Power, Money and Balance

If you look at his month’s elegant invitation, you will note a strange omission. Where it says “Paper to be presented,” nothing follows. The next line simply says “essayist. Mr. Calleo.” This makes these invitations extremely rare, radically distinct from those for the preceding 1158 meetings. It may also make them valuable, like a postage stamp with the head of Washington upside down. Members would be well advised to hang on to their invitations. Anyway I am here to confess that the fault for this lack is not Mrs. Brooks’s, but entirely Mr. Calleo’s. I simply forgot to produce a title and then Avis and I disappeared into the wilds of Upstate New York until a couple of days ago.

There is perhaps another reason for my diffidence in producing a title. Until I finished writing the talk, I didn’t really know what it was about! This is not an unfamiliar phenomenon for those of us who read student papers for a living. But in my case there were some particular circumstances. I am just sending off the page proofs of a recent book, Follies of Power, to be published by Cambridge University Press in early April. It is about American policy since the end of the Cold War. There is heavy emphasis on foreign and financial policy and the close connection between the two. Finishing this project has got me thinking about another: a history of the American dollar and its links with our foreign policy. I don’t foresee an inch by inch chronicle, but rather a series of essays on critical moments in our currency’s evolution –starting with the early days of the Republic. Since I was in New York State, it seemed only appropriate to begin reading about Alexander Hamilton. The more I looked at his ideas, and his deep differences with Madison and Jefferson, the more I began to see an early version of the same great geopolitical and financial issues that trouble us today. And so I decided to make a talk out of the linkage and call it: Power, Money and Balance. And, if you indulge me, this is a way for me to figure out what the new book might be.

Newspapers remind us daily of the close connection in our nation between political and financial power. The connection seems even more intimate internationally. The way the states of the world organize their financial relations — what is called the international monetary system — often seems a metaphor, expressed in economic or monetary terms, for how the world’s states organize themselves geopolitically. Thus, during the Cold War, when Europe and Japan depended on the US for their security,  it seemed only natural that the dollar should be the currency used among those states for their financial dealings with one another. This was also the common practice for the world’s big banks and business corporations generally. By the same reasoning, once America’s great geopolitical rival — the Soviet Union — had collapsed, the dollar should have been even more firmly implanted at the center of world finance. Instead, a decade or so after the Soviet collapse the dollar’s international position began to appear much weaker. Why?

For a start, even during the Cold War, it was often difficult to sustain a stable value for the dollar. The source of this recurring difficulty lay in our growing indebtedness to other countries. In the 1970s, we began to run a regular trade deficit for the first time since the 19th century. By the 1980s, we were running a full current-account deficit. This meant that the real American economy was absorbing, i.e. consuming and investing, more than it was producing. The difference had to come from outside. Hence our deficit with the rest of the world. This has gone on now for at least three decades. By now, our debt to the rest of the world is some $10 trillion. Although we are the world’s richest economy, we have become its biggest international debtor.

Debts owed to foreigners, of course, have to be financed. For most countries in deficit, this means borrowing enough foreign currency to service their foreign debt or else using up whatever foreign currency reserves they may possess. But since the dollar has been the money with which foreigners normally service and pay their international debts, the United States has had a big advantage in financing its own foreign debts: It can simply create more dollars and send them out into the world. Of course, under the classic gold standard, the U.S. would have had to exchange gold for the surplus dollars accumulated by foreigners. Sooner or later a U.S. still in deficit would have run short of gold. With less and less gold backing the dollar would lose value. In theory, exports would rise and imports fall. American deficits would diminish. But under a de-facto dollar standard, the U.S. could simply create more dollars, which others were expected to accept indefinitely.

As you might imagine, this whole arrangement provoked frequent complaints from our trading partners. The basic issue was succinctly laid out by General de Gaulle in 1965 – on the occasion of one of his famous press conferences. According to the General, the dollar-based system gave Americans an “exorbitant privilege” — being able to print the world’s money at will — but without any inner balance to prevent that privilege from being abused. Such an unbalanced system, de Gaulle argued, would be relentlessly inflationary and sooner or later would break down. A great financial crisis would ensue. While there was still time, De Gaulle recommended an international collaboration to abandon the dollar standard and return to gold.

Dollar crises did follow. The dollar’s exchange rate soon began floating and proved highly volatile throughout the 1970s and 1980s. Nevertheless, the dollar-based system survived. The U.S. went on printing dollars to pay its foreign deficits and foreigners went on accepting them. Why?

