created were most likely to prosper. In the wake of the financial crisis, both of these judgements have proved at least partially misleading. The risk that access to cheap capital would produce reckless borrowing and deleterious consequences for an entire economy proved to apply to rich states, as well as to developing-country and emerging-market states. Although, unlike developing-country and emerging-market states in the 1990s, the United States had borrowed in its own currency and done so in significant part from other states with a policy incentive to lend, it eventually paid a high price for 146 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 availing itself of the opportunity that international financial flows created. The risks of excessive international borrowing by corporations and households in a major economy went beyond exposure to the inherent volatility of financial markets. The financial flows involved deepened and reinforced the consequences of economic interdependence for all states because they tied so many markets, financial and otherwise, together. The securitisation of housing finance, and the way in which financial sectors around the world absorbed the products it generated, was at the centre of this problem. For developing-country governments themselves, the pattern of international financial flows since the beginning of the first phase of the financial crisis has only reinforced the conclusion that many of them had drawn during the 1990s that they simply cannot rely on integrated, supposedly freeflowing capital markets producing a steady supply of relatively cheap capital. Cross-border private financial flows started to fall sharply in the summer of 2007 and fell massively during the last quarter of 2008.31 As the financial crisis entered its third phase, western investors returned to national markets, and once rich-state governments intervened to rescue financial sectors from collapse, banks in those countries were compelled into lending domestically rather than abroad.32 Openness to trade was shown to be at least in part a liability for states during a time of crisis in world demand. Export-led growth proved vulnerable to the fallout of trade interdependence. It left states too dependent on demand in markets in relation to which, by definition, they had no policy tools by which that demand could be resurrected. It also left them exposed to other states making protectionist moves to deal with the crisis. Especially in times of recession, economic interdependence creates severe domestic political problems for states, and, as argued in the introduction, governments will not necessarily respond to those difficulties by doing what is anything like most economically efficient. Even in rich states, economic nationalism is not a historical relic, and it will almost certainly never be because settling the terms of trade and financial flows with other states entails imposing at least short-term damage on the employment and income prospects of some groups of producers. Meanwhile, the old and well-understood problems of economic interdependence endure. The financial crisis and its fallout have demonstrated once again that exchange rate management remains one of the most acute difficulties that economic interdependence creates for Conclusions 147 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 states. Despite their attempt to address this problem since the Asian financial crisis, the east Asian states have simply not been able to escape exchange rate problems. Ultimately, the efforts to create an east Asian dollar standard have failed. Before the first phase of the financial crisis began, some east Asian states had already abandoned their efforts to maintain currency stability. Between early 2002 and the middle of 2007, Indonesia, South Korea, Singapore Thailand, and the Philippines all saw large appreciations in their real exchange rate with the dollar.33 Once the third-phase of the financial crisis began, various emergingmarket states, including some in east Asia, faced full-scale currency crises with money exiting these economies at nearly the same speed and volume as it had during the Asian financial crisis. This fate befell states with current account surpluses as well as those with deficits. South Korea was hit particularly hard, despite having acted as systematically as any east Asian state to try to ensure that there could be no repetition of the earlier crisis and holding the sixth-largest portfolio of foreign exchange reserves of any state in the world. To try to abate the currency crisis it faced in the autumn of 2008, the South Korean government was forced to use the state’s foreign exchange reserves to guarantee foreign currency debts and provide dollars to corporations.34 Rather than finding any region-wide protection in the provisions of the Chiang Mai Initiative, the Bank of Korea ended up turning to the Federal Reserve Board to procure liquidity facilities and a $30 billion swap. When it mattered, the collective arrangements established by ASEAN Plus-Three to deal with a currency crisis of any of its memberstates proved irrelevant. Exchange rate problems in a world of economic interdependence endure because of the conjunction of the structural monetary and financial power enjoyed by the United States and the psychology of foreign exchange markets. Beyond the euro-zone, which may yet still be tested by the fallout of the financial crisis, states have not found a way around the dilemmas that these realities create for them. Whatever the long-term pressures on the dollar, the crisis of the autumn of 2008 vividly demonstrated that at times of panic and fear it remains the currency in which investors have most confidence. Despite all the question marks about the future of the financial relationship between the United States and east Asia raised by the events around Fannie Mae and Freddie Mac, the dollar strengthened significantly in the foreign exchange markets in the final quarter of 2008. Moreover, it did so as 148 China and the Mortgaging of America 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 the American federal borrowing requirement was ballooning and the Federal Reserve Board was slashing interest rates. Meanwhile the states that were most afflicted by currency problems proved willing to turn back to the IMF, with an array of governments accepting loans in late 2008 and early 2009 from the international financial institution. Two of these states – Latvia and Hungary – were members of the European Union (EU) and the dominant member-states of the EU appeared more than willing to let the IMF, and with it the United States, deal with these states’ currency and financial problems, despite the apparent opportunity that existed to tie them closer to the euro-zone. Providing emergency credit to new member-states proved a burden that the German government in particular did not want to carry. Certainly, recent developments have not simply strengthened American power. Since the onset of the third phase of the financial crisis both foreign central banks and private investors have drawn a very sharp line between the short term and the long term in their willingness to purchase dollar assets, and, despite the success of the Bush administration in procuring a measure of policy change in Beijing, President Obama has had to acquiesce to China’s efforts to depreciate its currency. Nonetheless, the fallout of the financial crisis has demonstrated once again just how far American monetary and financial power and American macro-economic autonomy shape the international economic world in which other states have to operate. For all the hopes invested in it by liberal optimists, economic interdependence itself cannot be a panacea to re-establish the conditions that produced rising prosperity and living standards across much of the world over the past two decades. The economic opportunities bestowed by interdependence have turned out to be more problematic than the optimists, and governments in those states that had in the past most benefitted from them, had supposed. Moreover, politics always complicates the opportunities that economic interdependence undoubtedly does create. Politics puts limits on what governments can readily choose to do in the economic policy decisions they have the autonomy to make, and the consequences of those limits then play their part in shaping and restricting the choices open to other governments. Interdependence is an economic and political problem that has to be permanently managed by governments. In today’s world, the domestic and international political complexity of the economic relationship between the United States and China has become a major Conclusions 149 10.1057/9780230283305 - China and the Mortgaging of America, Helen Thompson Copyright material from www.palgraveconnect.com - licensed to Yale University - PalgraveConnect - 2011-05-02 structural international economic problem. Having, directly and indirectly, driven so much of the economic growth across the world between 2002 and 2008 and created a particular set of interdependencies that played out through the financial crisis, this economic relationship in its present form would now appear to be quite probably politically unsustainable beyond the short term. The changes that dismantling, or adjusting that relationship will bring, will produce yet more economic turbulence of a kind that will hurt all states integrated into the international economy, and bequeath a whole new set of political problems of interdependence.