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And Then the Pattern Repeated Again—and Again

The pattern began to repeat even before the damage to the Tigers had healed, this time with China in the lead. By the late 1990s, the flow of official reserves to the United States from Asia, mostly China, had resumed. Again, the Fed failed to counteract the impact. The U.S. monetary base and lending again grew faster than required by the economic fundamentals, expanding 7.0% and 11.3% a year,⁸ respectively, after 1997 in an economy that fundamentally needed only 5.5% yearly growth in financial liquidity.⁹ Awash with funds again, private investors sought new places to make gains.

This time, chastened by the still-recent Asian crash, U.S. investors focused on the exciting computer technologies and Internet applications that were just then emerging. As before, the massive supply of funds filtering through financial markets pushed up asset prices disproportionately. Technology and Internet stock prices jumped so fast that the technology sector rose from 12.3% of the benchmark S&P 500^® Index¹⁰ in 1997 to almost 30% by 2000. Even that wonderfully imaginative and exciting sector could not support almost a third of the economy’s market value. Again, matters, under the sway of excess liquidity, had gone beyond economic fundamentals.

The end came not from China, which held its admittedly destabilizing policies constant throughout, but, inadvertently, from the Fed. By late 1999, worried not about financial excesses but rather about a modest rise in inflation, Fed policymakers engineered what must have seemed to them moderate monetary restraint. Seeking a slight slowdown in the growth of the economy, they raised short-term interest rates gradually, from 4.5% in early 1999 to 6.0% in early 2000 (still low for the times). But by then, financial matters were so bloated that what might have seemed modest in a purely economic context put the previous boon quickly into reverse. Asset prices collapsed. The S&P 500, led downward by technology and Internet stocks, tumbled some 40% between spring 2000 and September 2001.¹¹

Yet for all the financial damage, including that wrought by the terrorist attacks of September 11, 2001, the ongoing interplay between Asian currency policies and American liquidity quickly reemerged. The next difficult financial cycle began almost immediately. Beijing, still rigidly holding the yuan cheap to the dollar, continued purchasing dollars, and, as before, continued to send the funds to American financial markets, where, again, the Fed failed to sterilize their effect. Liquidity again built faster than the economy’s fundamental needs. Though for technical reasons the monetary base during these years grew slightly slower than the almost 6% yearly growth rate of the nominal economy’s liquidity needs,¹² the excess was clearly evident in the 26.5% yearly explosion of total borrowing.¹³

American investors once more used this flood of liquidity to reach for gains. This time, they skipped both Asia and the Internet and focused instead on residential real estate. Subprime mortgage lending was an ideal lure. Lenders could command premium rates and at the same time could convince themselves, falsely as it turned out, that tangible real property offered better security than the ethereal worlds of either Internet applications or faraway Asian dreams. Their speculation could go still further than it had in past booms because the flows were that much larger and because Washington, contrary to its more or less neutral stance regarding the surge into Asia or the Internet, actually encouraged both lenders and borrowers to extend themselves in residential real estate.

The price of residential real estate went well beyond economic reality. As with the Internet bubble, the Fed prompted the turn, again inadvertently. Ignoring asset markets and the flow of liquidity from abroad, as before, the Fed again gauged its behavior only on its assessment of the underlying economy. Seeking to take the edge off the pace of expansion, it applied what otherwise would have been moderate monetary restraint, raising interest rates very gradually. But as before, what in a purely economic context would have elicited a moderate response had instead a devastating effect on bloated financial markets that already depended heavily on excess liquidity. Denied even a small measure of earlier easy credit flows, home purchases collapsed. Housing prices followed. The 2008–09 financial crisis was underway.

Fixing the Problem: Little Hope in Changing Beijing

This destructive pattern will continue unless something breaks this chain of causality. There is, of course, always the hope that China and other emerging economies will obviate the need for other actions by changing their currency policies. If they were to cease their strenuous efforts to keep their currencies cheap to the dollar, they would cease buying dollars in huge volumes, have no need to shift them to American financial markets, and so would remove the cause of this financial volatility. But if history is any guide, such a change is highly unlikely. Beijing, for almost two decades now, has shown little inclination to alter its policy.