Here it is difficult to overlook geopolitics. During the Cold War, the major creditors of the U.S. — Western Europe and Japan –were American military protectorates. We were providing the security that they were unwilling to provide for themselves. We were spending more on European defense than the Europeans. From this “burden-sharing” perspective, America’s deficits were a sign not of our indiscipline but of our allies’ free riding. For them, holding our exported dollars was a sort of imperial tax, awkward to refuse, and not too expensive considering what was at stake.

Since the end of the Cold War, however, the geopolitical imperative binding Europe and Japan to the dollar has gradually ceased to exist. No more Soviet Union means no more Soviet threat. American diplomacy has been looking for a substitute “threat” –something to rebind the U.S. and Europe –but without great success. Afghanistan, the War on Terror, Iraq, Iran so far don’t cut the mustard. If the truth be known, they alienate many allies rather than bind them to us. Europe has been preoccupied with new challenges of its own. Principal among these has been how to bring Russia into a productive relationship with the rest of Europe –a challenge for which the U.S., busy surrounding Russia with NATO, has been a problem rather than a solution. Another geopolitical imperative pushes Europeans to build a friendly and stable relationship with the Muslim world to the south. Again, close ties with the United States seem more a handicap than a help. Meanwhile, our external deficits keep growing.

Not surprisingly, the major shifts in geopolitical relations over the past couple of decades have provoked some corresponding changes in international monetary relations as well. First: America’s deficits are shifting away from Europe. Japan and the oil states do still remain principal creditors but are joined more and more by China — close by now to being the government that is our single biggest source of credit. This shift naturally raises questions about how reliable a source of credit China will eventually prove to be. So far, China, like Japan, absorbs a great hoard of surplus dollars –both to protect its exports to the United States, and to protect the value of the dollar-based assets it already holds. China is by now a rich country but with still a very poor population. How long will China’s rulers go on investing a huge part of their nation’s annual savings in buying America’s ever growing debt, in particular now that the yield on dollar securities is minimal and the risk of depreciation extremely high? Meanwhile, China manifestly needs capital to build domestic infrastructure and protect its environment. It also needs to reduce its huge trade surplus, preferably by building up its own domestic market and thereby raising the nation’s general standard of living. Of course, China might hope, like Europe and Japan, to use its accumulated dollars to buy up critical sectors of the American economy. But this is not a development that we welcome, particularly in those industries whose high technology makes them of great strategic interest to the Chinese.

A second major change in the international monetary setup is that the dollar now has a rival international currency –the Euro. The new currency is automatically in heavy demand since it serves a rich home market, roughly as large as the American. In some respects the euro seems almost designed to be an international currency — a modern equivalent of gold. It is controlled by a central bank more independent than the Federal Reserve and charged, above all, with responsibility for maintaining the currency’s value against inflation. Europeans have been talking about establishing this currency since the late 1960s. It probably is not coincidental that they only launched it when the Cold War was over. In effect, the Euro is a financial declaration of independence.

Where do these geopolitical and financial changes point? For the sake of argument, let us say we have two major schools of analysis. There are the balancers and the imperialists. Balancers grew prominent in the late 1980s in the form of the Declinist school –a diverse group of writers who saw the U.S. caught up in a deteriorating geo-economic position, –a victim of “overstretch”– to use the terminology popularized by Paul Kennedy in his famous Rise and Fall of the Great Powers. Overstretch occurs, Kennedy argued, when a great power, pursuing hegemonic ambitions, takes on excessive debt and thereby cripples its economy and undermines the sources of its national strength. This was the fate, Kennedy said, of Habsburg Spain in the 17th century and of Bourbon France in the 18th. Reaganite America was set on the same path. As evidence, Kennedy pointed to America’s rapidly growing foreign debt.

By the early 1990s, the vogue for declinism was overtaken by the collapse of the Soviet Union. Whatever America’s troubles, the Soviets were in much worse shape. Triumphal imperialists read the Soviet fate not as warning of superpower overstretch but as a sign of America’s invincible global superiority. Russia’s reformation they saw as America’s victory. The U.S. was now the only military superpower in what had become a unipolar world. Persisting balancers, however, saw this imperialist reading as a grave mistake–the result of a deficient political imagination. Instead of a unipolar world with ourselves the unassailable hegemon, they saw the geopolitical system transforming itself into a plural world of several great powers. The Soviet demise, radically reducing European and Japanese dependence on America’s military strength, would, in fact, seriously weaken America’s own geopolitical power. In so doing it would also undermine European and Japanese tolerance for large American deficits. In short, the post-Soviet world would demand a major adjustment from the United States–a resolute turning away from deficits and overstretch.

