The Death of Money

In Shakespeare’s The Merchant of Venice, Salanio asks, “Now, what news on the Rialto?” He’s looking for information, gathering intelligence, and attempting to identify what’s happening in the marketplace. Salanio doesn’t intend to control the business unfolding around him; he knows he cannot. He looks to understand the flow of news, to find his place in the market.

Janet Yellen and the Federal Reserve would do well to be as humble.

The word market invokes images of everything from prehistoric trade goods to medieval town fairs to postmodern digital exchanges with nanosecond-speed bids and offers converging in a computational cloud. In essence, markets are places where buyers and sellers meet to conduct the sale of goods and services. In the world today, place may be an abstracted location, a digital venue; a meeting may amount to nothing more than a fleeting connection. But at their core, markets are unchanged since traders swapped amber for ebony on the shores of the Mediterranean during the Bronze Age.

Still, markets—whether for tangible commodities like gold or for intangibles such as stocks—have always been about deeper processes than the mere exchange of goods and services. Fundamentally, they are about information exchange concerning the price of goods and services. Prices are portable. Once a merchant or trader ascertains a market price, others can use that information to expand or contract output, hire or fire workers, or move to another marketplace with an informational advantage in tow.

Information can have greater value than the underlying transactions from which the information is derived; the multibillion-dollar Bloomberg fortune is based on this insight. How should a venture capitalist price a stake in an enterprise creating an entirely new product? Neither the investor nor the entrepreneur really knows. But information about past outcomes, whether occasional huge gains or frequent failures, gives guidance to the parties and allows an investment to go forward. Information about sales and investment returns is the lubricant and the fuel that allows more sales and investments to take place. An exchange of goods and services may be the result of market activity, but price discovery is the market function that allows an exchange to occur in the first place.

Anyone who has ever walked away from a carpet dealer in a Middle Eastern bazaar, only to be chased down by the dealer yelling, “Mister, mister, I have a better price, very cheap,” knows the charms of price discovery. This dynamic is no different than the digitized, automated, high-frequency trading that takes place in servers adjacent to exchange trading platforms in New York and Chicago. The computer is offering the nanosecond version of “Mister, I have a better price.” Price discovery is still the primary market function.

But markets are home to more than just buyers and sellers, speculators and arbitrageurs. Global markets today seem irresistible to central bankers with plans for better times. Planning is the central bankers’ baleful vanity since, for them, markets are a test tube in which to try out their interventionist theories.

Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious, and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the earth’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society?

The impulse toward central planning often springs from the perceived need to solve a problem with a top-down solution. For Russian Communists in 1917, it was the problem of the czar and a feudal society. For Chinese Communists in 1949, it was local corruption and foreign imperialism. For the central planners at central banks today, the problem is deflation and low nominal growth. The problems are real, but the top-down solutions are illusory, the product of hubris and false ideologies.

In the twentieth century, Russians and Chinese adhered to Marxist ideology and the arrogance of the gun. Today central bankers embrace Keynesianism and the arrogance of the Ph.D. Neither Marxist nor Keynesian ideology allows individuals the degrees of freedom necessary to discover those solutions that emerge spontaneously from the fog of complexity characteristic of an advanced economy. Instead, individuals, sensing manipulation and control from central banks, either restrain their economic activity or pursue entirely new, smaller enterprises removed from the sights of central bank market manipulation.

Market participants have been left with speculation, churning, and a game of trying to outthink the thinkers in the boardroom at the Federal Reserve. Lately, so-called markets have become a venue for trading ahead of the next Fed policy announcement, or piggybacking on its stubborn implementation. Since 2008, markets have become a venue for wealth extraction rather than wealth creation. Markets no longer perform true market functions. In markets today, the dead hands of the academic and the rentier have replaced the invisible hand of the merchant or the entrepreneur.

This critique is not new; it is as old as free markets themselves. Adam Smith, in The Theory of Moral Sentiments, a philosophical work from 1759, the dawn of the modern capitalist system, makes the point that no planner can direct a system of arrayed components that are also systems with unique properties beyond the planner’s purview. This might be called the Matryoshka Theory, named for the Russian dolls nested one inside the other and invisible from the outside. Only when the first doll is opened is the next unique doll revealed, and so on through a succession of dolls. The difference is that matryoshka dolls are finite, whereas variety in a modern economy is infinite, interactive, and beyond comprehension.

Friedrich Hayek, in his classic 1945 essay “The Use of Knowledge in Society,” written almost two hundred years after Adam Smith’s work, makes the same argument but with a shift in emphasis. Whereas Smith focused on individuals, Hayek focused on information. This was a reflection of Hayek’s perspective on the threshold of the computer age, when models based on systems of equations were beginning to dominate economic science. Of course, Hayek was a champion of individual liberty. He understood that the information he wrote about would ultimately be created at the level of individual autonomous actors within a complex economic system. His point was that no individual, committee, or computer program would ever have all the information needed to construct an economic order, even if a model of such order could be devised. Hayek wrote:

Charles Goodhart first articulated Goodhart’s Law in a 1975 paper published by the Reserve Bank of Australia. Goodhart’s Law is frequently paraphrased along the lines, “When a financial indicator becomes the object of policy, it ceases to function as an indicator.” That paraphrase captures the essence of Goodhart’s Law, but the original formulation was even more incisive because it included the phrase “for control purposes.” (In original form, it reads, “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”) This phrase emphasized the point that Goodhart was concerned not only with market intervention or manipulation generally but also on a particular kind of top-down effort by central banks to dictate outcomes in complex systems.

Adam Smith, Friedrich Hayek, and Charles Goodhart all concluded that central planning is not merely undesirable or suboptimal; it is impossible. This conclusion aligns with the more recent theory of computational complexity. This theory classifies computational challenges by their degree of difficulty as measured by the data, computing steps, and processing power needed to solve a given problem set. The theory has rules for assigning such classifications, including those problems that are regarded as impossible to compute because, variously, the data are too voluminous, the processing steps are infinite, all the computational power in the world is insufficient, or all three. Smith, Hayek, and Goodhart all make the point that the variety and adaptability of human action in the economic sphere are a quintessential case of computational complexity that exceeds the capacity of man or machine to optimize. This means not that economic systems cannot approach optimality but that optimality emerges from economic complexity spontaneously rather than being imposed by central banks through policy. Today central banks, especially the U.S. Federal Reserve, are repeating the blunders of Lenin, Stalin, and Mao without the violence, although the violence may come yet through income inequality, social unrest, and a confrontation with state power.

While the Adam Smith and Friedrich Hayek formulations of the economic complexity problem are well known, Charles Goodhart added a chilling coda. What happens when data used by central bankers to set policy is itself the result of prior policy manipulation?

■ The Wealth Effect

Measures of inflation, unemployment, income, and other indicators are carefully monitored by central bankers as a basis on which to make policy decisions. Declining unemployment and rising inflation may signal a need to tighten monetary policy, just as falling asset prices may signal a need to provide more monetary ease. Policy makers respond to economic distress by pursuing polices designed to improve the data. After a while, the data themselves may come to reflect not fundamental economic reality but a cosmetically induced policy result. If these data then guide the next dose of policy, the central banker has entered a wilderness of mirrors in which false signals induce policy, which induces more false signals and more policy manipulation and so on, in a feedback loop that diverges further from reality until it crashes against a steel wall of data that cannot easily be manipulated, such as real income and output.

A case in point is the so-called wealth effect. The idea is straightforward. Two asset classes—stocks and housing—represent most of the wealth of the American people. The wealth represented by stocks is highly visible; Americans receive their 401(k) account statements monthly, and they can check particular stock prices in real time if they so choose. Housing prices are less transparent, but anecdotal evidence gathered from real estate listings and water-cooler chatter is sufficient for Americans to have a sense of their home values. Advocates of the wealth effect say that when stocks and home prices are going up, Americans feel richer and more prosperous and are willing to save less and spend more.

The wealth effect is one pillar supporting the Fed’s zero-interest-rate policy and profligate money printing since 2008. The transmission channels are easy to follow. If rates are low, more Americans can afford mortgages, which increases home buying, resulting in higher prices for homes. Similarly, with low rates, brokers offer cheap margin loans to clients, which result in more stock buying and higher stock prices.

There are also important substitution effects. All investors like to receive a healthy return on their savings and investments. If bank accounts are paying close to zero, Americans will redirect those funds to stocks and housing in search of higher returns, which feeds on itself, resulting in higher prices for stocks and housing. At a superficial level, the zero-interest-rate and easy-money policies have produced the intended outcomes. Stock prices more than doubled from 2009 to 2014, and housing prices began rebounding sharply in mid-2012. After four years of trying to manipulate asset prices, the Fed appeared to have succeeded by 2014. The wealth was being created, at least on paper, but to what effect?

The wealth effect’s power has been debated for decades, but recent research has cast considerable doubt on its impact. Few economists doubt that the wealth effect exists to an extent. The issues are, how strong is it, how long does it last, and is it worth the negative impacts and distortions needed to achieve it?

The wealth effect is typically expressed as a percentage increase in consumer spending for each dollar increase in wealth. For example, a $100 billion increase in stock market and housing prices that had a 2 percent wealth effect would produce a $2 billion increase in consumer spending. The Congressional Budget Office shows that various studies put the wealth effect from housing prices in a range from 1.7 percent to 21 percent. Such a wide range of estimated effects is risible, casts doubt on similar studies, and highlights the methodological difficulties in this field.

A leading study of the wealth effect from stock prices, published by the Federal Reserve Bank of New York, contained findings that substantially undermine the Fed’s own belief in the wealth effect. The study says:

Another study shows that the wealth effect, to the extent it exists, is heavily concentrated among the rich and has no impact on the spending of everyday Americans. David K. Backus, chairman of the economics department at New York University, echoed this view:

Even more disturbing than doubts about the wealth effect’s size and timing is the fact that economists are not even sure about the direction of the effect. While conventional wisdom holds that rising stock prices increase consumption, economists have suggested that it may be the other way around; that rising consumption may increase stock prices. The prominent monetary economist Lacy H. Hunt summarizes the state of research on the wealth effect as follows:

Now consider that several of the leading studies on the wealth effect were published either in 1999 or in 2007, at the height of the two most recent stock bubbles. It’s hardly surprising that academic research on the wealth effect might be of particular interest during stock bubbles when the wealth effect was supposed to be at its strongest, but this research indicates that the wealth effect is actually weak and uncertain.

Taken together, all this suggests that while the Federal Reserve is printing trillions of dollars in pursuit of the wealth effect, it may actually be in service to a mere mirage.

■ Asset Bubbles

America is today witnessing its third stock bubble, and its second housing bubble, in the past fifteen years. These bubbles do not help the real economy but merely enrich brokers and bankers. When these bubbles burst, the economy will confront a worse panic than occurred in 2008, and the bankers’ cries for bailouts will not be far behind. The hubris of central bankers who do not trust markets, but seek to manipulate them, will be partly to blame.

Asset bubble creation is one of the most visible malignancies caused by Federal Reserve money printing, but there are many others. One obvious effect is the export of inflation from the United States to its trading partners through the exchange-rate mechanism. A persistent conundrum of Fed monetary policy since 2008 has been the absence of inflation in U.S. consumer prices. From 2008 through 2012, the year-over-year increase in the consumer price index averaged just 1.8 percent per year, the lowest for any five-year period since 1965. Fed critics have expected for years that inflation would rise sharply in the United States in response to money printing, albeit with a lag, but the inflation has not yet appeared; indeed persistent deflationary signs began emerging in 2013.

A principal reason for the absence of inflation in the United States is that inflation was exported abroad through the exchange-rate mechanism. Trading partners of the United States, such as China and Brazil, wanted to promote their exports by preventing their currencies from appreciating relative to the U.S. dollar. As the Fed prints dollars, these trading partners must expand their own money supplies to soak up the dollar flood coming into their economies in the form of trade surpluses or investment. These local money-printing policies cause inflation in the trading partner economies. U.S. inflation is muted because Americans import cheap goods from our trading partners.

From the start of the new millennium, the world in general and the United States in particular have had a natural deflationary bias. Initially the United States imported this deflation from China in the form of cheap goods produced by abundant labor there, aided by an undervalued currency that caused U.S. dollar prices for Chinese goods to be lower than economic fundamentals dictated. This deflationary bias became pronounced in 2001, when annual U.S. inflation dipped to 1.6 percent, perilously close to outright deflation.

It was this deflation scare that prompted then Fed chairman Alan Greenspan to sharply lower interest rates. In 2002 the average Federal Funds effective rate was 1.67 percent, then the lowest in forty-four years. In 2003 the average Federal Funds rate was even lower, 1.13 percent, and it remained low through 2004, averaging 1.35 percent for the year. The extraordinarily low interest-rate policy during this three-year period was designed to fend off deflation, and it worked. After the usual lag, the consumer price index rose 2.7 percent in 2004 and 3.4 percent in 2005. Greenspan was like the pilot of a crashing plane who pulls the aircraft out of a nosedive just before it hits the ground, stabilizes the aerodynamics, then regains altitude. By 2007, inflation was back over 4 percent, and the Fed Funds rate was over 5 percent.

Greenspan had fended off the deflation dragon, but in so doing he had created a worse conundrum. His low-rate policy led directly to an asset bubble in housing, which crashed with devastating impact in late 2007, marking the start of a new depression. Within a year, declining asset values, evaporating liquidity, and lost confidence produced the Panic of 2008, in which tens of trillions of dollars in paper wealth disappeared seemingly overnight.

The Federal Reserve chairmanship passed from Alan Greenspan to Ben Bernanke in February 2006, just as the housing calamity was starting to unfold. Bernanke inherited Greenspan’s deflation problem, which had never really gone away but had been masked by the 2002–4 easy-money policies. The consumer price index reached an interim peak in July 2008, then fell sharply for the remainder of that year. Annual inflation year over year from 2008 to 2009 actually dropped for the first time since 1955; inflation was turning to deflation again.

This time the cause was not the Chinese but deleveraging. The housing market collapse in 2007 destroyed the collateral value behind $1 trillion in subprime and other low-quality mortgages, and trillions of dollars more in derivatives based on those mortgages also collapsed in value. The Panic of 2008 forced financial firms and leveraged investors to sell assets in a disorderly fire sale to pay down debt. Other assets came on the market due to insolvencies such as Bear Stearns, Lehman Brothers, and AIG. The financial panic spread to the real economy as housing starts ground to a halt and construction jobs disappeared. Unemployment spiked, which was another boost to deflation. Inflation dropped to 1.6 percent in 2010, identical to the 1.6 percent rate that had spooked Greenspan in 2001. Bernanke’s response to the looming threat from deflation was even more aggressive than Greenspan’s response to the same threat almost a decade earlier. Bernanke lowered the effective Fed Funds rate to close to zero in 2008, where it has remained ever since.

The world is witnessing a climactic battle between deflation and inflation. The deflation is endogenous, derived from emerging markets’ productivity, demographic shifts, and balance sheet deleveraging. The inflation is exogenous, coming from central bank interest-rate policy and money printing. Price index time series are not mere data points; they are more like a seismograph that measures tectonic plates pushing against each other on a fault line. Often the fault line is quiet, almost still. At other times it is active, as pressure builds and one plate pushes under another. Inflation was relatively active in 2011 as the year-over-year increase reached 3.2 percent. Deflation got the upper hand in late 2012; a four-month stretch from September to December 2012 produced a steady decline in the consumer price index. The economy is neither in an inflationary nor a deflationary mode; it is experiencing both at the same time from different causes; price indexes reveal how these offsetting forces are playing out.

This dynamic has profound implications for policy. It means the Fed cannot stop its easing policy so long as the fundamental deflationary forces are in place. If the Fed relented in its money printing, deflation would quickly dominate the economy, with disastrous consequences for the national debt, government revenue, and the banking system. But deflation’s root causes are not going away either. At least a billion more workers will enter the labor force in Asia, Africa, and Latin America in coming decades, which will keep downward pressure on costs and prices. Meanwhile a demographic debacle in developed countries will put downward pressure on aggregate demand in these advanced economies. Finally, technological breakthroughs are accelerating and promise higher productivity with cheaper goods and services. The energy revolution in natural gas, shale oil, and fracking is another deflationary force.

In short, the world wants to deflate while governments want to inflate. Neither force will relent, so the pressure between them will continue to build. It is just a matter of time before the economy experiences more than just bubbles, but an earthquake in the form of either a deeper depression or higher inflation, as one force rapidly and unexpectedly overwhelms the other.

■ Tremors

Expected earthquakes of great magnitude near large population centers are colloquially referred to as “the big one.” But before those big quakes appear, they may be preceded by small tremors that wreak havoc in localities along the fault line far from the big cities. The same can be said for the Fed’s market interventions. In its desperate effort to fight deflation, the Fed is causing minor meltdowns in markets far removed from the main arena of U.S. government bond interest rates. The unintended and unforeseen consequences of the Fed’s easy-money policies are becoming more visible, costly, and problematic in many ways. An overview of these malignancies reveals how the Fed’s quixotic pursuit of the deflation dragon is doomed to fail.