Indeed, Beijing has shown only intransigence. That stance became clear as far back as the Clinton administration. As early as 1993, then Treasury undersecretary Lawrence Summers, with his usual delicate touch, demanded yuan appreciation. China not only refused but six months later, in 1994, it executed its massive devaluation of the yuan. Even as that decision led to the Asian crisis, Beijing refused to change and made no secret of its intention to hold the yuan relentlessly at that low level opposite the dollar. Though President Bill Clinton kept up the pressure on Beijing to the end of his tenure, he made no progress. Beijing even manipulated his celebrated Treasury secretary, Robert Rubin, getting him to pressure Tokyo to keep up the value of its yen, making it that much easier for China to compete globally against Japanese products. Chinese premier Zhu Rongji no doubt enjoyed the humiliation of American policy when he publically thanked Secretary Rubin for his efforts with Japan, as though he were an agent of Chinese policy.

George W. Bush picked up the frustrating effort. Two of his Treasury secretaries, Paul O’Neill and John Snow, each failed. The best the president and Secretary Snow could do was to talk Beijing out of a rigid peg to the dollar. Even then, China’s modest shift came in response to tariff threats that emerged separately in Congress. Besides, China really did not yield. The yuan’s subsequent rise proceeded so slowly that Snow complained about the “disappointing pace of reform.” After Bush left office, President Barack Obama picked up the same effort and met with even less success. Despite Treasury secretary Tim Geithner’s accusations of currency manipulation, China continued to control the yuan’s value, describing the administration’s importuning as “ridiculous” and an example of “gangster logic.”

After about 20 years of pressure under three American presidents and at least four Treasury secretaries, the yuan today remains almost 20% cheaper to the dollar than it was before China’s initial 1994 devaluation, making Chinese policy, for all the rhetoric, pressure, and maneuvering, that much more extreme than it was in 1993.

Fixing the Problem: There Are Limits to What Regulation Can Do

If, then, China is unlikely to make a substantive move on its currency, control of this destructive financial cycle must fall to domestic means. Regulatory control, though a perennial favorite with government, has limited use. It is not that regulation has no place. It does, to stop fraud and abuse, for example. Beyond that, however, regulation, in order to break this pattern, would have to impose a level of prudence on market participants that it has never succeeded in inculcating, much as it and law have failed to enforce ethics and prudence in any other walk of life.

Regulation’s limits were certainly on display during the crisis of 2008–09. Only two years before, for example, the Bank for International Settlements (BIS), in consultation with regulators in 120 countries, had laid out 25 new, stricter rules for bank supervision, including limits on licensing, ownership, capital adequacy, risk management, consolidated systems, ways of dealing with problem situations, divisions of tasks, and cross-border responsibilities. This raft of new rules and regulations (called Basel II, after the headquarters city of the BIS) was heralded as a bulwark against financial disaster (much as its successor, Basel III, has been hailed more recently). Yet, though every major financial institution in the world had fully complied with Basel II, the whole elaborate structure failed even to slow the financial panic that developed in 2008. When, for instance, the investment bank Bear Stearns collapsed in 2008, then Securities and Exchange Commission chairman Christopher Cox noted that the company had complied fully with all regulatory standards and was in fact $2.0 billion overcapitalized by those standards.

The regulatory answer has still more fundamental drawbacks. Rules, by nature, must establish specific guidelines and are almost always shaped by past experience. But, though the past is generally applicable to the future, its specifics seldom are. Rules framed around one incident invariably lack applicability to the next. After the Asian contagion, for instance, regulation responded by stressing flexibility, such as floating exchange rates, because the Tigers, with their fixed rates, were caught by China’s sudden devaluation. But such safeguards did little to temper the next boom’s focus on technology and the Internet. Similarly, the regulatory response to the tech collapse, with its stress on investment diversification, did little to prevent the subprime and related disasters of 2008–09. It simply asks too much of anyone to anticipate what particulars will surround the next boom. Even ex-Fed chairman Alan Greenspan, a man who clearly enjoys cultivating a wizard-like persona, acknowledged that “identifying a bubble in the process of inflating may be among the most formidable challenges.”

Of course, a regulatory regime might overcome such difficulties by shifting away from explicit rules and giving its investigators the flexibility to cope with new situations. Such a regime, however, would present a different set of problems. Because a group of investigators with such discretion would doubtless apply oversight differently, either from one investigator to the other or from one case to another, it would introduce uncertainty that would impair market efficiencies. And since such a scheme would necessarily be run by human beings instead of saints, discretion would inevitably risk abuse as well. Even in ancient Rome, the late first century AD poet Juvenal asked, Quis custodiet ipsos custodies? (Who is to guard the guards?)—a question worth applying even when power is well circumscribed and much more so when it allows wide discretion.