In its early years, the Clinton administration appeared to be making such an adjustment. It cut military spending drastically, installed the “Powell Doctrine” to limit future military adventures and eventually did balance the federal budget. But following Europe’s failures in Yugoslavia, together with its own enthusiasm for NATO enlargement, the Administration’s geopolitical rhetoric grew more aggressive. Embattled in scandal, it increasingly sought to appease the neo-conservatives who controlled Congress. By the end, Clinton was bombing Iraq and calling for a big jump in defense spending.

The Clinton administration’s triumphal imperialism remained, however, mostly financial rather than military. As Clinton cut government consumption, private consumption had grown by leaps and bounds. The already huge deficit with the rest of the world grew steadily bigger. Foreign financing, however, was abundant. From the mid 1990s to the end of the decade, America’s dot-com boom attracted an enormous influx of foreign capital, much of it from private investors in Europe. This inspired Clinton’s economists to generate a new imperial view of the world economy. The miraculous market had produced a new global division of labor. America’s role was to innovate, educate, and consume — to create the world’s new industrial and information technologies, management techniques, and financial products. The rest of the world was to follow our lead,  produce ordinary goods for our market, save heavily, and invest heavily in America, thereby financing our deficits — the outsized American consumption and investment that was thought to be driving the new world economy.

Old-fashioned conservative economists were skeptical. For the remnants of the balancing school, the great Clinton boom was evidence of “asset inflation”: an enormous and volatile pool of exported dollars, feeding an increasingly hectic series of bubbles and crashes, pointing toward eventual hyperinflation and depression –De Gaulle’s vision of 40 years earlier. Unfortunately, contemporary events have given these old declinist prognostications more credence than any of us would like.

The recent Bush administration has greatly assisted the balancers’ case. Bush’s hyper-active response to the dot-com crash quickly threw away Clinton’s fiscal balance. The unmeasured response to 9/11 returned the U.S. to jumbo-sized military spending. This resumption of profligacy has greatly lessened the attractiveness of the American economy for foreign investors. In the past few months the massive sums being devoted to preventing the collapse of America’s banking industry and the aid now extended to several giant industrial corporations promise to raise America’s debt to hallucinatory levels. A recent estimate shows the federal government already to have taken on $7.8 trillion in obligations — roughly half the size of the American economy. As the classical liberal economist Friedrich Hayek once foresaw, exploding debt has forced the federal government to assert unprecedented control over the economy. Still more control seems unavoidable. Private property in America has probably never before been more at the mercy of politics.

However prescient the balancers’ vision may have been about the consequences of continuing deficits, no administration in sight seems likely to adopt the balancers’ cure. That cure is presumably to reduce deficits — to move toward an economy in balance with the rest of the world. To do this would be a painful process, involving a prolonged deflationary climate and a general drop in living standards. “We are all Keynesians now,” Nixon said in 1971 as he abandoned just such a deflationary regime. Instead Nixon accepted the neo-Keynesian paradigm. When the economy stalls, the state’s function is to assume new debt and inject new money. The new state debt, transformed into more consumption and investment, is expected to translate into growth that compensates for the debt by increasing the size of the economy. Nixon, like most presidents, found Keynes a more agreeable cure than the declinists’ painful return to balance.

These ideas favoring debt in the monetary sphere have their equivalents in geopolitics, where debt has ardent defenders. Among these is a major contemporary scholar – Niall Ferguson – a Harvard professor who, like Kennedy, bases his analysis on grand historical analogies. In contrast to Kennedy’s claim that geopolitical overstretch ruined Habsburg Spain and Bourbon France, Ferguson argues that, in reality, debt permitted Hanoverian Britain to defeat Bourbon France in the great wars of the eighteenth and early nineteenth centuries –wars that gave Britain hegemony over the global system. Ferguson’s argument is powerful and clear. Although France was initially much richer and more populous than England, the British were persistently able to outspend the French. In 1689, as the great rivalry began, France had three times the population and an economy twice as large as Britain’s. England’s ordinary government revenue was only 1/5th that of France. But during the Seven Years War, for example, Britain was able to outspend France by 40%. Over the century and a quarter of their great rivalry, England’s financial capacity seemed almost unlimited. What was the British secret? They borrowed –went into debt hugely. The French were unable to borrow on the same scale because their interest rates were more than 50% higher. Naturally, the huge difference in interest costs accumulated. By 1788, France’s ratio of debt service to total debt was twice as large as Britain’s –even though Britain’s debt was 3 times larger in relation to its GNP. To put it in another way: Britain and France each paid roughly similar amounts of revenue for debt service. But Britain’s interest payments sustained a much larger debt. Unquestionably, access to abundant cheap credit gave Britain a great advantage.