While inflation was quite low from 2008 to 2013, it was not zero, yet growth in personal income and household income was close to zero. This meant that real incomes declined even in a low-inflation environment. If the Fed had instead allowed deflation, real incomes would have risen even without nominal gains, because consumer goods prices would have been lower. In this way, deflation is the workingman’s bonus because it allows an increase in the living standard even when wages are stagnant. Instead, real incomes declined. Economist Lacy Hunt captured this effect succinctly when he wrote,

Another unintended consequence of Fed policy involves the impact on savers. The Federal Reserve’s zero-interest-rate policy causes a $400 billion-per-year wealth transfer from everyday Americans to large banks. This is because a normalized interest-rate environment of 2 percent would pay $400 billion to savers who leave money in the bank. Instead, those savers get nothing, and the benefit goes to banks that can relend the free money on a leveraged basis and make significant profits. Part of the Fed’s design is to penalize savers and discourage them from leaving money in the bank, and to encourage them to invest in risky assets, such as stocks and real estate, to prop up collateral values in those markets.

But many savers are inherently conservative and with good reason. An eighty-two-year-old retiree does not want to invest in stocks because she could easily lose 30 percent of her retirement savings when the next bubble bursts. A twenty-two-year-old professional saving for a down payment on his first condo may avoid stocks for the same reason. Both savers hope to get a reasonable return on their bank accounts, but the Fed uses rate policy to ensure that they receive nothing. As a result, many citizens are saving even more from retirement checks and paychecks to make up for the lack of a market interest rate. So a Fed manipulation designed to discourage savings actually increases savings, on a precautionary basis, to make up for lost interest. This is a behavioral response not taught in textbooks or included in models used by the Fed.

Federal Reserve policy has also damaged lending to small and medium-size enterprises (SMEs). This does not trouble the Fed, because it favors the interests of large banks. Johns Hopkins professor Steve Hanke has recently pointed out the reason for this damage to SME lending. SME loans, he argues, are funded by banks through interbank lending. In effect, Bank A lends money to Bank B in the interbank market, so that Bank B can fund a loan to a small business. But such lending is unattractive to banks today because the interbank lending rate is zero due to Fed intervention. Since banks cannot earn a market return on such interbank lending, they don’t participate in that market. As a result, liquidity in the interbank lending market is low, and banks can no longer be confident that they can obtain funds when needed. Banks are therefore reluctant to expand their SME loan portfolios because of uncertain funding.

The resulting credit crunch for SMEs is one reason unemployment remains stubbornly high. Big businesses such as Apple and IBM do not need banks to fund growth; they have no problem funding activities from internal cash resources or the bond markets. But big business does not create new jobs; the job creation comes largely from small business. So when the Fed distorts the interbank lending market by keeping rates too low, it deprives small business of working capital loans and hurts their ability to fund job creation.

Other unintended consequences of Fed policy are more opaque and insidious. One such consequence is perilous behavior by banks in search of yield. With interest rates near zero, financial institutions have a difficult time making sufficient returns on equity, and they resort to leverage, the use of debt or derivatives, to increase their returns. Leverage from debt expands a bank’s balance sheet and simultaneously increases its capital requirements. Therefore financial institutions prefer derivatives strategies using swaps and options to achieve the targeted returns, since derivatives are recorded off balance sheet and do not require as much capital as borrowings.

Counterparties to derivatives trades require high-quality collateral such as Treasury notes to guarantee contractual performance. Often the quality of assets available for these bank collateral pledges is poor. In these circumstances, the bank that wants to do the off-balance-sheet transaction will engage in an “asset swap” with an institutional investor, whereby the bank gives the investor low-rated securities in exchange for highly rated securities such as Treasury notes. The bank promises to reverse the transaction at a later date so the institutional investor can get its Treasury notes back. Once the bank has the Treasury notes, it can pledge them to the derivatives counterparty as “good collateral” and enter into the trade, thus earning high returns off balance sheet with scant capital required. As a result of the asset swap, a two-party trade turns into a three-party trade, with more promises involved, and a more complex web of reciprocal obligations involving banks and nonbank investors.

These machinations work as long as markets stay calm and there is no panic to repossess collateral. But in a liquidity crisis of the kind experienced in 2008, these densely constructed webs of interlocking obligations quickly freeze up as the demand for “good” collateral instantaneously exceeds the supply and parties scramble to dump all collateral at fire-sale prices to raise cash. As a result of the scramble to seize good collateral, another liquidity-driven panic soon begins, producing tremors in the market.

Asset swaps are just one of many ways financial institutions increase risk in the search for higher yields in low-interest-rate environments. A definitive study conducted by the IMF covering the period 1997–2011 showed that Federal Reserve low-interest-rate policy is consistently associated with greater risk taking by banks. The IMF study also demonstrated that the longer rates are held low, the greater the amount of risk taking by the banks. The study concludes that extended periods of exceptionally low interest rates of the kind the Fed has engineered since 2008 are a recipe for increased systemic risk. By manipulating interest rates to zero, the Fed encourages this search for yield and all the off-balance-sheet tricks and asset swaps that go with it. In the course of putting out the fire from the last panic, the Fed has supplied kindling for an even greater conflagration.

■ The Clouded Crystal Ball

The most alarming consequence of Fed manipulation is the prospect of a stock market crash playing out over a period of a few months or less. This could result from Fed policy based on forecasts that are materially wrong. In fact, the accuracy of Fed forecasts has long been abysmal.

If the Fed underestimates potential growth, then interest rates will be too low, with inflation and negative real interest rates a likely result. Such conditions hurt capital formation and, historically, have produced the worst returns for stocks. Conversely, if the Fed overestimates potential growth, then policy will be too tight, and the economy will go into recession, which hurts corporate profits and causes stocks to decline. In other words, forecasting errors in either direction produce policy errors that will result in a declining stock market. The only condition that is not eventually bad for stocks is if the Fed’s forecast is highly accurate and its policy is correct—which unfortunately is the least likely scenario.

Given high expectations for equities, bank interconnectedness, and hidden leverage, any weakness in stock markets can easily cascade into a market crash. This is not certain to happen but is likely based on current conditions and past forecasting errors by the Federal Reserve.

As these illustrations show, the consequences of Federal Reserve market manipulation extend far beyond policy interest rates. Fed policy punishes savings, investment, and small business. The resulting unemployment is deflationary, although the Fed is desperately trying to promote inflation. This nascent deflation strengthens the dollar, which then weakens the dollar price of gold and other commodities, making the deflation worse.

Conversely, Fed policies intended to promote inflation in the United States, partly through exchange rates, make deflation worse in the economies of U.S. trading partners such as Japan. These trading partners fight back by cheapening their own currencies. Japan is currently the most prominent example. The Japanese yen crashed 33 percent against the U.S. dollar in an eight-month stretch from mid-September 2012 to mid-May 2013. The cheap yen was intended to increase inflation in Japan through higher import prices for energy. But it also hurt Korean exports from companies such as Samsung and Hyundai that compete with Japanese exports from Sony and Toyota. This caused Korea to cut interest rates to cheapen its currency, and so on around the world, in a blur of rate cuts, money printing, imported inflation, and knock-on effects triggered by Fed manipulation of the world’s reserve currency. The result is not effective policy; the result is global confusion.

The Federal Reserve defends its market interventions as necessary to overcome market dysfunctions such as those witnessed in 2008 when liquidity evaporated and confidence in money market-funds collapsed. Of course, it is also true that the 2008 liquidity crisis was itself the product of earlier Fed policy blunders starting in 2002. While the Fed is focused on the intended effects of its policies, it seems to have little regard for the unintended ones.

■ The Asymmetric Market

In the Fed’s view, the most important part of its program to mitigate fear in markets is communications policy, also called “forward guidance,” through which the Fed seeks to amplify easing’s impact by promising it will continue for sustained periods of time, or until certain unemployment and inflation targets are reached. The policy debate over forward guidance as an adjunct to market manipulation is a continuation of one of the most long-standing areas of intellectual inquiry in modern economics. This inquiry involves imperfect information or information asymmetry: a situation in which one party has superior information to another that induces suboptimal behavior by both parties.

This field took flight with a 1970 paper by George Akerlof, “The Market for ‘Lemons,’” that chose used car sales as an example to make its point. Akerlof was awarded the Nobel Prize in Economics in 2001 in part for this work. The seller of a used car, he states, knows perfectly well whether the car runs smoothly or is of poor quality, a “lemon.” The buyer does not know; hence an information asymmetry arises between buyer and seller. The unequal information then conditions behavior in adverse ways. Buyers might assume that all used cars are lemons, otherwise the sellers would hang on to them. This belief causes buyers to lower the prices they are willing to pay. Sellers of high-quality used cars might reject the extra-low prices offered by buyers and refuse to sell. In an extreme case, there might be no market at all for used cars because buyers and sellers are too far apart on price, even though there would theoretically be a market-clearing price if both sides to the transaction knew all the facts.

Used cars are just one illustration of the asymmetric information problem, which can apply to a vast array of goods and services, including financial transactions. Interestingly, gold does not suffer this problem because it has a uniform grade. Absent fraud, there are no “lemons” when it comes to gold bars.

A touchstone for economists since 1970, Akerlof’s work has been applied to numerous problems. The implications of his analysis are profound. If communication can be improved, and information asymmetries reduced, markets become more efficient and perform their price discovery functions more smoothly, reducing costs to consumers.

In 1980 the challenge of analyzing information’s role in efficient markets was picked up by a twenty-six-year-old economist named Ben S. Bernanke. In a paper called “Irreversibility, Uncertainty, and Cyclical Investment,” Bernanke addressed the decision-making process behind an investment, asking how uncertainty regarding future policy and business conditions impedes such investment. This was a momentous question. Investment is one of the four fundamental components of GDP, along with consumption, government spending, and net exports. Of these components, investment may be the most important because it drives GDP not only when the investment is made, but in future years through a payoff of improved productivity. Investment in new enterprises can also be a catalyst for hiring, which can then boost consumption through wage payments from investment profits. Any impediments to investment will have a deleterious effect on the growth of the overall economy.

Lack of investment was a large contributor to the duration of the Great Depression. Scholars from Milton Friedman and Anna Schwartz to Ben Bernanke have identified monetary policy as a leading cause of the Depression. But far less work has been done on why the Great Depression lasted so long compared to the relatively brief depression of 1920. Charles Kindleberger correctly identified the cause of the protracted nature of the Great Depression as regime uncertainty. This theory holds that even when market prices have declined sufficiently to attract investors back into the economy, investors may still refrain because unsteady public policy makes it impossible to calculate returns with any degree of accuracy. Regime uncertainty refers to more than just the usual uncertainty of any business caused by changing consumer preferences, or the more-or-less efficient execution of a business plan. It refers to the added uncertainty caused by activist government policy ostensibly designed to improve conditions that typically makes matters worse.

The publication date of Bernanke’s paper, 1980, is poised in the midst of the three great periods of regime uncertainty in the past one hundred years: the 1930s, the 1970s, and the 2010s.

In the 1930s this uncertainty was caused by the erratic on-again-off-again nature of the Hoover-Roosevelt interventionist policies of price controls, price subsidies, labor laws, gold confiscation, and more, exacerbated by Supreme Court decisions that supported certain programs and voided others. Even with huge pools of unused labor and rock-bottom prices, capitalists sat on the sidelines in the 1930s until the policy uncertainty cloud was lifted by duress during the Second World War and finally by tax cuts in 1946. It was only when government got out of the way that the U.S. economy finally escaped the Great Depression.

In the 1970s the U.S. economy was experiencing another episode of extreme regime uncertainty. This episode lasted ten years, beginning with Nixon’s 1971 wage and price controls and abandonment of the gold standard, and continuing through Jimmy Carter’s 1980 crude oil windfall profit tax.

The same malaise afflicts the U.S. economy today due to regime uncertainty caused by budget battles, health care regulation, tax policy, and environmental regulation. The issue is not whether each policy choice is intrinsically good or bad. Most investors can roll with the punches when it comes to bad policy. The core issue is that investors do not know which policy will be favored and therefore cannot calculate returns with sufficient clarity to risk capital.

In his 1980 paper, Bernanke began his analysis by recapitulating the classic distinction between risk and uncertainty first made by Frank H. Knight in 1921. In Knight’s parlance, risk applies to random outcomes that investors can model with known probabilities, while uncertainty applies to random outcomes with unknown probabilities. An investor is typically willing to confront risk but may be paralyzed in the face of extreme uncertainty. Bernanke’s contribution was to construct the problem as one of opportunity cost. Investors may indeed fear uncertainty, but they may also have a fear of inaction, and the costs of inaction may exceed the costs of plunging into the unknown. Conversely, the costs of inaction may be reduced by the benefits of awaiting new information. In Bernanke’s formulation, “It will pay to invest… when the cost of waiting… exceeds the expected gains from waiting. The expected gain from waiting is the probability that [new] information… will make the investor regret his decision to invest…. The motive for waiting is… concern over the possible arrival of unfavorable news.”

This passage is the Rosetta stone for interpreting all of Bernanke’s policies relating to monetary policy during his time as chairman of the Federal Reserve. After 2008, Bernanke’s Fed would increase the cost of waiting by offering investors zero return on cash, and it would reduce the cost of moving ahead by offering forward guidance on policy. By increasing the costs of waiting and reducing the costs of moving ahead, Bernanke would tip the scales in favor of immediate investment and help the economy grow through the jobs and incomes that go with such investment. Bernanke would be the master planner who pushes capitalists back into the investment game. He showed his hand when he wrote, “It would not be difficult to recast our example of the… economy in an equilibrium business cycle mold. As given, the economy… is best thought of as being run by a central planner.”

Bernanke’s logic is deeply flawed because it supposes that the agency that reduces uncertainty does not also add to uncertainty by its conduct. When the Fed offers forward guidance on interest rates, how certain can investors be that it will not change its mind? When the Fed says it will raise interest rates upon the occurrence of certain conditions, how certain can investors be that those conditions will ever be satisfied? In trying to remove one type of uncertainty, the Fed merely substitutes a new uncertainty related to its ability to perform the first task. Uncertainty about future policy has been replaced with uncertainty about the reliability of forward guidance. This may be the second derivative of uncertainty, but it is uncertainty nonetheless, made worse by dependence on planners’ whims rather than the market’s operation.

An important paper by Robert Hall of Stanford University, delivered at the Fed’s Jackson Hole gathering in August 2013, demonstrates the counterproductive nature of Bernanke’s reasoning. Hall’s paper makes the point that the decision to hire a new worker implicitly involves a calculation by the employer of the present value of the worker’s future output. Present value calculations depend on the discount rates used to convert future returns into current dollars. But uncertainty caused by the Fed’s policy flip-flops makes the discount rate difficult to ascertain and causes employers to reduce or delay hiring. In effect, the Fed’s efforts to stimulate the economy are actually retarding it.

Free markets matter not because of ideology but because of efficiency; they are imperfect, yet they are better than the next best thing. Akerlof illustrates the costs of information asymmetry at one point in time, while Bernanke shows the costs of information uncertainty over time. Both are correct about these theoretical costs, but both ignore the full costs of trying to fix the problem with government intervention. Akerlof was at least humble about these limitations, while Bernanke exhibited a central planner’s hubris throughout his career.

Adam Smith and Friedrich Hayek warned of the impossibility of the Fed’s task and the dangers of attempting it, but Charles Goodhart points to a greater danger. Even the central planner requires market signals to implement a plan. A Soviet-style clothing commissar who orders that all wool socks be the color green might be interested to know that green is deeply unpopular and the socks will sit on the shelves. The Fed relies on price signals too, particularly those related to inflation, commodity prices, stock prices, unemployment, housing, and many other variables. What happens when you manipulate markets using price signals that are the output of manipulated markets? This is the question posed by Goodhart’s Law.

The central planner must suspend belief in one’s own intervention to gather information about the intervention’s effects. But that information is a false signal because it is not the result of free-market activity. This is a recursive function. In plain English, the central planner has no option but to drink his own Kool-Aid. This is the great dilemma for the Federal Reserve and all central banks that seek to direct their economies out of the new depression. The more these institutions intervene in markets, the less they know about real economic conditions, and the greater the need to intervene. One form of Knightian uncertainty is replaced by another. Regime uncertainty becomes pervasive as capital waits for the return of real markets.

Unlike Shakespeare’s Salanio, we can no longer trust what the markets tell us. That’s because those who control them do not trust the markets themselves; Yellen and the rest have come to think their academic hand is more powerful than Adam Smith’s invisible one. The result has been the slow demise of market utility that, in turn, presages the slow demise of the real economy—and of the dollar.

■ History’s Burden

To contemporary Western eyes, China appears like a monolithic juggernaut poised to dominate East Asia and surpass the West in wealth and output in a matter of years. In fact, China is a fragile construct that could easily descend into chaos, as it has many times before. No one is more aware of this than the Chinese themselves, who understand that China’s future is highly uncertain.

China’s is the longest continuous civilization in world history, encompassing twelve major dynasties, scores of minor ones, and hundreds of rulers and regimes. Far from being homogeneous, however, China is composed of countless cultures and ethnicities, comprising a dense, complex network of regions, cities, towns, and villages linked by trade and infrastructure, that has avoided the terminal discontinuities of other great civilizations, from the Aztec to the Zimbabwe.

A main contributor to the longevity of Chinese civilization is the in-and-out nature of governance consisting of periods of centralization, followed by periods of decentralization, then recentralization, and so on across the millennia. This history is like the action of an accordion that expands and contracts while playing a single song. The tendency to decentralize politically has given Chinese civilization the robustness needed to avoid a complete collapse at the center, characteristic of Rome and the Inca. Conversely, an ability to centralize politically has prevented thousands of local nodes from devolving into an agrarian mosaic, disparate and disconnected. China ebbs and flows but never disappears.

Recognizing the Chinese history of centralization, disintegration, and reemerging order is indispensible to understanding China today. Western financial analysts often approach China with an exaggerated confidence in market data and not enough historical perspective to understand its cultural dynamics. The Zhou Dynasty philosopher Lao Tzu expressed the Chinese sense of history in the Tao Te Ching—“Things grow and grow, but each goes back to its root.” Appreciating that view is no less important today.