Even incorruptible regulators would have difficulties identifying where risks reside. Indeed, most regulations implicitly acknowledge this problem and look to practitioners for guidance. When in the aftermath of the 2008–09 crisis the U.S. Treasury made suggestions for risk control, it asked financial firms themselves, not the government agents, to “identify firm-wide risk considerations (credit, business lines, liquidity, and other) and establish appropriate limits and controls around these considerations.” It warned firms to avoid “incentives that could threaten the safety and soundness of supervised institutions.” But the Treasury Department left it to company managements to determine what those incentives were. While such guidance sounds eminently reasonable on the surface, it says little more than that firms should know their business, keep track of risks, and proceed very carefully. Most firms, even when taking horrible risks, believe they are doing just that.

None of this is to suggest that the authorities abandon all oversight, much less that they cease their efforts to prevent fraud and other abuses. Their rules offer important guidelines, and forcefully remind firms and their employees of the elements of sound financial management. But for all these virtues, it should be apparent that the most carefully wrought regulations still cannot prevent excess in the face of the boom-bust cycle that has grown up with globalization. Even Harvard Law professor Elizabeth Warren—chair of the Congressional Oversight Panel for the Implementation of the Emergency Economic Stabilization Act, member of the Executive Council of the National Bankruptcy Conference, first head of the Financial Consumer Protec-tion Agency, liberal senator-elect, and major proponent of government oversight and control—admits “regulations, over time, fail.”

Fixing the Problem: More Promise in Monetary Management

In the face of regulation’s severe limitations and Chinese intransigence, monetary management presents itself as the most viable way to break the destructive boom-bust cycle. Here, there is real promise, since it is clear in past crises that the excesses occurred in part because of a failure by central banks to sterilize funds flowing from abroad. Technically, central banks long have had the ability to manage such situations. Since they effectively control the entire stock of liquidity in their markets, they can easily avoid excesses by withdrawing an amount equivalent to any inflows. They have failed to do this, however, no doubt out of a misplaced focus on economic conditions, most particularly on inflation, to the exclusion of financial considerations. If they are to break this destructive cycle, they must now change.

Past central bank biases are certainly understandable. Though the boom-bust cycles associated with globalization have lasted for some time now, they are, nonetheless, relatively recent in the grand scheme of things. Most of today’s central bankers and other policymakers spent their formative years fighting destructive bouts of inflation during the 1970s and early 1980s, when at times general price levels rose at annual rates of more than 18%. They naturally look for danger from these quarters instead of from financial volatility. When, for example, Chairman Greenspan worried about “irrational exuberance,” he did nothing to moderate it, but instead immediately retreated into an assessment of inflation, ignoring the impact of financial flows and instead lauding China as a means to keep inflation down by tapping the “world’s productive capacity.” Neither was Greenspan alone in his biases. They are common among central bankers the world over.

But whatever the reason for past neglect, the boom-bust financial cycles now demand that the Fed and other central banks shed such biases. Going forward, they need to conduct monetary policy in a way that also takes such international liquidity flows seriously into consideration and counteracts their distorting effects. They can do this by adhering to targets for overall money and liquidity growth that are true to the economy’s fundamental liquidity needs. Such a focus on liquidity would guard against the financial excesses of the past 20-plus years. But more, because inflation is primarily a monetary phenomenon, this approach might also do a better job of inflation control than the present, heavy reliance on forecasts. This policy change, then, would not only stifle volatility but also would do so without giving up anything in the control of fundamental economic matters.

A Best Path

Some might be tempted to remedy such excesses by stopping the process of globalization altogether. Though such actions, even if they were feasible, might return finance to the well-ordered and manageable pattern of the 1950s and 1960s, they would also steal from the world the many benefits of globalization, which, for all its documented ills, have clearly fostered development in regions of the world that otherwise would have remained impoverished and have brought lower-income people the world over flows of inexpensive consumer goods that have significantly improved their living standards. Rather than relinquish such benefits for the sake of financial stability (or relief from other burdens associated with globalization), it would surely be better to find remedies, such as a shift in monetary policy, that alleviate the strains of globalization even as they allow nations to secure its benefits.

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