Ferguson cites his source for all this information — a scholarly article by Kenneth Schultz and Barry Weingast called “The Democratic Advantage: Institutional Foundations of Financial Power in International Competition.”[1] Ferguson uses this research to defend Reagan’s massive military buildup and big deficits. “A good parallel,” Ferguson says, “can be drawn with Britain’s victory over ancien regime France in the eighteenth century.” Ferguson goes on: Since U.S. in the 1980s could borrow much more cheaply than the Soviets, Reagan was right to pursue his buildup. Kennedy was wrong to overlook “the ease with which the United States financed its increased debt burden.” In Ferguson’s view, declinists were using a spurious defense of pre-Keynesian economics to mask an outburst of pusillanimous American isolationism.

Ferguson speaks from the perspective of a self-confessed imperialist – a believer in the view that the world is better off with a dominant power committed to “making the world safe for capitalism and democracy.” This means strong institutional foundations for international law and order. Sustaining such institutions was Britain’s role in the 19th century, Ferguson argues, and largely kept the peace. The terrible tragedies of the 20th century flowed from America’s unwillingness to take on Britain’s role. Today, “the proper role of an imperial America,” Ferguson says in The Cash Nexus, is to establish the institutions needed for international order where they are lacking, “if necessary –as in Germany and Japan in 1945 – by military force.” “Perhaps … the greatest disappointment facing the world in the twenty-first century,” Ferguson asserts, is “that the leaders of the one state with the economic resources to make the world a better place lack the guts to do it.”[2]

I wrote a review of Ferguson’s book in 2001.[3] I praised its brilliance but resisted its world view and prescriptions. I warned against unreasonable geopolitical ambitions, enabled by “Nietzschean” economics. Instead I tried to give a spirited defense of equilibrium in economics and the balance of power in geopolitics. I argued that America, seduced by a runaway will to power backed up by self-indulgent economics, was in danger of losing its inner balance and becoming a menace to itself and to the world. It was not a universally popular view, then or now. Still, it was not a bad call for 2001.

As I review these arguments, I note that the authors of the article on which Ferguson bases his recommendations themselves arrive at somewhat different conclusions from his. Like Ferguson, they argue that the U.S. won the Cold War because of its superior borrowing power, effectively brought to bear by the Reagan administration. But they also argue that the superior borrowing power of both Hanoverian England and Reaganite America stemmed from their balanced constitutional governments, representative political systems where the holders of capital were well represented and therefore able to inhibit the state from unreasonably extravagant ambitions. In such constitutionalist regimes, the risk of default through overstretch is much less and so interest rates for state borrowing are significantly lower. In effect, Messrs Schultz and Weingast coax their research into a variety of democratic peace theory: States with liberal and democratic constitutions –because they limit government’s power – possess a critical financial advantage. The ability to borrow heavily and cheaply renders them better able to win history’s great struggles. This is a conclusion more in spirit with America’s own constitutional thinking –expressed in the Federalist Papers of Hamilton, Madison and Jay – than Professor Ferguson’s preoccupation with transforming Republican America into a new British Empire.

Many Americans would doubtless like to believe that our national way of thinking still remains deeply committed to constitutional balance – rather than to concentrating power for an imperial vocation. But we are, in fact, deeply divided on this issue. Only a few years ago, for example, our Secretary of State was seriously arguing: Now that America has all the power, why should anyone want to balance it? I argued at the time: if the authors of the Federalist Papers had been confronted with such a statement, they would have replied: “This is the language of tyranny.” “Power without balance is a menace — to those who possess it as well as to those subject to it.”