The centralized ancient dynasties include the Zhou, from around 1100 B.C.; the Qin, from 221 B.C.; and the Han, which immediately followed the Qin and lasted until A.D. 220. In the middle period of Chinese civilization came the centralized Sui Dynasty in A.D. 581 and the Tang Dynasty, which followed the Sui in A.D. 618. The past millennium has been characterized more by political centralization than disorder, under four great centralized dynasties. These began with Kublai Khan’s legendary Yuan Dynasty in 1271 and continued through the Ming in 1378, the Qing in 1644, and the Communist Dynasty in 1949.

Famous episodes of decentralization and discord include the Warring States period around 350 B.C., when fourteen kingdoms competed for power in an area between the Yangtze and Huang He Rivers. Six hundred years later, in A.D. 220, another decentralized phase began with the Three Kingdoms of the Wei, Shu, and Wu, followed by rivalries between the former Qin and the rising Jin Dynasties. Instability was intermittent through the sixth century, with fighting among the Chen, Northern Zhou, Northern Qi, and Western Liang kingdoms, before another unified period began with the Sui Dynasty. A final period of disunity arose around A.D. 923, when eight kingdoms competed for power in eastern and central China.

However, discord was not limited to the long decentralized periods. Even the periods of centralization included disorderly stages that were suppressed or that marked a tumultuous transition from one dynasty to another. Possibly the most dangerous of these episodes was the Taiping Rebellion, from 1850 to 1864. The origins of this rebellion, which turned into a civil war, seem incredible today. A candidate for the administrative elite, Hong Ziuquan, repeatedly failed the imperial examination in the late 1830s, ending his chance to join the scholars who made up the elite. He later attributed his failure to a vision that told him he was the younger brother of Jesus. With help from friends and a missionary, he began a campaign to rid China of “devils.” Throughout the 1840s he attracted more followers and began to exert local autonomy in opposition to the ruling Qing Dynasty.

By 1850, Hong’s local religious sect had emerged as a cohesive military force and began to win notable victories against Qing armies. The Taiping Heavenly Kingdom was declared, with its capital in Nanjing. The Heavenly Kingdom, which exercised authority over more than 100 million Chinese in the south, moved to seize Shanghai in August 1860. The attack on Shanghai was repulsed by Qing armies, now led and advised by European commanders, supplemented with Western troops and arms. By 1864, the rebellion had been crushed, but the cost was great. Scholarly estimates of those killed in the rebellion range from 20 million to 40 million.

A similarly chaotic stage emerged in the so-called Warlord Period of 1916 to 1928, when China was centrally governed in name only. Power was contested by twenty-seven cliques led by warlords, who allied and broke apart in various combinations. Not until Chiang Kai-shek and the National Revolutionary Army finally defeated rival warlords in 1928 was a semblance of unity established. Even then the Chinese Communist Party, which had been ruthlessly purged by Chiang in 1927, managed to survive in southern enclaves before undertaking the Long March, a strategic retreat from attacking Nationalist forces, finally finding refuge in the Shaanxi Province of north-central China.

The most recent period of decentralized political chaos arose in the midst of the Communist Dynasty during the Cultural Revolution of 1966 to 1976. In this chaotic period, Mao Zedong mobilized youth cadres called Red Guards to identify and root out alleged bourgeois and revisionist elements in government, military, academic, and other institutional settings. Millions were killed, tortured, degraded, or forcibly relocated from cities to the countryside. Historic sites were looted and artifacts smashed in an effort to “destroy the old world and forge the new world,” in the words of one slogan. Only with Mao’s death in 1976, and the arrest of the radical Gang of Four, who briefly seized power after Mao’s death, were the flames of cultural and economic destruction finally extinguished.

Historical memories of these turbulent episodes run deep in the minds of China’s leadership. This explains the brutal suppressions of nations such as Tibet, cultures such as the Uighurs, and spiritual sects such as Falun Gong. The Communist Party does not know when the next Heavenly Kingdom might arise, but they fear its emergence. The slaughter of students and others in Tiananmen Square in 1989 sprang from this same insecurity. A protest that in the West would have been controlled with tear gas and arrests was to Communist officials a movement that could have cascaded out of control and therefore justified lethal force to suppress.

David T. C. Lie, a senior princeling, the contemporary offspring of Communist revolutionary heroes, recently said in Shanghai that the current Communist leadership’s greatest fear is not the U.S. military but a volatile convergence of migrant workers and Twitter mobile apps. China has over 200 million migrant workers who live in cities without official permission to do so, and they can be forcibly returned to the countryside on Communist Party orders. China exercises tight control over the Internet, but mobile apps, transmitting through 4G wireless mobile broadband channels, are more difficult to monitor. This combination of rootless workers and uncontrolled broadband is no less dangerous in official eyes than the zeal of a failed mandarin who believed he was the brother of Jesus Christ. This potential for instability is why economic growth is paramount to China’s leadership—growth is the counterweight to emerging dissent.

Prior to 1979, the Chinese economy operated on the “iron rice bowl” principle. The leadership did not promise high growth, jobs, or opportunities; instead, it promised sufficient food and life’s basic necessities. Collective farms, forced labor, and central planning were enough to deliver on these promises, but not much more. Stability was the goal, and growth was an afterthought.

Beginning in 1979, Deng Xiaoping broke the iron rice bowl and replaced it with a growth-driven economy that would not guarantee food and necessities so much as provide people the opportunity to find them on their own. It was not a free market by any means, and there was no relaxation of Communist Party control. Still, it was enough to allow local managers and foreign buyers to utilize both cheap labor and imported know-how in order to create comparative advantage in a wide range of tradable manufactured goods.

The China Miracle resulted. Chinese GDP rose from $263 billion in 1979 to $404 billion in 1990, $1.2 trillion in 2000, and over $7.2 trillion in 2011, an astounding twenty-seven-fold increase in just over thirty years. Total Chinese economic output now stands at about half the size of the U.S. economy. This high Chinese growth rate has led to numerous extrapolations and estimates of a date in the not-so-distant future when the Chinese economy will surpass that of the United States in total output. At that point, say the prognosticators, China will resume its role in the first rank of global powers, a position it held in the long-ago days of the Ming Dynasty.

Extrapolation is seldom a good guide to the future, and these predictions may prove premature. Close examination of the economic growth process from a low base shows that such growth is not a miracle at all. If reasonable policies of the kind used in Singapore and Japan had substituted for the chaos of the Cultural Revolution, high growth could have happened decades sooner. Today the same analytic scrutiny raises doubts about China’s ability to continue to grow at the torrid pace of recent years.

Dynamic processes such as economic growth are subject to abrupt changes, for better or worse, based on the utilization or exhaustion of factors of production. This was pointed out in a classic 1994 article by Princeton professor Paul Krugman called “The Myth of Asia’s Miracle.” This article was widely criticized upon publication for predicting a slowdown in Chinese growth, but it has proved prophetic.

Krugman began with the basic point that growth in any economy is the result of increases in labor force participation and productivity. If an economy has a stagnant labor force operating at a constant level of productivity, it will have constant output but no growth. The main drivers of labor force expansion are demographics and education, while the main drivers of productivity are capital and technology. Without those factor inputs, an economy cannot expand. But when those factor inputs are available in abundance, rapid growth is well within reach.

By 1980, China was poised to absorb a massive influx of domestic labor and foreign capital, with predictably positive results. Such a transition requires training that starts with basic literacy and ultimately includes the development of technical and vocational skills. The fact that China had over half a billion peasants in 1980 did not necessarily mean that those peasants could turn into factory workers overnight. The transition also requires housing and transportation infrastructure. This takes time, but by 1980 the process had begun.

As labor flowed into the cities in the 1980s and 1990s, capital was mobilized to facilitate labor productivity. This capital came from private foreign investment, multilateral institutions such as the World Bank, and China’s domestic savings. Finance capital was quickly converted into plant, equipment, and infrastructure needed to leverage the expanding labor pool.

As Krugman points out, this labor-capital factor input model is a two-edged sword. When the factors are plentiful, growth can be high, but what happens when the factors are in scarce supply? Krugman answers with the obvious conclusion—as labor and capital inputs slow down, growth will do the same. While Krugman’s analysis is well known to scholars and policy makers, it is less known to Wall Street cheerleaders and the media. Those extrapolating high growth far into the future are ignoring the inevitable decline in factor inputs.

For example, five factory workers assembling goods by hand will result in a certain output level. If five peasants then arrive from the countryside and join the existing factory labor force using the same hand assembly technique, then output will double since there are twice as many workers performing the same task. Now assume the factory owner acquires machines that replace hand assembly with automated assembly, then trains his workers to use the machines. If each machine doubles output versus hand assembly, and every worker gets one machine, output will double again. In this example, factory output has increased 400 percent, first by doubling the labor force, then by automating the process. As Krugman explains, this is not a “miracle.” It is a straightforward process of expanding labor and productivity.

This process does have limits. Eventually, new workers will stop arriving from the countryside, and even if workers are available, there may be physical or financial constraints on the ability to utilize capital. Once every worker has a machine, additional machines do not increase output if workers can use only one at a time. Economic development is more complex than this example suggests, and many other forces affect the growth path. But the fundamental paradigm, that fewer inputs equals lower growth, is inescapable.

China is now nearing this point. This does not mean growth will cease, merely that it will decelerate to a sustainable level. China has put itself in this position because of its one-child-per-family policy adopted in 1978, enforced until recently with abortion and the murder of millions of girls. That drop in population growth beginning thirty-five years ago is affecting the adult workforce composition today. The results are summarized in a recent report produced by the IMF:

Importantly, when labor force participation levels off, technology is the only driver of growth. The United States also faces demographic headwinds due to declining birth rates, but it is still able to expand the labor force 1.5 percent per year, partly through immigration, and it retains the potential to grow even faster through its technological prowess. In contrast, China has not proved adept at inventing new technologies despite its success at stealing existing ones. The twin engines of growth—labor and technology—are both beginning to stall in China.

Still, official statistics show China growing in excess of 7 percent per year, a growth rate that advanced economies can only watch with envy. How can these sky-high growth rates be reconciled with the decline of labor and capital factor inputs that Krugman predicted almost twenty years ago? To answer this, one must consider not only the factor inputs but the composition of growth. As defined by economists, GDP consists of consumption, investment, government spending, and net exports. Growth in any or all of those components contributes to growth in the economy. How does China appear to increase these components when the factor inputs are leveling off? It does so with leverage, debt, and a dose of fraud.

To understand how, consider the composition of China’s GDP compared with those of developed economies such as the United States. In the United States, consumption typically makes up 71 percent of GDP, while in China, the consumption component is 35 percent, less than half the United States’. Conversely, investment typically makes up 13 percent of U.S. GDP, while in China investment is an enormous 48 percent of the total. Net exports are about 4 percent of the economy in the United States and China, except the signs are reversed. China has a trade surplus that adds 4 percent to GDP, while the United States has a trade deficit that subtracts 4 percent from GDP. In concise terms, the U.S. economy is driven by consumption, and the Chinese economy is driven by investment.

Investment can be a healthy way to grow an economy since it has a double payoff. GDP grows when the investment is first made, then grows again from the added productivity that the original investment provides in future years. Still, this kind of investment-led expansion is not automatic. Much depends on the quality of the investment: whether it in fact adds to productivity or whether it is wasted—so-called malinvestment. Evidence from recent years is that China’s infrastructure investment involves massive waste. Even worse, this investment has been financed with unpayable debt. This confluence of wasted capital and looming bad debt makes the Chinese economy a bubble about to burst.

■ The Investment Trap

The recent history of Chinese malinvestment marks a new chapter in the repeated decline of Chinese civilization. This new story revolves around the rise of a Chinese warlord caste, financial not military in kind, that acts in its own self-interest rather than in China’s interest. The new financial warlords operate through bribery, corruption, and coercion. They are a cancer on the Chinese growth model and the so-called Chinese miracle.

After the 1949 Communist takeover of China, all businesses were owned and operated by the state. This model prevailed for thirty years, until Deng Xiaoping’s economic reforms began in 1979. In the decades that followed, state-owned enterprises (SOEs) took one of three paths. Some were closed or merged into larger SOEs to achieve efficiencies. Certain SOEs were privatized and became listed companies, while those remaining as SOEs grew powerful as designated “national champions” in particular sectors.

Among the best known of these super-SOEs are the China State Shipbuilding Corporation, the China National Petroleum Corporation, the China Petrochemical Corporation (SINOPEC), and China Telecom. There are more than one hundred such giant government-owned corporations in China under centralized state administration. In 2010 the ten most profitable SOEs produced over $50 billion in net profits. The super-SOEs are further organized into sixteen megaprojects intended to advance technology and innovation in China. These megaprojects cover sectors such as broadband wireless, oil and gas exploration, and large aircraft manufacture.

Regardless of the path taken by state enterprise, corruption and cronyism permeated the process. Managers of SOEs that were privatized received sweetheart deals, including share allocations ahead of the public listing, and executive appointments in the privatized entity. For the enterprises that remained as SOEs, opportunities for corruption were even more direct. Board members and executive officers were political appointees, and the SOEs were protected against foreign and domestic competition. SOEs received cheap financing from government-owned banks and got orders for goods and services from government agencies as well as other SOEs. The result was a dense, complex network of government officials, Communist Party princelings, and private owner-managers, all being enriched by Chinese growth. The elites became a parasite class gorging themselves at the expense of an otherwise healthy and normal growth process.

The rise of a parasitic elite is closely linked to the prevalence of malinvestment. The need for the Chinese economy to rebalance from investment to consumption, as urged by the IMF and other official institutions, has run headlong into the self-interest of the elites who favor infrastructure because it keeps the profits flowing at their steel, aluminum, and other heavy industrial enterprises. The new financial warlords are addicted to the profits of infrastructure, even as economists lament the lack of growth in services and consumption. The fact that this problem is recognized does not mean that it will be managed well. As in all societies, including the United States, elite interests can prevail over national interests once elite political power is entrenched.

Specific examples of infrastructure projects illustrate the waste. Nanjing is one of the largest cities in China, with a population approaching seven million. It is also one of the most historically significant cities, having served as China’s capital under several dynasties as well as capital of the Taipei Rebellion’s Heavenly Kingdom. More recently, Nanjing was the seat of government, intermittently from 1912 to 1949, during the Chinese Republic of Dr. Sun Yat-sen and later Chiang Kai-shek.

While Nanjing has many of the same problems of pollution and uncontrolled growth of other Chinese cities, it is altogether more pleasant, with abundant parks, museums, and broad, tree-lined boulevards built under imperial influence during the late nineteenth century. Nanjing lies on the Beijing-Shanghai high-speed railway line and is easily reached from both cities. It is among the most important political, economic, and educational hubs in China today.

Immediately south of Nanjing proper lies the Jiangning district, site of one of the most ambitious infrastructure projects now under way in China. Jiangning consists of seven new cities, still under construction, connected by a highway network and an underground metro. Each city has its own cluster of skyscrapers, luxury shopping malls, five-star hotels, man-made lakes, golf courses, recreation centers, and housing and science facilities. The entire metroplex is served by the Nanjing South Railway Station to the north and a newly constructed airport to the south. A visitor cannot help but be impressed with the project’s scale, the quality of the finished phases, and the rapidity with which the entire project is being completed. What struck one as odd on a recent visit is that all of these impressive facilities were empty.

Provincial officials and project managers gladly escort interested parties on a new city tour to explain the possibilities. One laboratory is pointed out as the future source of Chinese wireless broadband technology. Another skyscraper is eagerly described as a future incubator for a Chinese alternative asset management industry. An unfinished hotel is also said to be taking reservations for world-class conferences with A-list speakers from around the world.

Meanwhile the visitor stares out at miles of mud flats, with poured concrete and steel rebar footings for dozens more malls, skyscrapers, and hotels. This vision of seven new cities would be daunting enough—until one realizes that Nanjing is among dozens of cities all over China building similar metroplexes on a mind-boggling scale. The Chinese have earned a reputation around the world as master builders to rival the Pharaoh Ramesses II.

The Nanjing South Railway Station is not empty, but it also illustrates China’s deficient approach to infrastructure development. In 2009 China was reeling from the same collapse in global demand that had affected the United States after the Panic of 2008. Its policy response was a ¥4 trillion stimulus program, equal to about $600 billion, directed mainly at investment in infrastructure. The United States launched an $800 billion stimulus program at the same time. However, the U.S. economy is more than twice as large as China’s, so on a comparative basis, China’s stimulus was the equivalent of $1.2 trillion applied to the United States. Four years after the program was launched, results are now visible in projects like the Beijing-Shanghai high-speed railroad and the Nanjing South Railway Station.

The station has 4.9 million square feet of floor space and 128 escalators; it generates over 7 megawatts of power from solar panels on the roof. Ticketing and entry to platforms are highly automated and efficient. The new trains are not only fast but also comfortable and quiet, even at their top speed of 305 kilometers per hour. Importantly, the station took two years to build, using a force of 20,000 workers. If the object of such infrastructure is to create short-term jobs rather than transportation profits, the Nanjing South station might be judged a qualified success. The long-term problem is that a high-speed train ticket from Shanghai to Nanjing costs the equivalent of thirty dollars, while a journey of similar length in the United States costs two hundred dollars. The debt incurred by China to build this monumental train station can never be paid with these deeply discounted fares.

Chinese officials rebut the excess capacity criticism by saying that they are building high-quality infrastructure for the long term. They point out that even if it takes five to ten years to fully utilize the capacity, the investment will prove to have been well founded. But it remains to be seen if such capacity will ever be used.

Apart from the infrastructure’s sheer scale, China’s vision of expanding the science and technology sectors of the economy faces institutional and legal impediments. The high-tech wireless broadband laboratory in Jiangning is a case in point. The research facility has massive buildings with spacious offices, conference rooms, and large labs surrounded by attractive grounds and efficient transportation. Local officials assure visitors that fifteen hundred scientists and support staff will soon arrive, but the most talented technologists require more than nice premises. These scientists will want an entrepreneurial culture, close proximity to cutting-edge university research, and access to the kind of start-up financial mentoring that comes with more than just a checkbook. Whether or not these x-factors can be supplied along with the buildings is an open question. Another problem with building for the long run is that obsolescence and depreciation may overtake the projects while they await utilization.

China’s political leaders are aware that wasted infrastructure spending has permeated the Chinese economy. But like political leaders elsewhere, they are highly constrained in their response. The projects do create jobs, at least in the short run, and no politician wants to preside over a policy that causes job losses, even if it will result in healthier long-run outcomes. Too often in politics everything is short-term, and the long run is ignored.

Meanwhile the infrastructure projects are a windfall for the princelings, cronies, and cadres who run the SOEs. The projects require steel, cement, heavy equipment, glass, and copper. The building spree is beneficial to the producers of such materials and equipment, and their interests always favor more construction regardless of costs or benefits. China has no market discipline to slow down these interests or redirect investment in more beneficial ways. Instead China has an elite oligarchy that insists that its interests be served ahead of the national interest. The political elite’s capacity to stand up to this economic elite is limited because the two are frequently intertwined. Bloomberg News has exposed the interlocking interests of the political and economic elites through cross-ownership, family ties, front companies, and straw man stockholders. Saying no to a greedy businessman is one thing, but denying a son, daughter, or friend is another. China’s dysfunctional system for pursuing infrastructure at all costs is hard-wired.

China can continue its infrastructure binge because it has unused borrowing capacity with which to finance new projects and to paper over losses on the old ones. But there are limits to expansion of this kind, and the Chinese leadership is aware of them.

In the end, if you build it, they may not come, and a hard landing will follow.

■ Shadow Finance

Behind this untenable infrastructure boom is an even more precarious banking structure used to finance the overbuilding. Wall Street analysts insist that the Chinese banking system shows few signs of stress and has a sound balance sheet. China’s financial reserves, in excess of $3 trillion, are enormous and provide sufficient resources to bail out the banking system if needed. The problem is that China’s banks are only part of the picture. The other part consists of a shadow banking system of bad assets and hidden liabilities large enough to threaten the stability of China’s banks and cause a financial panic with global repercussions. Yet the opacity of the system is such that not even Chinese banking regulators know how large and how concentrated the risks are. That will make the panic harder to stop once it arrives.

Shadow banking in China has three tributaries consisting of local government obligations, trust products, and wealth management products. City and provincial governments in China are not allowed to incur bonded debt in the same fashion as U.S. states and municipalities. However, local Chinese authorities use contingent obligations such as implied guarantees, contractual commitments, and accounts payable to leverage their financial condition. Trust products and wealth management products are two Chinese variants of Western structured finance.

The Chinese people have a high savings rate, driven by rational motives rather than any irrational or cultural traits. The rational motives include the absence of a social safety net, adequate health care, disability insurance, and retirement income. Historically the Chinese counted on large families and respect for elders to support them in their later years, but the one-child policy has eroded that social pillar, and now aging Chinese couples find that they are on their own. A high savings rate is a sensible response.

But like savers in the West, the Chinese are starved for yield. The low interest rates offered by the banks, a type of financial repression also practiced in the United States, make Chinese savers susceptible to higher-yielding investments. Foreign markets are mostly off-limits because of capital controls, and China’s own stock markets have proved highly volatile, performing poorly in recent years. China’s bond markets remain immature. Instead, Chinese savers have been attracted by two asset classes—real estate and structured products.

The bubble in Chinese property markets, especially apartments and condos, is well known, but not every Chinese saver is positioned to participate in that market. For them, the banking system has devised trust structures and “wealth management products” (WMPs). A WMP is a pool or fund in which investors buy small units. The pool then takes the aggregate proceeds and invests in higher-yielding assets. Not surprisingly, the assets often consist of mortgages, properties, and corporate debt. In the WMP, China has an unregulated version of the worst of Western finance. WMPs resemble the collateralized debt obligations, collateralized loan obligations, and mortgage-backed securities, so-called CDOs, CLOs, and MBSs, that nearly destroyed Western capital markets in 2008. They are being sold in China without even the minimal scrutiny required by America’s own incompetent rating agencies and the SEC.

The WMPs are sponsored by banks, but the related assets and liabilities do not appear on the bank balance sheets. This allows the banks to claim they are healthy when in fact they are building an inverted pyramid of high-risk debt. Investors are attracted by the higher yields offered in WMPs. They assume that because the WMPs are sponsored and promoted by the banks, the principal must be protected by the banks in the same manner as deposit insurance. But both the high yield and the principal protection are illusory.

The investors’ funds going into the WMPs are being used to finance the same wasted infrastructure and property bubbles that the banks formerly financed before recent credit-tightening measures were put in place. The cash flows from these projects are often too scant to meet the obligations to the WMP investors. The maturities of the WMPs are often short-term while the projects they invest in are long-term. The resulting asset-liability maturity mismatch would create a potential panic scenario if investors refused to roll over their WMPs when they mature. This is the same dynamic that caused the failures of Bear Stearns and Lehman Brothers in the United States in 2008.

Bank sponsors of WMPs address the problems of nonperforming assets and maturity mismatches by issuing new WMPs. The new WMP proceeds are then used to buy the bad assets of the old WMPs at inflated values so the old WMPs can be redeemed at maturity. This is a Ponzi scheme on a colossal scale. Estimates are that there were twenty thousand WMP programs in existence in 2013 versus seven hundred in 2007. One report on WMP sales in the first half of 2012 estimates that almost $2 trillion of new money was raised.

The undoing of any Ponzi scheme is inevitable, and the Chinese property and infrastructure bubbles fueled by shadow banking are no exception. A collapse could begin with the failure of a particular rollover scheme or with exposure of corruption associated with a particular project. The exact trigger for the debacle is unimportant because it is certain to happen, and once it commences, the catastrophe will be unstoppable without government controls or bailouts. Not long after a crackup begins, investors typically line up to redeem their certificates. Bank sponsors will pay the first ones in line, but as the line grows longer in classic fashion, the banks will suspend redemptions and leave the majority with worthless paper. Investors will then claim that the banks guaranteed the principal, which the banks will deny. Runs will begin on the banks themselves, and regulators will be forced to close certain banks. Social unrest will emerge, and the Communist Party’s worst nightmare, a replay of the spontaneous Taiping Rebellion or Tiananmen Square demonstrations, will then loom.

China’s $3 trillion in reserves are enough to recapitalize the banks and provide for recovery of losses in this scenario. China has additional borrowing power at the sovereign level to deal with a crisis if needed, while China’s credit at the IMF is another source of support. In the end, China has the resources to suppress the dissent and clean up the financial mess if the property Ponzi plays out as described.

But the blow to confidence will be incalculable. Ironically, savings will increase, not decrease, in the wake of a financial collapse, because individuals will need to save even more to make up their losses. Stocks will plunge as investors sell liquid assets to offset the impact of now-illiquid WMPs. Consumption will collapse at exactly the moment the world is waiting for Chinese consumers to ride to the rescue of anemic world growth. Deflation will beset China, making the Chinese even more reluctant to allow their currency to strengthen against trading partners, especially the United States. The damage to confidence and growth will not be confined to China but will ripple worldwide.

■ Autumn of the Financial Warlords

The Chinese elites understand these vulnerabilities and see the chaos coming. This anticipation of financial collapse in China is driving one of the greatest episodes of capital flight in world history. Chinese elites and oligarchs, and even everyday citizens, are getting out while the getting is still good.

Chinese law prohibits citizens from taking more than $50,000 per year out of the country. However, the techniques for getting cash out of China, through either legal or illegal means, are limited only by the imagination and creativity of those behind the capital flight. Certain techniques are as direct as stuffing cash in a suitcase before boarding an overseas flight. The Wall Street Journal reported the following episode from 2012:

In another vignette, a Chinese brewery billionaire flew from Shanghai to Sydney, drove an hour into the countryside to see a vineyard, bid $30 million for the property on the spot, and promptly returned to Shanghai as quickly as he had arrived. It is not known if the oligarch preferred wine to beer, but he preferred Australia to China when it came to choosing a safe haven for his wealth.

Other capital flight techniques are more complicated but no less effective. A favorite method is to establish a relationship with a corrupt casino operator in Macao, where a high-rolling Chinese gambler can open a line of credit backed by his bank account. The gambler then proceeds deliberately to lose an enormous amount of money in a glamorous game such as baccarat played in an ostentatious VIP room. The gambling debt is promptly paid by debiting the gambler’s bank account in China. This transfer is not counted against the annual ceiling on capital exports because it is viewed as payment of a legitimate debt. The “unlucky” gambler later recovers the cash from the corrupt casino operator, minus a commission for the money-laundering service rendered.

Even larger amounts are moved offshore through the mis-invoicing of exports and imports. For example, a Chinese furniture manufacturer can create a shell distribution company in a tax haven jurisdiction such as Panama. Assuming the normal export price of each piece of furniture is $200, the Chinese manufacturer can underinvoice the Panamanian company and charge only $100 for each piece. The Panamanian company can then resell into normal distribution channels for the usual price of $200 per piece. The $100 “profit” per piece resulting from the underinvoicing is then left to accumulate in Panama. With millions of furniture items shipped, the accumulated phony profit in Panama can reach into the hundreds of millions of dollars. This is money that would have ended up in China but for the invoicing scheme.

Capital flight by elites is only part of a much larger story of income inequality between elites and citizens in China. In urban areas, the household income of the top 1 percent is twenty-four times the average of all urban households. Nationwide, the disparity between the top 1 percent and the average household is thirty times. These wide gaps are based on official figures. When hidden income and capital flight are taken into account, the disparities are even greater. The Wall Street Journal reported:

Minxin Pei, a China expert at Claremont McKenna College, states that corruption, cronyism, and income inequality in China today are so stark that social conditions closely resemble those in France just before the French Revolution. The overall financial, social, and political instability is so great as to constitute a threat to the continued rule of China’s Communist Party.

Chinese authorities routinely downplay these threats from malinvestment in infrastructure, asset bubbles, overleverage, corruption, and income inequality. While they acknowledge that these are all significant problems, officials insist that corrective actions are being taken and that the issues are manageable in relation to the overall size and dynamic growth of the Chinese economy. These threats are viewed as growing pains in the birth of a new China as opposed to an existential crisis in the making.

Given the history of crashes and panics in both developed and emerging markets over the past thirty years, Chinese leaders may be overly sanguine about their ability to avoid a financial disaster. The sheer scale and interconnectedness of SOEs, banks, government, and citizen savers has created a complex system in the critical state, waiting for a spark to start a conflagration. Even if the leadership is correct in saying that these specific problems are manageable in relation to the whole, they must still confront the fact that the entire economy is unhealthy in ways that even the Communist Party cannot easily finesse. The larger issue for China’s leadership is the impossibility of rebalancing the economy from investment to consumption without a sharp decline in growth. This slowdown, in effect the feared hard landing, is an event for which neither the Communists nor the world at large is prepared.

Understanding the challenge of rebalancing requires taking another look at China’s infrastructure addiction. Evidence for overinvestment by China is not limited to anecdotes about colossal train stations and empty cities. The IMF conducted a rigorous analytic study of capital investment by China compared to a large sample of thirty-six developing economies, including fourteen in Asia. It concluded that investment in China is far too high and has come at the expense of household income and consumption, stating, “Investment in China may currently be around 10 percent of GDP higher than suggested by fundamentals.”

There is also no mystery about who is to blame for the dysfunction of overinvestment. The IMF study points directly at the state-controlled banks and SOEs, the corrupt system of crony lending and malinvestment that is visible all over China: “State-owned enterprises (SOEs) tend to be consistently implicated… because their implied cost of capital is artificially low…. China’s banking system continues to be biased toward them in terms of capital allocation.” State-controlled banks are funneling cheap money to state-owned enterprises that are wasting the money on overcapacity and the construction of ghost cities.

Even more disturbing is the fact that this infrastructure investment is not only wasteful, it is unsustainable. Each dollar of investment in China produces less in economic output than the dollar before, a case of diminishing marginal returns. If China wants to maintain its GDP growth rates in the years ahead, investment will eventually be well in excess of 60 percent of GDP. This trend is not a mere trade-off between consumption and investment. Households deferring consumption to support investment so that they may consume more later is a classic development model. But China’s current investment program is a dysfunctional version of the healthy investment model. The malinvestment in China is a deadweight loss to the economy, so there will be no consumption payoff down the road. China is destroying wealth with this model.

Households bear the cost of this malinvestment, since savers receive a below-market interest rate on their bank deposits so that SOEs can pay a below-market interest rate on their loans. The result is a wealth transfer from households to big business, estimated by the IMF to be 4 percent of GDP, equal to $300 billion per year. This is one reason for the extreme income inequality in China. So the Chinese economy is caught in a feedback loop. Elites insist on further investment, which produces low payoffs, while household income lags due to wealth transfers to those same elites. If GDP were reduced by the amount of malinvestment, the Chinese growth miracle would already be in a state of collapse.

Nevertheless, collapse is coming. Michael Pettis of Peking University has done an interesting piece of arithmetic based on the IMF’s infrastructure research. In the first instance, Pettis disputes the IMF estimate of 10 percent of GDP as the amount of Chinese overinvestment. He points out that the peer group of countries used by the IMF to gauge the correct level of investment may have overinvested themselves, so actual malinvestment by China is greater than 10 percent of GDP. Still, accepting the IMF conclusion that China needs to reduce investment by 10 percent of GDP, he writes:

The suggestion that China needs to rebalance its economy away from investment toward consumption is hardly news; both U.S. and Chinese policy makers have discussed this for years. The implication is that rebalancing means a slowdown in Chinese growth from the 7 percent annual rate it has experienced in recent years. But it may already be too late to accomplish the adjustment smoothly; China’s “rebalancing moment” may have come and gone.

Rebalancing requires a combination of higher household income and a lower savings rate. The resulting disposable income can then go into spending on goods and services. The contributors to higher income include higher interest rates to reward savers and higher wages for workers. But the flip side of higher interest rates and higher wages is lower corporate profits, which negatively impacts the Chinese oligarchs. These oligarchs apply political pressure to keep wages and interest rates low. In the past decade, the share of Chinese GDP attributable to wages has fallen from over 50 percent to 40 percent. This compares to a relatively constant rate in the United States of 55 percent. The consumption situation is even worse than the averages imply, because Chinese wages are skewed to high earners with a lower propensity to spend.

Another force, more powerful than financial warlords, is standing in the way of consumer spending. This drag on growth is demographic. Both younger workers and older retirees have a higher propensity to spend. It is workers in their middle years who maintain the highest savings rate in order to afford additional consumption later in life. The Chinese workforce is now dominated by that midcareer demographic. In effect, China is stuck with a high savings rate until 2030 or later for demographic reasons, independent of policy and the greed of the oligarchs.

Based on these demographics, the ideal moment for China to shift to a consumption-led growth model was the period 2002 to 2005. This was precisely the time when the productive stage of the investment-led model began to run out of steam, and a younger demographic favored higher spending. A combination of higher interest rates to reward savers, a higher exchange rate to encourage imports, and higher wages for factory workers to increase spending might have jump-started consumption and shifted resources away from wasted investment. Instead, oligarchs prevailed to press interest rates, exchange rates, and wages below their optimal levels. A natural demographic boost to consumption was thereby suppressed and squandered.

Even if China were to reverse policy today, which is highly doubtful, it faces an uphill climb because the population, on average, is now at an age that favors savings. No policy can change these demographics in the short run, so China’s weak consumption crisis is now locked in place.

Taking into account the components of GDP, China is seen to be nearing collapse on many fronts. Consumption suffers from low wages and high savings due to demographics. Exports suffer from a stronger Chinese yuan and from external efforts to weaken the dollar and the Japanese yen. Investment suffers from malinvestment and diminishing marginal returns. To the extent that the economy is temporarily propped up by high investment, this is a mirage built on shifting sands of bad debt. The value of much investment in China is as empty as the buildings it produces. Even the beneficiaries of this dysfunction—the financial warlords—are like rats abandoning a sinking ship through the medium of capital flight.

China could respond to these dilemmas by raising interest rates and wages to boost household income, but these policies, while helping the people, would bankrupt many SOEs, and the financial warlords would steadfastly oppose them. The only other efficacious solution would be large-scale privatization, designed to unleash entrepreneurial energy and creativity. But this solution would be opposed not only by the warlords but by the Communist Party itself. Opposition to privatization is where the self-interest of the warlords and the Communists’ survival instincts converge.

Four percent growth may be the best that China can hope for going forward, and if the financial warlords have their way, the results will be much worse. Continued subsidies for malinvestment and wage suppression will exacerbate the twin crises of bad debt and income inequality, possibly igniting a financial panic leading to social unrest, even revolution. China’s reserves may not be enough to douse the flames of financial panic, since most of those reserves are in dollars and the Fed is determined to devalue the dollar through inflation. China’s reserves are being hollowed out by the Fed even as its economy is being hollowed out by the warlords. It is unclear if the Chinese growth miracle will end with a bang or with a whimper, but it will end nonetheless.