This is perhaps what Madison would have said, but what about Hamilton? Of all our great founders, Hamilton is probably the one who most faithfully reflects the deep tension between power and balance that runs through our history. It seems appropriate to close with a few observations about Hamilton. He was born on the tiny Caribbean island of Nevis, a brutal world dominated by slavery. His mother, Rachael Faucette came from an old Huguenot family, was married unhappily, fled to St. Croix and ultimately was divorced by her husband, Peter Lavien. Meanwhile, she lived with James Hamilton — a black sheep from an ancient Scottish family, who, after exhausting her inheritance, abandoned his common-law family and fled.   The young Alexander’s mother died when he was 11 and left him dependent on the charity of her well-to-do relations. Small, slight, frail, the young Alexander burned with ambition –to be a great soldier and do great things. Napoleon was to become his hero. The family took charge of his education for a few years and provided him with a gifted tutor. But money could not be found for sending him away to college, so at the age of 13 he went to work on St. Croix as a clerk for the firm of Beekman & Cruger –big Dutch merchants from New York, the biggest such firm in the Caribbean, centered principally in St. Croix. The boy proved so able an administrator that at 15 he was left in complete charge of the substantial business in St. Croix, while the owners were absent and ill in New York. The business prospered nonetheless, and Hamilton’s talents were so obviously outstanding that family and friends finally rallied to send him to King’s College in New York (Columbia). He was a brilliant student who soon came to the attention of several of the City’s leaders. He joined Washington’s revolutionary army and quickly became Washington’s indispensable aide, performing all sorts of critical missions. Washington saw him as a son. Hamilton insisted, however, on being given his own command. He led a company and fought with distinction at the Battle of Yorktown.

Thereafter, he was a tireless promoter of a Federal Constitution. He was the author –with Madison and Jay – of the Federalist Papers. Washington named him the country’s first Secretary of the Treasury. Hamilton worked with all his prodigious energy and talent to foster a strong national economy. He favored tariffs for America’s infant industries. Above all, he struggled to build a solid financial structure for the new nation. He demanded that the federal government assume and honor fully the Revolutionary War debts, including those of the states. To this end he insisted upon a national sinking fund for the debt –as a technically enlightened way to ensure the repayment of debt and, in a sense, to limit new borrowing. He promoted a national central bank modeled on Bank of England. Having accomplished these great labors, he resigned the Treasury in 1795 to build his own fortune. He was a brilliantly successful lawyer in New York. As such, he was notable for defending the property rights of Tory Royalists. He remained Washington’s close confidant, and was the animator of the Federalist Party. But he also had bad relations with Washington’s successor John Adams, who was known to describe Hamilton as “that bastard brat of a Scotch pedlar.” Finally Hamilton met a tragic and stupid early death, killed in a duel with another ambitious New York lawyer, Aaron Burr.

A colleague of mine, John Harper, calls Hamilton “the American Machiavelli.” He means not that Hamilton was unprincipled. Quite the contrary, Hamilton recognized and fought for the best, even if he was never surprised by the worst. Growing up poor in a tropical slave society he knew all about human depravity. He had no illusions about mob rule. Hamilton is of particular interest to our topic because of his keen sense of the relationship between government power and national finance. Behind his tireless promotion of a national bank was his awareness that sound and abundant credit is needed for a strong national economy, and also for the war-making powers of a state. His preoccupation with military and financial power fits closely with his dream of a great global destiny for America. Although committed to the revolution against British colonial rule, Imperial Britain was, in fact, his model for America’s future, not Republican France. Once independence was gained he did his best to restore cordial relations with London.

Incorporating Hamilton’s preoccupations into the Federalist Papers, along with those of Madison, prefigures a fundamental tension that runs through the evolution of our Republic. To collaborate successfully with Madison and Jay, Hamilton accepted their insistence on constitutional balance. But he repeatedly expressed his worry about a government with too little executive authority –unable to give policy the energy and direction that his imperial vision of the American future called for. Thus the Federalist papers are a compromise between Hamilton’s imperialism and Madison’s constitutional balance. A tension mirrored today in that between Ferguson, on the one hand, and Schultz and Weingast, on the other. Hamilton was dreaming of a federal power that would rule the world. Madison wanted a government that could do no harm. Who was the real father of today’s America? Virginians, of course, believe it was Madison and Jefferson. We, New Yorkers, however, know it was Hamilton.

One last thought, inspired by Schultz and Weingast: America’s strength, they teach us, flows from its constitutional self-restraint. That penchant for self-restraint has given us vast cheap credit. Thanks to that credit we have been hugely successful at war. But too much military power and too much easy credit ultimately undermine self-restraint. And as our recent history suggests, power and money without balance can easily grow self-destructive.