China is not the first civilization to ignore its own history. Centralization engenders complexity, and a densely connected web of reciprocal adaptations are the essence of complex systems. A small failure in any part quickly propagates through the whole, and there are no firebreaks or high peaks to stop the conflagration. While the Communist Party views centralization as a source of strength, it is the most pernicious form of weakness, because it blinds one to the coming collapse.

China has fallen prey to the new financial warlords, who loot savings with one hand and send the loot abroad with the other. The China growth story is not over, but it is heading for a fall. Worse yet, the ramifications will not be confined to China but will ripple around the world. This will come at a time when growth in the United States, Japan, and Europe is already anemic or in decline. As in the 1930s, the depression will go global, and there will be nowhere to hide.

■ The First Reich

Those blithely predicting the breakup of Europe and the euro would do well to understand that we are witnessing the apotheosis of a project first begun twelve hundred years ago. A long view of history repeating itself reveals why the euro is the strongest currency in the world. Today the euro waits in the wings, one more threat to the hegemony of the dollar.

Europe has been united before: not all of it in the geographic sense, but enough to constitute a distinct European polity in contrast to a mere city, kingdom, or country in the area called Europe. That unity arose in Charlemagne’s Frankish Empire, the Frankenreich, near the turn of the ninth century. The similarities of Charlemagne’s empire to twenty-first-century Europe are striking and instructive to those, especially in the United States, who struggle to understand European dynamics today.

While many focus on the divisions, nationalities, and distinct cultures within Europe, a small group of leaders, supported by their citizens, continue the work of European unification begun in the ashes of the Second World War. “United in diversity” is the European Union’s official motto, and the word united is the theme most often overlooked by the critics and skeptics of a political project now in its eighth decade. Markets are powerful, but politics are more so, and this truth is slowly becoming more apparent on trading floors in London, New York, and Tokyo. Europe and its currency, the euro, despite their flaws and crises, are set to endure.

Charlemagne, a late eighth- and early ninth-century Christian successor to the Roman emperors, was the first emperor in the West following the fall of the Western Roman Empire in A.D. 476. The Roman Empire was not a true European empire but a Mediterranean one, although it extended from the Roman heartland to provinces in present-day Spain, France, and even England. Charlemagne was the first emperor to include parts of present-day Germany, the Netherlands, and the Czech Republic with the former Roman provinces and Italy, to form a unified entity along geographic lines that resemble modern western Europe. Charlemagne is called, by popes and laymen alike, pater Europae, the Father of Europe.

Charlemagne was more than a king and conqueror, although he was both. He prized literacy and scholarship as well as the arts, and he created a court at Aachen comprised of the finest minds of the early Middle Ages such as Saint Alcuin of York, considered “the most learned man anywhere” by Charlemagne’s contemporary and biographer, Einhard. The achievements of Charlemagne and his court in education, art, and architecture gave rise to what historians call the Carolingian Renaissance, a burst of light to end an extended dark age. Importantly, Charlemagne understood the significance of uniformity throughout his empire for ease of administration, communication, and commerce. He sponsored a Carolingian minuscule script that supplanted numerous forms of writing that had evolved in different parts of Europe, and he instituted administrative and military reforms designed to bind the diverse cultures he had conquered into a cohesive realm.

Charlemagne did not pursue his penchant for uniformity past the point necessary for stability. He advocated diversity if it aided his larger goals pertaining to education and religion. He promoted the use of vernacular Romance and German languages by priests, a practice later abandoned by the Catholic Church (and belatedly revived in 1965 by the Second Vatican Council). He accepted vassalage from conquered foes in lieu of destroying their cultures and institutions. In these respects, he embraced a policy the European Union today calls subsidiarity: the idea that uniform regulation should be applied only in areas where it is necessary to achieve efficiencies for the greater good; otherwise local custom and practice should prevail.

Charlemagne’s monetary reforms should seem quite familiar to the European Central Bank. The European monetary standard prior to Charlemagne was a gold sou, derived from solidus, a Byzantine Roman coin introduced by Emperor Constantine I in A.D. 312. Gold had been supplied to the Roman Empire since ancient times from sources near the Upper Nile and Anatolia. However, Islam’s rise in the seventh century, and losses in Italy to the Byzantine Empire, cut off trade routes between East and West. This resulted in a gold shortage and tight monetary conditions in Charlemagne’s western empire. He engaged in an early form of quantitative easing by switching to a silver standard, since silver was far more plentiful than gold in the West. He also created a single currency, the livre carolinienne, equal to a pound of silver, as a measure of weight and money, and the coin of the realm was the denire, equal to one-twentieth of a sou. With the increased money supply and standardized coinage, along with other reforms, trade and commerce thrived in the Frankish Empire.

Charlemagne’s empire lasted only seventy-four years beyond his death in A.D. 814. The empire was initially divided into three parts, each granted to one of Charlemagne’s sons, but a combination of early deaths, illegitimate heirs, fraternal wars, and failed diplomacy led to the empire’s long decline and final dissolution in 887. Still, the political foundations for modern France and Germany had been laid. The Frankenreich’s legacy lived on until it took a new form with the creation of the Holy Roman Empire and the coronation of Otto I as emperor in 962. That empire, the First Reich, lasted over eight centuries, until it was dissolved by Napoleon in 1806. By reviving Roman political unity and advancing arts and sciences, Charlemagne and his realm were the most important bridge between ancient Rome and modern Europe.

Notwithstanding the institutions of the Holy Roman Empire, the millennium after Charlemagne can be seen largely as a chronicle of looting, war, and conquest set against a background of intermittent ethnic and religious slaughter. The centuries from 900 to 1100 were punctuated by raids and invasions led by Vikings and their Norman descendants. The period 1100 to 1300 was dominated by the Crusades abroad and knightly combat at home. The fourteenth century saw the Black Death, which killed from one-third to one-half the population of Europe. The epoch starting with the Counter-Reformation in 1545 was especially bloody. Doctrinal conflicts between Protestants and Catholics turned violent in the French Wars of Religion from 1562 to 1598, then culminated in the Thirty Years’ War from 1618 to 1648, a Europe-wide, early modern example of total war, in which civilian populations and nonmilitary targets were destroyed along with armies.

The sheer suffering and inhumanity of these latter centuries is captured in this description of the siege of Sancerre in 1572. Sancerre’s starving population successively ate their donkeys, mules, horses, cats, and dogs. Then the sancerrois consumed leather, hides, and parchment documents. Lauro Martines, citing the contemporary writer, Jean de Léry, describes what came next:

These bloodbaths were followed by the wars of Louis XIV, waged continually from 1667 to 1714, in which the Sun King pursued an explicit policy of conquest aimed at reuniting France with territory once ruled by Charlemagne.

The European major litany of carnage continued with the Seven Years’ War (1754–63), the Napoleonic Wars (1803–15), the Franco-Prussian War (1870–71), the First World War, the Second World War, and the Holocaust. By 1946, Europe was spiritually and materially exhausted and looked back with disgust and horror at the bitter fruits of nationalism, chauvinism, religious division, and anti-Semitism.

France was involved in every one of these wars, and Franco-German conflict was at the heart of the three most recent, in 1870, 1914, and 1939, all occurring within a seventy-year span, a single lifetime. After the Second World War, while the U.K. wrestled with the demise of its own empire and a U.S.-Soviet condominium descended in the form of the Iron Curtain and the Cold War, Continental statesmen, economists, and intellectuals confronted the central question of how to avoid yet another war between France and Germany.

■ The New Europe

A first step toward a unified, federal Europe took place in 1948 with the Hague Congress, which included public intellectuals, professionals, and politicians from both left and right in a broad-based discussion of the potential for political and economic union in Europe. Winston Churchill, Konrad Adenauer, and François Mitterrand, among many others, took part. This was followed in 1949 by the founding of the College of Europe, an elite postgraduate university dedicated to the promotion of solidarity among western European nations and the training of experts to implement that mission. Behind both the Hague Congress and the College of Europe were the statesmen Paul-Henri Spaak, Robert Schuman, Jean Monnet, and Alcide De Gasperi.

The great insight of these leaders was that economic integration would lead to political integration, thereby making war obsolete, if not impossible.

The first concrete step toward economic integration was the European Coal and Steel Community (ECSC), launched in 1952. Its six original members were France, West Germany, Italy, Belgium, Luxembourg, and the Netherlands. The ECSC was a common market for coal and steel, two of the largest industries in Europe at the time. In 1957 it was joined by the European Atomic Energy Community (Euratom), dedicated to developing the nuclear energy industry in Europe, and also by the European Economic Community (EEC), created by the Treaty of Rome and devoted to creating a common market in Europe for goods and services beyond coal and steel.

In 1967 the Merger Treaty unified the ECSC, Euratom, and the EEC under the name of the European Communities (EC). The 1992 Maastricht Treaty recognized the European Communities as one of the “three pillars” of a new European Union (EU), along with Police and Judicial Cooperation, and a Common Foreign and Security Policy (CFSP), formed as the representative of the new EU to the rest of the world. Finally, in 2009, the Lisbon Treaty merged the three pillars into the sole legal entity of the European Union and named a European Council president to direct general objectives and policies.

Alongside this economic and political integration was an equally ambitious effort at monetary integration. At the heart of monetary union is the European Central Bank (ECB), envisioned in the 1992 Maastricht Treaty and legally formed in 1998 pursuant to the Treaty of Amsterdam. The ECB issues the euro, which is a single currency for the eighteen nations that are Eurozone members. The ECB conducts monetary policy with a single mandate to maintain price stability in the Eurozone. It also trades in foreign exchange markets as needed to affect the euro’s value relative to other currencies. The ECB manages the foreign exchange reserves of the eighteen national central banks in the Eurozone and operates a payments platform among those banks called TARGET2.

At present, Europe’s most tangible and visible symbol is the euro. It is literally held, exchanged, earned, or saved by hundreds of millions of Europeans daily, and it is the basis for trillions of euros in transactions conducted by many millions more around the world. In late 2014 the ECB will occupy its new headquarters building, almost six hundred feet high, located in a landscaped enclave in eastern Frankfurt. The building is a monument to the permanence and prominence of the ECB and the euro.

Many market analysts, Americans in particular, approach Europe and the euro through the lens of efficient-markets theory and standard financial models—but with a grossly deficient sense of history. The structural problems in Europe are real enough, and analysts are right to point them out. Glib solutions from the likes of Nobelists Paul Krugman and Joseph Stiglitz—that nations like Spain and Greece should exit the Eurozone, revert to their former local currencies, and devalue to improve export competitiveness—ignore how these nations got to the euro in the first place. Italians and Greeks know all too well that the continual local currency devaluations they had suffered in the past were a form of state-sanctioned theft from savers and small businesses for the benefit of banks and informed elites. Theft by devaluation is the technocratic equivalent of theft by looting and war that Europeans set out to eradicate with the entire European project. Europeans see that there are far better options to achieve competitiveness than devaluation. The strength of this vision is confirmed by the fact that pro-euro forces have ultimately prevailed in every democratic election or referendum, and pro-euro opinion dominates poll and survey results.

Charlemagne’s enlightened policies of uniformity, in combination with the continuity of local custom, exist today in the EU’s subsidiarity principle. The contemporary EU motto, “United in diversity,” could as well have been Charlemagne’s.

■ From Bretton Woods to Beijing

The euro project is a part of the more broadly based international monetary system, which itself is subject to considerable stress and periodic reformation. Since the Second World War, the system has passed through distinct phases known as Bretton Woods, the Washington Consensus, and the Beijing Consensus. All three of these phrases are shorthand for shared norms of behavior in international finance, what are called the rules of the game.

The Washington Consensus arose after the collapse of the Bretton Woods system in the late 1970s. The international monetary system was saved between 1980 and 1983 as Paul Volcker raised interest rates, and Ronald Reagan lowered taxes, and together they created the sound-dollar or King Dollar policy. The combination of higher interest rates, lower taxes, and less regulation made the United States a magnet for savings from around the world and thereby rescued the dollar. By 1985, the dollar was so strong that an international conference was held at the Plaza Hotel in New York in order to reduce its value. This was followed by another international monetary conference in 1987, at the Louvre in Paris, that informally stabilized exchange rates. The Plaza and Louvre Accords cemented the new dollar standard, but the international monetary system was still ad hoc and in search of a coherent set of principles.

In 1989 the missing intellectual glue for the new dollar standard was provided by economist John Williamson. In his landmark paper, “What Washington Means by Policy Reform,” Williamson prescribed the “Washington Consensus” for good behavior by other countries, in the new world of the dollar standard. He made his meaning explicit in the opening paragraphs:

It is hard to imagine a more blunt statement of global dollar hegemony emanating from Washington, D.C. The omission of any reference to nations other than the United States, or any institution other than those controlled by the United States, speaks to the state of international finance in 1989 and the years that followed.

Williamson went on to describe what Washington meant by debtors “setting their houses in order.” He set forth ten policies that made up the Washington Consensus. These policies included commonsense initiatives such as fiscal discipline, elimination of wasteful subsidies, lower tax rates, positive real interest rates, openness to foreign investment, deregulation, and protection for property rights. The fact that these policies favored free-market capitalism and promoted the expansion of U.S. banks and corporations in global markets did not go unnoticed.

By the early 2000s, the Washington Consensus was in tatters due to the rise of emerging market economies that viewed dollar hegemony as favoring the United States at their expense. This view was highlighted by the IMF response to the Asian financial crisis of 1997–98, in which IMF austerity plans resulted in riots and bloodshed in the cities of Jakarta and Seoul.

Washington’s failure over time to adhere to its own fiscal prescriptions, combined with the acceleration of Asian economic growth after 1999, gave rise to the Beijing Consensus as a policy alternative to the Washington Consensus. The Beijing Consensus comes in conflicting versions and lacks the intellectual consistency that Williamson gave to the Washington Consensus. Author Joshua Cooper Ramo is credited with putting the phrase Beijing Consensus into wide use with his seminal 2004 article on the subject. Ramo’s analysis, while original and provocative, candidly admits that the definition of Beijing Consensus is amorphous: “the Beijing Consensus… is flexible enough that it is barely classifiable as a doctrine.”

Despite the numerous economic elements thrown into the stew of the Beijing Consensus, Ramo’s most important analytic contribution was the recognition that the new economic paradigm was not solely about economics but rather was fundamentally geopolitical. The ubiquitous John Williamson expanded on Ramo in 2012 by defining the five pillars of the Beijing Consensus as incremental reform, innovation, export-led growth, state capitalism, and authoritarianism.

As viewed from China, the Beijing Consensus is a curious blend of seventeenth-century Anglo-Dutch mercantilism and Alexander Hamilton’s eighteenth-century American School development policies. As interpreted by the Chinese Communist Party, it consists of protection for domestic industry, export-driven growth, and massive reserve accumulation.

No sooner had policy intellectuals defined the Beijing Consensus than it began to break down due to internal contradictions and deviations from the original mercantilist model. China used protectionism to support infant industries as Hamilton recommended, but it failed to follow Hamilton’s support for domestic competition. Hamilton used protectionism to give new industries time to establish themselves, but he relied on competition to make them grow stronger so they could eventually hold their own in international trade. In contrast, Chinese elites coddled China’s “national champions” to the point that most are not globally competitive without state subsidies. By 2012, the deficiencies and limits of the Beijing Consensus were plain to see, although the policies were still widely practiced.

■ The Berlin Consensus

By 2012, a new Berlin Consensus emerged from the ashes of the 2008 global financial crisis and the European sovereign debt crises of 2010–11. The Berlin Consensus has no pretensions to be a global one-size-fits-all economic growth model; rather it is highly specific to Europe and the evolving institutions of the EU and Eurozone. In particular, it represents the imposition of the successful German model on Europe’s periphery through the intermediation of Brussels and the ECB. German chancellor Angela Merkel has summarized her efforts under the motto of “More Europe,” but it would be more accurate to say that the project is about more Germany. The Berlin Consensus cannot be fully implemented without structural adjustments in order to make the periphery receptive and complementary to the German model.

The Berlin Consensus, as conceived in Germany and applied to the Eurozone, consists of seven pillars:

• Promotion of exports through innovation and technology

• Low corporate tax rates

• Low inflation

• Investment in productive infrastructure

• Cooperative labor-management relations

• Globally competitive unit labor costs and labor mobility

• Positive business climate

Each one of the seven pillars implies policies designed to promote specific goals and produce sustained growth. These policies, in turn, presuppose certain monetary arrangements. At the heart of the Berlin Consensus is a recognition that savings and trade, rather than borrowing and consumption, are the best path to growth.

Taking the elements of the Berlin Consensus singly, one begins with the emphasis on innovation and technology as the key to a robust export sector. German companies such as SAP, Siemens, Volkswagen, Daimler, and many others exemplify this ethic. The World Intellectual Property Organization (WIPO) reports that six of the top ten applicants for international trademark protection in 2012 were EU members. Of 182,112 applications filed under the WIPO Patent Cooperation Treaty in 2011, 27.5 percent were filed by EU members, 26.8 percent by the United States, and 9.0 percent by China. The EU’s attainments in university education, basic research, and intellectual property are now on a par with those of the United States and well ahead of China’s.

Intellectual property drives economic growth only to the extent that business can utilize it to create value-added products. A key factor in the ability of business to drive productivity through innovation is a low corporate tax rate. Statutory tax rates are an imperfect guide because they may be higher than the tax rate actually paid due to deductions, credits, and depreciation allowances; still, the statutory rate is a good starting place for analysis. Here Europe once again stands out favorably. The average European corporate tax rate is 20.67 percent, compared to 40 percent for the United States and 25 percent for China, once local income taxes are added to national taxes. Corporations in the EU are predominantly taxed on a national basis, meaning tax is paid to a host country only based on profits made in that country, which contrasts favorably with the U.S. system of global taxation, in which a U.S. corporation pays tax on foreign as well as domestic profits.

Both the EU and the United States have managed to maintain low inflation in recent years, but Europe has done so with significantly less money printing and yield-curve manipulation, which means its potential for future inflation based on changes in the turnover or velocity of money is reduced. In contrast, China has had a persistent problem with inflation due to Chinese efforts to absorb Federal Reserve money printing to maintain a peg between the yuan and the dollar. Of the three largest economic zones, the EU has the best track record on inflation both in terms of recent experience and prospects going forward.

The EU’s approach to infrastructure investment has resulted in higher quality and more productive investment than that of either the United States or China. Because large infrastructure projects in Europe typically involve cross-border collaboration, they tend to be more economically rational and less subject to political pressures. A prominent example is the Gotthard Base Tunnel, scheduled to open in 2017, which will run thirty-four miles end to end beneath the Swiss Alps, which tower ten thousand feet above it. The tunnel will be the longest in the world and has rightly been compared to the Panama Canal and the Suez Canal as a world-historic achievement in the advancement of transportation infrastructure for the benefit of trade and commerce. Although the Gotthard Base Tunnel lies entirely in Switzerland, it is a critical link in a Europe-wide high-speed rail transportation network.

For passengers, the tunnel will cut an hour off the current three-hour-and-forty-minute travel time from Milan to Zurich. For rail freight traffic, the tunnel will increase annual capacity through the Gotthard Pass by 250 percent, from the current 20 million tons to a projected 50 million tons. The Gotthard Base Tunnel will be linked to scores of high-speed rail corridors coordinated by the EU’s Trans-European high-speed rail network, called TEN-R. These and many similar European infrastructure projects compare favorably in terms of long-term payoffs with Chinese ghost cities and the U.S. practice of wasted investments such as solar cell maker Solyndra and electric car maker Fisker, which both filed for bankruptcy.

The German labor-management coordination model for large enterprises, called Mitbestimmung, or codetermination, has been in place since the end of the Second World War. It was expanded significantly in 1976 with the requirement that worker delegates hold board seats of any corporation with more than five hundred employees. Codetermination does not replace unions but complements them by allowing worker input in corporate decision making in a regular and continuous way, in addition to the sporadic and often disruptive processes of collective bargaining and occasional strikes. The model is unique to Germany and may not be copied specifically by other EU members. What is significant about codetermination for Europe is not the exact model but the example it sets with regard to improving productivity and competitiveness for business. The German model compares favorably with that of China, where workers have few rights, and the United States, where labor-management relations are adversarial rather than cooperative.

Of the Berlin Consensus pillars, the one most difficult to engender in the EU as a whole, especially in the periphery, is the efficient labor pillar including lower unit labor costs. Here the policy is to force internal adjustment through lower nominal wages in euros, rather than external adjustment either by devaluing the euro or by abandoning it in favor of local currencies in countries such as Greece or Spain. Keynesians have argued that wages are “sticky” and do not respond to normal supply and demand forces. Paul Krugman puts the conventional Keynesian view as follows:

As with much of Keynesianism, this analysis applies at best to the special case of heavily unionized labor in closed markets rather than nonunion labor in more open markets. With regard to Europe, Krugman misses the most important point. The emphasis on sticky wages and pay cuts assumes the workers involved already have or had jobs. In Spain, Italy, Greece, Portugal, France, and elsewhere, millions of well-educated youth have never had a job. This labor pool does not have any anchored expectations about how much one should be making. Any job with decent working conditions, training, and possibilities for advancement will prove attractive, even at wages that an older generation might have rejected.

The second part of the efficient labor pillar of the Berlin Consensus is labor mobility. As long ago as 1961, Robert Mundell highlighted its importance to a single-currency area in his landmark article “A Theory of Optimum Currency Areas”:

Although this article was written almost forty years before the euro’s launch, the implications for the Eurozone are pertinent. When the terms of trade turn adverse to the periphery and in Germany’s favor, either the periphery will have unemployment or Germany will have inflation, or there will be a combination of the two. Since Germany indirectly controls the ECB and has so far been unwilling to tolerate inflation, rising unemployment in the periphery is inevitable.

Mundell, however, also pointed out that the solution to this dilemma is capital and labor factor mobility across national boundaries. If capital could shift from Germany to Spain to take advantage of abundant labor, or if labor could shift from Spain to Germany to take advantage of abundant capital in the form of plant and equipment, then the unemployment problem could be solved without inflation. EU directives and use of the euro have gone far toward increasing the mobility of capital. However, Europe has lagged behind the rest of the developed world in mobility-of-labor terms, partly due to linguistic and cultural differences among the national populations. This problem is widely recognized, and because steps are being taken to improve labor mobility within the EU, prospects for growth are greater than many observers believe.

This brings the analysis to the final element of the Berlin Consensus—a positive business climate. What economists call regime uncertainty is a principal differentiator between long, anemic depressions and short, sharp ones. Monetary policy and fiscal policy uncertainty can negatively impact an economy, as was seen in the United States during the Great Depression of 1929 to 1940, and as is being seen again in the depression that began in 2007. But policy cannot improve an economy if businesses are unwilling to invest capital and create the new jobs associated with such investment. Once the panic phase of a financially induced depression is over, the greatest impediment to capital investment is uncertainty about policy regimes related to matters such as taxes, health care, regulation, and other costs of doing business. Both the United States and the EU suffer from regime uncertainty. The Berlin Consensus is designed to remove as much uncertainty as possible by providing for price stability, sound money, fiscal responsibility, and uniformity across Europe on important regulatory matters.

In turn, a positive business climate becomes a magnet for capital not just from local entrepreneurs and executives but also from abroad. This points to an emerging driver of EU growth harnessed to the Berlin Consensus—Chinese capital. As the Beijing Consensus collapses and Chinese capital seeks a new home, Chinese investors looks increasingly to Europe. Chinese leaders realize they have overinvested in U.S.-dollar-denominated assets; they also know they cannot divest those assets quickly. But at the margin they can invest new reserves in diverse ways, including euro-denominated assets. China was in no hurry to prop up a flailing Eurozone in 2011, but now that the EU has stabilized, they find the euro an attractive alternative to dollar-denominated assets. The Washington Post reported on this phenomenon in 2013:

The Wall Street Journal reported in July 2013 that the Chinese State Administration for Foreign Exchange (SAFE), which manages China’s reserves, “was an early investor in bonds issued by the European Financial Stability Fund… and has invested regularly since then in the bailout fund.” A sound euro is an important attraction for Chinese capital because a stable currency mitigates exchange-rate risk to investors. Indeed, capital inflows from China provided support for the euro—an example of a positive feedback loop between a sound currency and capital flows.

Increasing capital inflows to the Eurozone were not limited to those coming from China. The U.S. money-market industry has also been investing heavily in the Eurozone. After panicked outflows in 2011, the ten largest money-market funds in the United States almost doubled their investments in the Eurozone between the summer of 2012 and early 2013.

The Berlin Consensus is taking root in Europe, based on the seven pillars and directed as much from the EU in Brussels as from Berlin, to mitigate resentment of Germany’s economic dominance. The consensus is powered by a virtuous troika of German technology, periphery youth labor, and Chinese capital. It receives its staying power from a farsighted blend of low inflation, sound money, and positive real interest rates. The new Berlin Consensus has the potential to replicate the Wirtschaftswunder, Germany’s “economic miracle” reconstruction after the Second World War, on a continental scale.

German chancellor Angela Merkel was born during German reconstruction in the 1950s, grew up in Communist East Germany, and had firsthand experience with German reunification in the 1990s. Few political leaders anywhere have her experience in facing such daunting development challenges. She is now turning those skills to the greatest development challenge of all: growing the European periphery and preserving the euro at the same time.

■ The Euro Skeptics

Europe may have the will to preserve both its unity and the euro, but does it have the means? Events since the 2008 financial crisis have raised considerable doubt in many quarters about Europe’s capacity to deal with successive crises, notwithstanding the overriding political objectives of the Berlin Consensus. A close examination reveals that these doubts are misplaced, and that the euro project is considerably more durable than the critics suppose.

Foreign exchange and debt markets have existed in a state of continual turmoil since the global sovereign debt crisis erupted with the announcement of default by Dubai World on November 27, 2009. Any visitor to Dubai in the months leading up to the default could see the real estate bubble forming, in the shape of a skyline with miles of empty office buildings and luxury condos for sale. Investors assumed that Dubai, with oil wealth provided by rich neighbors in Abu Dhabi, would muddle through, but it did not. Its collapse became contagious, spreading to Europe and Greece in particular.

By early 2010, serious fraud had been uncovered in Greece’s national accounting, enabled by off-the-books swaps provided by Goldman Sachs and other Wall Street banks. It became apparent that Greece could not pay its debts without both massive structural reforms and outside assistance. The sovereign debt crisis had gone global and would soon push Ireland and Portugal to the brink of default, raising serious doubts about the public finances of the much larger economies of Spain and Italy.

Fears about sovereign finances spread quickly to the banks in those countries most affected, and a feedback loop emerged. Since the banks owned sovereign bonds, any distress in the bonds would impair bank capital. If the banks needed bailouts, the sovereign regulators would have to provide the funds. But this meant issuing more bonds, further impairing sovereign credit, which hurt bank balance sheets more, spawning a death spiral of simultaneously imploding sovereign and bank credit. Only new capital from outside sources, whose own credit was not impaired, could break the cycle.

After three years of on-again, off-again crises and contagion, the solution was finally found in the troika of the IMF, the ECB, and the EU, backstopped by Germany. The IMF obtained its funds by borrowing from nations with healthy reserve balances, such as China and Canada. The EU raised funds by pooling member resources, largely from Germany. Finally, the ECB created funds by printing money as needed. The troika members operated under the central bankers’ new mantra, “Whatever it takes.” By late 2012, the European sovereign debt and bank crisis was largely contained, although rebuilding bank balance sheets and making the required structural adjustments will take years to complete.

Despite this turmoil, the euro held up quite well, to the surprise of many analysts and investors, especially those in the United States. In July 2008 the euro reached a peak of $1.60 and remained in a trading range between $1.20 and $1.60 during the sovereign debt crisis. Throughout the turmoil, the euro always traded at a higher dollar price than where it began in 1999.

The euro has also increased its share of global reserves significantly since its issue date. The IMF maintains a data time series showing the composition of official foreign exchange reserves broken down by currency. Data for the first quarter of 1999 show that the euro comprised 18.1 percent of global allocated foreign exchange reserves. By the end of 2012, after three years of crisis, the euro’s share had risen to 23.9 percent of global reserves.

Such objective data is at odds with the histrionics produced by the Euro skeptics, and that helps explain why, by early 2013, the prophets of Euro-doom were mostly mute on the subject of a Eurozone breakup. The skeptics had committed a succession of analytic failures, easily seen even at the hysteria’s height in early 2012. The first analytic failure involved the zero-sum nature of cross exchange rates.

Beginning in 2010, the United States initiated a cheap-dollar policy, intended to import inflation from abroad in the form of higher import prices on energy, electronics, textiles, and other manufactured goods. The cheap-dollar policy was made explicit in numerous pronouncements, including President Obama’s 2010 State of the Union address, where he announced the National Export Initiative, and former Federal Reserve chairman Ben Bernanke’s Tokyo speech on October 14, 2012, in which he threatened trading partners with higher inflation if they did not allow their currencies to strengthen against the dollar. Since the United States wanted a cheap dollar, it wanted a strong euro in dollar terms. In effect, the United States was using powerful policy tools to strengthen the euro. Why this obvious point was lost on many U.S. analysts is a mystery, but a permanently weak euro was always contrary to U.S. policy.

The second analytic failure had to do with the tendency to conflate the simultaneous crises in debt, banking, and currencies. Analysts looked at defaulting sovereign bonds in Greece and at weak banks in Spain, then breezily concluded that the euro must weaken also. This is superficial: economically, there is nothing inconsistent about weak bonds, weak banks, and a strong currency.

Lehman Brothers is a case in point. In 2008 Lehman defaulted on billions of dollars in bond obligations. This default meant the end of the bonds but not the end of the dollar, since the currency in which bonds are issued has a different dynamic than the bonds themselves. A currency’s strength has more to do with central bank policy and global capital flows than with the fate of specific bonds in that currency. Analysts who treated European banks and bonds and the single currency as subject to the same distress made a fundamental error. The euro could do quite well despite the fate of Greek bonds and Irish banks.

The third analytic blind spot was a failure to recognize that capital flows dominate trade flows in setting exchange rates. Too much emphasis was placed on Europe’s perceived lack of export competitiveness, especially in the Eurozone periphery of Ireland, Portugal, Spain, Italy, Greece, and Cyprus. Export competitiveness is important when it comes to growth, but it is not the decisive factor in determining exchange rates. Capital flows to the euro from the Federal Reserve in the form of central bank swaps with the ECB, and from China in the form of reserve allocations and direct foreign investment, placed a solid floor under the euro. If the two largest economies in the world, the United States and China, did not want the euro to go down, then it would not go down.

The fourth blind spot had to do with the need to lower unit labor costs as part of the structural adjustment required to make peripheral Eurozone economies globally competitive. Euro skeptics suffer from the legacy of misguided Keynesian economics and the sticky-wage myth, technically called downward nominal wage rigidity. Keynesians rely on a theory of sticky wages to justify inflation, or theft from savers. The idea is that wages will rise during periods of inflation but will not decline easily during periods of deflation; they will tend to stick at the old nominal wage levels.

As a result, wages fail to adjust downward, employers fire workers, unemployment rises, and aggregate demand is weakened. A liquidity trap then develops, and deflation becomes worse as the cycle feeds on itself, resulting in impossibly high debt, bankruptcies, and depression. Inflation is considered advisable policy because it allows employers to give workers a nominal raise, even if there is no raise in real terms due to higher prices. Workers receive raises in nominal terms, while wages adjust downward in real terms. This is a form of money illusion or deception of workers by central banks, but it works in theory to lower real unit labor costs. As applied to Europe, the Keynesian view is that the quickest way to achieve the needed inflation is for member nations to quit the euro, revert to a former local currency, and then devalue these currencies. This was the theoretical basis for the many predictions that the euro must fail and that members would quit to help their economies grow.

In twenty-first-century economies, all aspects of this theory are flawed, starting with the premise. Sticky wages are a special case, arising in limited conditions where labor is a predominant factor input to productivity, labor substitutes do not exist, unionization is strong, globalized outsourcing is unavailable, and unemployment is reasonably low. Today all those factors are reversed.

Capital is the predominant factor input, robotics and outsourcing are readily available, and the union movement is weak in the private sector. Consequently, workers will accept lower nominal wages if that enables them to retain their jobs. This form of lowering unit labor costs is known as internal adjustment via lower wages versus external adjustment through a cheaper currency and inflation. External adjustment may have worked in the 1930s in the U.K., when Keynes first advanced his ideas on sticky wages. However, under twenty-first-century globalized conditions, internal adjustment is a far superior remedy because it treats the problem directly and avoids the exogenous costs of breaking up the Eurozone. As a case in point, on July 2, 2013, Greece’s Hellenic Statistical Authority (ELSTAT) reported that private-sector salaries in Greece had dropped an average of 22.3 percent since the first quarter of 2012, a clear refutation of the obsolete sticky-wage theories of Keynes and Krugman.

The sentiment that sticking with the euro is desirable, despite contracting economies and falling wages, is widely shared among everyday citizens in the Eurozone periphery despite the pretensions of academic theory. In 2013 Marcus Walker and Alessandra Galloni did extensive reporting on this topic for The Wall Street Journal and revealed the following:

The fifth and final analytic blind spot of the Euro skeptics was a failure to understand that the euro is—and always has been—a political project rather than an economic one and that the political will to preserve it was never in doubt. A true understanding of the euro is summarized by leading French intellectual Guy Sorman:

In sum, the euro is strong and getting stronger.

■ The Euro’s Future

This tour d’horizon of the Euro skeptics’ analytic blind spots not only rebuts their criticism of the euro but reveals the euro’s underlying strengths and future direction. These strengths are part of a larger, emergent worldview of how to prosper in a highly competitive, globalized economy.

The most encouraging reports involve Greece, the economy that was most reviled. Over $175 million of new money entered the Greek stock market between June 2012 and February 2013, and according to The Wall Street Journal, “everything from Greek real estate to energy stocks are finding buyers.” In April 2013 the troika approved the disbursement of further bailout assistance to Greece based on its progress in cutting government spending and moving toward a balanced budget. On May 14, 2013, the Fitch service upgraded Greece’s credit rating, and in a review of the Greek economy, The New York Times reported, “The drive to improve competitiveness, mainly through much lower wage costs, is finally bearing fruit, too. This is most visible in tourism, which accounts for 17 percent of gross domestic product. Revenues are expected to jump 9 percent to 10 percent this year.” Greece is also benefiting from the privatization of government-owned assets. The fifteen-hundred-acre former Athens airport site is expected to attract €6 billion of investment to establish a mixed-use development that should create more than twenty thousand well-paying jobs.

Another recent story from Greece involves events tantamount to a controlled experiment, something economists seek but seldom find. Prior to 2010, port facilities in the major Greek port of Piraeus had been owned by the government. That year the government sold half the port for €500 million to Cosco, a Chinese shipping concern, while retaining the other half. A comparison of operations in the Chinese- and Greek-controlled halves of the facility in 2012 showed a striking contrast:

This comparison perfectly illustrates the fact that there is nothing intrinsically noncompetitive about Greek workers or Greek infrastructure. Greece needs only more flexible work rules, lower unit labor costs, and new capital. Chinese capital is a conspicuous part of the solution, and Chinese investors such as Cosco are willing to commit capital when a productive business climate can be assured.

Developments in Spain are equally encouraging. Spanish unit labor costs have already dropped over 7 percent relative to Germany, and economists expect further decreases. In February 2012 Spain’s prime minister, Mariano Rajoy, implemented laws that increased labor flexibility by allowing employers to terminate workers in a downturn, reduce severance pay, and renegotiate contracts entered into during the property boom prior to 2008. The result was a drastic increase in Spain’s competitiveness in manufacturing, especially the automotive industry.

The positive effect was immediate. Renault announced plans to increase production in the northern Spanish city of Palencia. Ford Motor Company and Peugeot also announced increased production at their plants in Spain. In October 2012 Volkswagen announced an €800 million investment in its plant near Barcelona. All these investment and expansion plans will have positive ripple effects because the large manufacturers are tied to a network of parts suppliers and subcontractors throughout Spain.

The expanded employment and output as the result of lower wages in Spain is a refutation of the sticky-wage theories of Keynes and Krugman, and it is happening on a widespread scale from Greece to Ireland. Although this is a difficult and painful adjustment, the shift is sustainable, and it leaves Europe well positioned to be a globally competitive manufacturing base and magnet for capital inflows.

The Economist, along with many others, has cited adverse demographics as a major hurdle in the way of more robust European growth. Europe does have a rapidly aging society (as do Russia, Japan, China, and other major economies). Over a twenty-year horizon, the demographics of working-age populations are rigid in a closed society, which can be a large determinant of economic outcomes, but this view ignores forms of flexibility even in a closed society.

A working-age population is not the same as a workforce. When unemployment is high, as it is in much of Europe, new entrants can come into the workforce at a much higher rate than population growth, assuming jobs are available. The pools of well-educated unemployed are so large in Europe today that demography places no short-term constraints on productive labor factor inputs. As noted, improved labor mobility can also facilitate growth in the productive workforce by enabling unemployed workers in the Eurozone’s depressed regions to move to more productive regions to supply the labor needed. Immigration from eastern Europe and Turkey can supply ample labor to western Europe, much as the Chinese interior has supplied labor to Chinese coastal factories for decades. In short, demographics are not a constraint on European growth as long as there is underutilized labor, labor mobility, and immigration.

Internal economic adjustment alone may not be enough to secure the future of the euro and the EU more broadly. Expansion of the institutions of the EU will also be required, as captured in Merkel’s phrase “More Europe.” The EU is like an aircraft with a single wing; it can choose to remain grounded, or it can build the other wing. Efforts to deal with the immediate crises in 2010 and 2011, including monetary ease and multilateral bailout packages, have been sufficient to avoid a collapse, but they are not sufficient to correct the fundamental contradictions in the design of the euro and the ECB. A single currency has been shown to be dysfunctional without uniformity of fiscal policy and bank regulation, along with improved mobility of labor and capital among currency union members.

The good news is that these deficiencies are well understood by political and financial leaders in Europe and are being remedied at a rapid pace. On January 1, 2013, the EU Fiscal Stability Treaty entered into force for the sixteen EU member nations that had ratified it as of that date, including all the periphery nations. The treaty contains binding procedures requiring signatories to have budget deficits of less than 3 percent of GDP when their debt-to-GDP ratio is under 60 percent. In cases where the debt-to-GDP ratio exceeds 60 percent, the deficit must be less than 0.5 percent of GDP. The treaty also contains the so-called debt brake that requires signatories with a debt-to-GDP ratio in excess of 60 percent to reduce the ratio by 5 percent of the excess each year until the ratio is less than 60 percent. Treaty provisions are implemented and enforced at the member level for the time being, but the treaty stipulates that the members will incorporate the treaty rules in the overall EU legal framework before January 1, 2018.

An EU-wide bank deposit insurance program to mitigate banking panics is currently under consideration, as are proposals to replace separate sovereign bonds issued by Eurozone members with true Eurobonds backed by the credit of the Eurozone as whole. Action on these fronts may follow, but first further progress must be made on fiscal restraint and other market reforms.

The threads of banking union and consolidated bailout funds have begun to intertwine. In June 2013 a Euro Working Group of senior finance ministry officials from the Eurozone announced a €60 billion bailout fund to provide direct support to banks in distress.

Beyond these fiscal and banking reforms, the EU’s future is further brightened by the accession of new members either to the EU, the Eurozone, or both. In July 2013 Latvia received approval from the European Commission and the ECB to adopt the euro as its currency. Croatia officially became an EU member on July 1, 2013, and its central bank governor, Boris Vujcic, announced that Croatia wanted to move as quickly as possible to full adoption of the euro as its currency. Candidate countries whose membership in the EU is under way but not yet completed are Montenegro, Serbia, Macedonia, and Turkey. Potential candidates who do not yet meet the requirements for EU membership but are working toward conformity are Albania, Bosnia and Herzegovina, and Kosovo. In the future, it is not too much to expect that Scotland and Ukraine may apply for membership.

The EU is already the largest economic power in the world, with combined GDP greater than that of the United States and more than double that of China and Japan. Over the next ten years, the EU is destined to evolve into the world’s economic superpower, stretching from Asia Minor to Greenland and from the Arctic Ocean to the Sahara Desert.

Germany sits at the heart of this vast economic and demographic domain. While Germany cannot control the entire region politically, it will be the greatest economic power within the region. Through its indirect control of the ECB and the euro, it will dominate commerce, finance, and trade. Eurobonds will provide a deep, liquid pool of investable assets larger than the U.S. Treasury bond market. If needed, the euro can be supported by its members’ combined gold holdings, which exceed 10,000 tonnes, about 25 percent more than the U.S. Treasury’s official gold holdings. This combination of large, liquid bond markets, a sound currency, and huge gold reserves may enable the euro to displace the dollar as the world’s leading reserve currency by 2025. This prospect will hearten Russia and China, which have been seeking escape from U.S. dollar hegemony since 2009. Germany is also the key to this monetary evolution because of its insistence on sound money, and because of the example it has set of how to be an export giant without a weak currency.

Germany’s new Reich, intermediated through the EU, the euro, and the ECB, will be the greatest expression of German social, political, and economic influence since Charlemagne’s reign. Even though it will come at the expense of the dollar, the changes will be positive in most ways, because of Germany’s productivity and its adherence to democratic values. Europe’s diverse historical and cultural landscape will be preserved within an improved economic framework. With German leadership and foresight, the EU motto, “United in diversity,” will be realized in its truest form.

■ Supranational

The European Union, the United States, China, and Japan constitute a global Gang of Four that comprises 65 percent of the world’s economy. The remaining 157 nations tracked by the IMF make up the other 35 percent of global output. Among these 157 nations is a Gang of Ten consisting of Brazil, Russia, India, Canada, Australia, Mexico, Korea, Indonesia, Turkey, and Saudi Arabia, which each produce between 1 percent and 3 percent of global output. Each of the smallest 147 nations produces less than 1 percent of global output, and most produce far less. The wealth concentration among nations is as starkly skewed as it is within nations. Among the 80 percent of nations with the lowest output, any one could disappear tomorrow and the impact on global growth would scarcely be noticed.

This is important to recall when Wall Street analysts promote theses on investing in emerging markets, frontier markets, and more exotic locales. The fact is there are few significant capital markets, their capacity to absorb inflows is limited, and they have a tendency to overheat when they try to absorb more than a modest amount of capital. Yet as China heads for a hard landing, as the United States is stuck in low gear, as Japan endures its third decade in depression, and as Europe muddles through a structural adjustment, it is difficult to deny the Gang of Ten’s investment appeal, and the appeal of those not far behind, such as Poland, Taiwan, South Africa, Colombia, and Thailand.

Consider the BRICS. For convenience, as well as for marketing purposes, analysts bundle smaller nations into groups tagged with acronyms made of members’ names. BRICS is the granddaddy of such groups, consisting of Brazil, Russia, India, China, and a late entry to the club, South Africa. Each BRICS member has its own attractions and problems; what the BRICS do not have is much in common. The Russian economy is best understood as a natural-resource-extraction racket run by oligarchs and politicians who skim enormous amounts off the top and reinvest just enough to keep the game going. China has produced real growth but has also produced waste, pollution, and corruption to the point that China has an unsustainable model hostile to any foreign investor from whom it cannot steal technology. India has growth and great promise but has not come close to realizing its potential because its world-class red-tape raj stifles innovation. Among the BRICS, Brazil and South Africa come closest to being “real” economies in the sense that growth is sustainable, corruption is not completely rampant, and entrepreneurship has room to breathe.

Yet there is no denying the success of the BRICS moniker. The original term BRIC was created by Jim O’Neill and his colleagues at Goldman Sachs in 2001 to highlight the group’s share of global GDP and higher growth rates compared to established large economy groups such as the G7. But O’Neill’s analysis was not primarily economic; it was political. Beyond the basic facts about size and growth, O’Neill called for rethinking the G7’s international governance model to reduce Europe’s role and increase the role of emerging economies in a new G5 + BRICs = G9 formula.

In his proposed G9, O’Neill glossed over differences in social development, including bedrock principles such as civil rights and the rule of law, with the comment “The other members would need to recognise that not all member countries need to be the ‘same.’” He recognized that the BRICs were not at all homogeneous as economic models: “The four countries under consideration are very different economically, socially and politically.”

How O’Neill’s original work morphed from a political manifesto to an investment theme is best explained by Wall Street’s penchant for salespeople engaging their customers with a good story. But it is difficult to fault O’Neill for this; he had a political agenda, and it worked. By 2008, the G7 was practically a museum piece, and the G20, including the BRICS and others, was the de facto board of directors of the international monetary system. O’Neill correctly foresaw that in the post–Cold War, globalized world, the economic had become the political. Economic output trumped civil society and other traditional metrics of inclusion in global leadership groups. The BRICS concept was never an investment thesis so much as a political injunction, and the world took heed.

The BRICS success bred a host of acronymic imitators. Among the recent entrants in this naming derby are the BELLs, consisting of Bulgaria, Estonia, Latvia, and Lithuania; and the GIIPS of the EU periphery, consisting of Greece, Ireland, Italy, Portugal, and Spain. As a group, the GIIPS are best understood as a Eurozone subset that share the euro and are undergoing arduous internal economic adjustments. Within the GIIPS, one should distinguish between Spain and Italy on the one hand, which are true economic giants making up almost 5 percent of the global economy, and Portugal, Ireland, and Greece on the other, whose combined output is less than 1 percent of global total. On the whole, the BELLs and GIIPS have more economic factors in common than do the BRICS, and their proponents have explicit economic themes in mind versus the overtly political perspectives of O’Neill and Goldman Sachs.

■ BELLs

The BELLs are small, almost inconsequential, as their economies add up to just 0.2 percent of global GDP combined. But their geopolitical significance is enormous, since they form the EU’s eastern frontier and are the frontline states buffering Europe and the traditional eastern powers, Russia and Turkey. Unlike the BRICS, the BELLs do have much in common. In addition to being EU members, they had all fixed the value of their local currencies to the euro. Pegging to the euro has led the BELLs into the same internal adjustment and devaluation as the Eurozone periphery, since they cannot use currency devaluation as a quick fix for dealing with economic adjustment issues.

Economists lament that they cannot conduct scientific experiments on national economies because many variables cannot be controlled and processes cannot be replicated. But certain cases have enough controlled variables to produce telling results when divergent polices are pursued under similar conditions. Two such quasi-experiments involving the BELLs have played out recently. The first contrasts the BELLs and the GIIPS; the second contrasts each BELLs member to the others.

Experiments are typically conducted by controlling certain variables among all participants and measuring differences in the factors that are not controlled. The first control variable in this real-world experiment is that neither the BELLs nor the GIIPS devalued their currencies. The BELLs have maintained a local currency peg to the euro and have not devalued. Indeed, Estonia actually joined the euro on January 1, 2011, at the height of anti-euro hysteria, and Latvia joined on January 1, 2014.

The second control variable is the depth of the economic collapse in both the BELLs and the GIIPS beginning in 2008 and continuing into 2009. Each BELL suffered approximately a 20 percent decline in output in those two years, and unemployment reached 20 percent. The decline in output in the GIIPS in the same period was only slightly less. The third control variable is that both the BELLs and the GIIPS suffered an evaporation of direct foreign investment and lost access to capital markets, a shortfall that had to be made up with various forms of official assistance. In short, the BELLs and the GIIPS both experienced collapsing output, rising unemployment, and a sudden stop in foreign investment in 2008 and 2009. At the same time, the governments never seriously considered devaluation, despite wails from the pundits.

From these comparable initial conditions, divergent policies were pursued. The GIIPS initially continued so-called economic stimulus and made only slight cuts in public spending. Greece actually increased the number of government employees between 2010 and 2011. The principal way of addressing fiscal issues in the GIIPS was through tax increases. The internal adjustment process of lowering unit labor costs began in the GIIPS only in 2010, and serious fiscal and labor market reform was begun in 2013; much work remains.

In contrast, the BELLs took immediate, drastic measures to put their fiscal houses in order, and strong growth resumed as early as 2010 and is now the highest in the EU. The turnaround was dramatic. Latvia’s economy contracted 24 percent in 2008–9, but then grew over 10 percent in 2011–12. Estonia contracted 20 percent in 2008–9 but grew at a robust 7.9 percent rate in 2011. Lithuania’s economy did not suffer as much as the other BELLs in the crisis and actually grew 2.8 percent in 2008. Lithuania’s growth did decline in 2009, but it bounced back quickly and rose 5.9 percent in 2011. This pattern of collapse followed by robust growth in the Baltic BELLs is the classic V pattern that is much discussed but seldom seen in recent years because governments such as the United States use money printing to truncate the V, leaving protracted, anemic growth in its wake.

How does one account for this sharp turnaround in the Baltic states’ growth compared to the EU periphery? Anders Åslund, a scholar at the Peterson Institute for International Economics in Washington, D.C., and an expert on the eastern European and Russian economies, has written extensively on this topic. He attributes economic success in the Baltics and failure in southern Europe from 2009 to 2012 to specific factors. When confronted with severe economic contraction, he suggests, an affected nation must embrace the crisis and turn it to political advantage. Political leaders who explain clearly the economic choices to their citizens will gain support for tough policies, while leaders such as those in the United States and southern Europe who deny the problem’s depth will find that the sense of urgency recedes and that citizens are less willing over time to make the needed sacrifices. Åslund also urges that countries facing economic crises should embrace new leaders with new ideas. Vested interests associated with old leadership will be most likely to cling to failed policies, while new leaders are able to pursue the cuts in government spending needed to restore fiscal health.

Åslund also recommends that the emergency economic responses be clearly communicated, front-loaded, and weighted more to spending cuts than tax increases. Citizens will support policies they understand but will be ambivalent about the need for spending cuts if politicians sugarcoat the situation and prolong the process. He also says that “credible culprits are useful.” In Latvia’s case, three oligarchs dominated the economy in 2006, and 51 percent of the seats in parliament were held by parties they controlled. Reform politicians campaigned against their corruption, and by 2011 the oligarchs’ representation had shrunk to 13 percent. The United States also had corrupt bankers as ready-made culprits but chose to bail them out rather than hold them accountable for the precrisis excesses.

Finally and most important, Åslund emphasizes that the restructuring process must be equitable and take the form of a social compact. All societal sectors, government and nongovernment, union and nonunion, must sacrifice to restore vigor to the economy. With regard to Latvia, he writes, “The government prohibited double incomes for senior civil servants… and cut salaries of top officials more than of junior public employees, with 35 percent salary cuts for ministers.” Again, the process in the Baltics contrasts sharply with that of countries such as the United States, where government spending has increased since the crisis. In the United States, public union and government employee salaries and benefits have mostly been protected, while the brunt of adjustment has fallen on the nonunion private sector. Åslund concludes by noting that these recommendations were mostly followed in the Baltics and disregarded in the southern periphery, with the result that the Baltics are now growing robustly while Europe’s southern periphery is stuck in recession with uncertain prospects.

The BELLs’ success in quickly restoring growth and competitiveness contrasts sharply with the GIIPS, which have stretched the process out over six years and still have a considerable way to go to achieve fiscal sustainability. Reports from the Baltic region are overwhelmingly positive on the economies there. Reporting on Estonia in 2012, CNBC’s Paul Ames writes, “Shoppers throng Nordic design shops and cool new restaurants in Tallinn, the medieval capital, and cutting-edge tech firms complain they can’t find people to fill their job vacancies.” The BELLs have also made good use of their human capital and a relatively well-educated workforce. Estonia in particular has become a high-tech hub centered on its most successful company, Skype, which has more than four hundred employees in a worker-friendly campus near Tallinn.

The New York Times published a story on Latvia in 2013 that accurately captured the trajectory of steep collapse and strong recovery that used to be typical of business cycles but is now mostly avoided by Western governments at the expense of long-term growth:

Even the IMF, which has generally counseled against the sharp government spending cutbacks used in Baltic states, acknowledged the Baltics’ success in a 2013 speech by its managing director, Christine Lagarde, in Riga:

The peg to the euro and, in the Estonian and Latvian cases, actual conversion to the euro, have proved instrumental in the recovery and growth stories in the BELLs. Anchoring a local currency to the euro, and ultimately adopting it, removes exchange-rate uncertainty for trading partners, investors, and lenders. The benefits of offering economic certainty were illustrated in a recent Bloomberg report:

Lithuania and Bulgaria constitute an experiment within an experiment since they have not pursued fiscal consolidation as strenuously as Latvia and Estonia and, as a result, have not recovered as robustly. But overall, the BELLs have implemented fiscal consolidation and other reforms far more rigorously than have the GIIPS, and they are achieving sustainable debt and deficit levels, trade surpluses, and improved credit ratings as a reward.

If not a perfectly controlled experiment, the contrast between the BELLs’ and the GIIPS’ policy choices is a powerful case study. The findings show that economic prudence works and Keynesian-style stimulus fails. The results are not surprising, given Keynesianism’s dismal track record over the decades and the lack of empirical support for its claims. But the BELLs example is likely to resonate for decades among objective observers, who look for empirical economic proof as opposed to classroom hypotheticals.

The cases of the BELLs and the GIIPS illustrate both the benefits of fiscal consolidation (as practiced by the former) and the costs of delay and denial (as practiced by the latter). The overriding lesson is that currency devaluation is not a precondition to recovery but rather a hindrance. A strong, stable currency is a magnet for investment and a catalyst for expanded trade. The essential ingredients for rapid growth following a crisis are accountability, transparency, fiscal consolidation, and an equitable distribution of sacrifices. The BELLs’ experience from 2008 to 2014 offers powerful lessons for Europe’s southern periphery as it continues to adjust in the years ahead.

■ BRICS

While the BELLs were breaking new ground in demonstrating fiscal consolidation’s benefits, the more powerful BRICS have unsettled conventional wisdom and cast doubt on the U.S. dollar’s future as the world’s leading reserve currency.

When the BRICS leaders convened a finance ministers’ summit in September 2006 in New York City, they showed every sign of evolving in line with O’Neill’s original prescription, not so much as a coherent economic bloc but as a political force. The meetings evolved into a formal leaders’ summit in Yekaterinburg, Russia, in June 2009, and the summits have continued at the ministerial and leaders’ level. In 2010 the original BRIC group of Brazil, Russia, India, and China invited South Africa to join its ranks, and the acronym was changed to BRICS. In April 2011 South Africa attended its first BRICS leaders’ summit as a full member in Sanya, China.

O’Neill has consistently downplayed the idea that South Africa should be among the BRICS, because the size of its economy and population coupled with its unemployment problem do not put it in the first rank of developing economies. This is true economically, but ironically South Africa’s addition vindicates O’Neill’s original thesis that the BRIC project was more political than economic. The other BRICS were located in eastern Europe, Asia, and Latin America. The African continent was a conspicuous gap in the alignment of the East and the South against the West. South Africa, as the largest economy in Africa, filled that gap with its advanced infrastructure and highly educated workers, despite its relatively small size.

The BRICS’ combined economic heft is undeniable. The members represent over 40 percent of global population, 20 percent of global economic output, and 40 percent of total foreign exchange reserves. The BRICS have emerged as a counterweight to the original G7 of highly developed economies and a powerful caucus within the more inclusive G20. However, the BRICS have not taken any measures to integrate their economies into a free-trading area or EU-style currency union except on a limited bilateral basis. The BRICS’ principal impact has been to weigh in on global governance and the future of the international monetary system with one voice.

The BRICS leaders have begun to stake out radical new positions on five key issues: IMF voting, UN voting, multilateral assistance, development assistance, and global reserve composition. Their manifesto calls for nothing less than a rethinking or overturning of the post–Second World War arrangements made at Bretton Woods and San Francisco that led to the original forms of the IMF, World Bank, and the United Nations. The BRICS insist that unless those institutions are reformed to be more inclusive of BRICS’ priorities, the BRICS will take concrete steps to create their own institutions to perform their functions on a regional basis. The evolution of such institutions would inevitably entail a diminution in the role of the institutions they were meant to replace. It is unclear whether these proposals are a stalking horse to promote real reform in the existing forums or whether there are concrete plans to proceed in the direction announced. Perhaps both intentions are true. In any case, the BRICS are unwilling to accept the international monetary and governance status quo.

Specifically, the BRICS have called for expansion of the UN Security Council permanent members to include Brazil and India. Russia and China are already permanent members. This would create a seven-member permanent membership with the BRICS holding four seats—a slight majority. There would be no elimination of the U.S. veto in this scenario, but the addition of a Brazilian or Indian veto would significantly increase BRICS leverage in the behind-the-scenes negotiations that precede formal Security Council votes. Inclusion of Brazil and India would increase the occasions on which BRICS hold the rotating Security Council presidency. The Security Council presidency gives the presiding nation the ability to set the agenda and affect Security Council processes.

The BRICS, especially China, have also pushed for voting reform at the IMF. If population, reserves, and economic output are the relevant criteria, then current voting power in the IMF is skewed in western Europe’s favor and against the BRICS. The IMF leadership recognizes this, and managing director Christine Lagarde has been outspoken in favor of the needed voting reforms (called “voice” in IMF jargon), especially with regard to China. The difficulty lies in getting countries such as Belgium and the Netherlands to reduce their voice in favor of China. This process has dragged on for years. The BRICS have played their cards astutely by conditioning BRICS’ pledges for badly needed IMF lending facilities to progress on voting reform. The BRICS’ trump card in this game is to launch an alternative multilateral reserve lending institution if the IMF does not increase their voting power.

A blueprint for BRICS alternatives to the IMF and World Bank was a principal result of their March 2013 summit in Durban, South Africa. At that summit’s conclusion, the BRICS issued a communiqué, which stated in part:

The BRICS summit also specifically addressed the U.S. dollar’s role as the world’s leading reserve currency, and its possible replacement by SDRs:

Finally, and so as to leave no doubt about the BRICS’ status as a political rather than an economic project, the Durban summit devoted substantial time to topics such as the crisis in Syria, a Palestinian state, Israeli settlements, Iranian nuclear weapons development, the war in Afghanistan, instability in the Congo, and other purely geopolitical issues.

The BRICS reaffirmed their commitment to their new multilateral lending facility at their summit in St. Petersburg on September 5, 2013, held in conjunction with the G20 Leaders Summit. At that summit, the BRICS agreed that their contributions to the new fund would come 41 percent from China, 18 percent each from Russia, Brazil, and India, and 5 percent from South Africa.

In a surprising coda to the revelations of U.S. spying on allies emerging from defector Edward Snowden, Brazil announced plans in September 2013 to build a twenty-thousand-mile undersea fiber optic cable network from Fortaleza, Brazil, to Vladivostok, Russia, with links in Cape Town, South Africa, Chennai, India, and Shantou, China, to be completed by 2015. This system is tantamount to a BRICS Internet intended to be free from U.S. surveillance. The United States has long had excellent capability in tapping into undersea cables, so the actual security of the new system may be problematic. Nevertheless, the proprietary nature of this system could easily be adapted to include a BRICS interbank payments system, which would facilitate the use of any BRICS-sponsored alternatives to dollar payments.

In addition to the regular meetings of BRICS leaders, a large number of ancillary and shadow institutions have sprung up around the BRICS, including the BRICS Think Tanks Council, the BRICS Business Council, and a BRICS virtual secretariat, among others. The BRICS are also coordinating foreign policy through the BRICS foreign affairs ministers’ meetings in conjunction with the annual UN General Assembly meeting in New York. These initiatives have spawned a new international facilitator class: the “BRICS Sherpa” and their “Sous-Sherpas.” These BRICS institutions form a formidable caucus in the midst of other multilateral forums conducted by the IMF, UN, and G20.

Today the BRICS must be regarded as a powerful economic and political force, notwithstanding a recent slowdown in growth rates in certain members, especially China. The global BRICS footprint in terms of territory, population, output, natural resources, and financial reserves is impossible to ignore. The world should anticipate a gradual convergence between the BRICS’ vision for the future and the West’s legacy institutions, now that the BRICS have found policies and processes that unite them.

This convergence has many facets, which can be condensed into a single theme: the diminution in the dollar’s international role and a decline in the ability of the United States and its closest allies to affect outcomes in major forums and in geopolitical disputes. The BRICS may have had humble origins in O’Neill’s brief research paper, but the group has taken on a life of its own.

■ The Shanghai Cooperation Organization

Wall Street analysts are not alone in identifying commonalities in emerging market economies, as other regional groups have come to the fore in recent years. These linkages, based upon regional proximity or community of interest, are beginning to challenge the postwar arrangements of the leading Western economies. They include the Shanghai Cooperation Organization (SCO) and the Gulf Cooperation Council (GCC). Once again, these groupings share an inclination to reduce the U.S. dollar’s role as the leading reserve currency. Their agendas go beyond the free-trade areas and common markets found throughout the world and include strategic, military, natural resource, and international monetary initiatives. Depending on how well these groups pursue their agendas and overcome internal rivalries, they stand to play a significant role in any reformation or evolution of the international monetary system from its current configuration.

The Shanghai Cooperation Organization was formed in June 2001 as the continuation of a predecessor organization, the Shanghai Five. The SCO members are the original Shanghai Five members—Russia, China, Kazakhstan, Kyrgyzstan, and Tajikistan—plus new member Uzbekistan. However, the SCO includes India, Iran, and Pakistan among its observer states and regularly invites the former Soviet republics and members of the Association of South-East Asian Nations (ASEAN) to their meetings.

The SCO had its origins in security issues indigenous to its member states, including suppression of secessionist tendencies in the Caucasus, Tibet, and Taiwan. The members also had a shared interest in defeating Al Qaeda and other terrorist groups in Chechnya and western China. But the SCO quickly evolved into an Asian counterweight to NATO. Russia gained China’s support in its confrontation with NATO in eastern Europe, and China gained the support of the Russians in its confrontation with the United States in East Asia. In this context, the SCO’s rejection of a U.S. application for observer status in 2005 was unsurprising.

In addition to conducting joint military exercises and cooperating in dozens of large-scale infrastructure projects related to energy, telecommunications, and water, the SCO has also launched initiatives in banking and multilateral finance, which are pertinent to the international monetary system’s future. The Prime Ministers Council of the SCO signed an agreement at its Moscow summit on October 26, 2005, creating the SCO Interbank Consortium, designed to facilitate economic cooperation among its central banks, joint infrastructure financing, and formation of specialized development lenders to its members.

At the SCO Prime Ministers Summit in Astana, Kazakhstan, in October, 2008, Chinese premier Wen Jiabao and Russian prime minister Vladimir Putin endorsed Iran’s application to become a full member of the SCO. At that summit, Iranian vice president Parviz Davoudi remarked that “the Shanghai Cooperation Organisation is a good venue for designing a new banking system which is independent from international banking systems.” The SCO summit in June 2009 was conducted side by side with the BRICS summit in Yekaterinburg, Russia. Chinese president Hu Jintao and Russian president Dmitry Medvedev used the occasion of the SCO and BRICS summits to sign a joint Sino-Russian declaration calling for reform of the global financial system and international financial institutions and greater developing economy representation in the IMF.

Newly elected Iranian president Hassan Rouhani had a kind of international coming-out party at the SCO summit in Kyrgyzstan’s capital, Bishkek, on September 13, 2013. At the summit, Iran received strong support from Russia, China, and the rest of the SCO for noninterference in Iran’s uranium-enrichment efforts.

As geopolitics are increasingly played out in the realm of international economics rather than purely military-diplomatic spheres, the SCO’s evolution from a security alliance to a potential monetary zone should be expected. This has already happened covertly through Russian and Chinese banks’ role in facilitating Iranian hard-currency transactions, despite sanctions on Iranian money transfers imposed by the United States and the EU.

The convergence of the BRICS’ and SCO’s agendas on international monetary matters should be most worrying for traditional Western elites. The drivers are Russia and China, the two most powerful members of both organizations. The BRICS and the SCO may have separate agendas in military and strategic affairs, but they are like-minded on the subjects of IMF voting rights, and they share an emerging antipathy to the dollar’s dominant role.

■ The Gulf

Another strategic and geographically contiguous alliance, the Gulf Cooperation Council (GCC), genuinely has the potential to form a single-currency area that would diminish the U.S. dollar’s role.

The GCC was founded on May 25, 1981, when Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates signed a pact in Riyadh, Saudi Arabia. There have been no additions to this original group, although Morocco and Jordan are currently under consideration for membership.

The GCC does not have links to Iraq or Iran, despite the fact that both of those nations border the Persian Gulf along with all the GCC members. The reasons are obvious. Iraq ruined its GCC relations with the invasion of member Kuwait in 1990. Iran is not a candidate for membership because it is ethnically and religiously distinct from the Arab states with which it shares the Persian Gulf and because it is Saudi Arabia’s bitter enemy. But the possible additions of Jordan and Morocco make sense. The existing GCC members are all Arab monarchies. Jordan is an Arab monarchy, and Morocco is an Arabic-speaking monarchy and Arab League member. While the GCC pursues relatively liberal economic and trade policies, it is still a de facto club for the remaining kings of Arabia.

The GCC has pursued a path not unlike the EU in that it successfully launched a common market in 2008 and is now moving toward a single currency. The GCC’s significance for the international monetary system lies more in its single-currency initiative than in other facets of strategic and economic cooperation, which are of mostly regional rather than international importance. As was the case with the euro, implementation of a single currency in the GCC will take a decade or more to complete. Key issues that need to be resolved include convergence criteria for members’ fiscal and monetary policies and the powers of the new central bank. Most vexing in the short run are the inevitable politics that swirl around issues such as the physical location of the central bank’s headquarters and the membership and governance of its board.

The GCC members are already in a quasi-currency union because their individual currencies are pegged to the U.S. dollar and therefore to one another using fixed exchange rates. However, each GCC member retains an independent central bank. This arrangement resembles the European Rate Mechanism (ERM), which lasted from 1979 to 1999 and was a predecessor to the euro, although the GCC has had more success than the ERM, which witnessed numerous breaks with designated exchange-rate parities by its members.

The conversion from the current GCC arrangement to a single currency would appear to be a straightforward process. But recent stresses in the Eurozone have given pause to the GCC members and impeded the monetary integration process. The most prominent impediment is running a single monetary policy with divergent fiscal policies. This problem was one of the principal contributors to the European sovereign debt crisis. Countries such as Greece and Spain engaged in nonsustainable fiscal policies financed with debt issued in a strong currency, the euro, to investors who inferred incorrectly that Euro-denominated sovereign debt had the implicit support of all the Eurozone members. The core problem for any proposed currency union (such as the GCC) is how to enforce fiscal discipline among members when there is a single central bank and a single monetary policy. The need is to prevent a recurrence of Greek-style free-riding on the stronger members’ fiscal discipline.

The GCC has already witnessed this free-riding problem in the 2009 Dubai World collapse. Dubai is part of the United Arab Emirates along with six other principalities, most prominently Abu Dhabi. The emirates share a single currency, the dirham, issued by a central bank located in Abu Dhabi.

Dubai World, an investment holding company, was created in 2006 by Dubai’s ruler, Sheikh Mohammed bin Rashid Al Maktoum. Although Dubai World insisted its debts were not government guaranteed, its debt appeared to investors as tantamount to a UAE member’s sovereign debt. Between 2006 and 2009, Dubai World borrowed approximately $60 billion to finance infrastructure projects, including office buildings, apartments, and transportation systems, many of which remain empty or underused to this day.

On November 27, 2009, Dubai World unexpectedly announced it was requesting a “standstill” among creditors and called for debt-maturity extensions across the board. This default, rather than any specific event in Europe, was the catalyst for the sovereign debt crisis that quickly engulfed Europe and lasted from 2010 to 2012. Eventually Abu Dhabi and the UAE central bank intervened to bail out Dubai World in much the same manner as the EU and the European Central Bank intervened to bail out Greece, Portugal, Ireland, and Spain. These lessons from the UAE and Europe are not lost on Saudi Arabia, Qatar, and the other wealthy GCC members. An enforceable GCC fiscal pact with limits on deficit spending is likely to be required before the single-currency project moves forward.

The other major issue looming over the GCC single currency is the question of an initial par value relative to the U.S. dollar. Too low a value would be inflationary, while too high a value would prove deflationary. This is the same dilemma that confronted the U.K. when it returned to the gold standard in 1925 after suspending it in 1914 to fight the First World War. The U.K. blundered then by setting sterling’s value against gold too high, which caused extreme deflation and contributed to the Great Depression.

When a country or group of countries peg to the U.S. dollar, those countries effectively outsource their monetary policy to the Federal Reserve. If the Fed is engaged in monetary ease and the pegging country is running a trade surplus or experiencing capital inflows, the pegging country has to print its own money to purchase the incoming dollars in order to maintain the peg. In effect, the Fed’s easy-money policy is exported through the exchange-rate mechanism, which forces the pegging country to engage in its own easy-money policy. If the pegging country economy is stronger than the U.S. economy, this easy-money policy will produce inflation, as has occurred in China and the GCC since 2008. The simplest solution is to abandon the peg and allow the local currency to appreciate against the dollar. Such reductions in the dollar’s value are the Fed’s goal under its cheap-dollar policy.

An alternative solution is to maintain a single currency with a value fixed to a currency other than the dollar. Monetary experts have suggested several candidates for an alternative peg. One obvious candidate is the IMF’s special drawing right, the SDR. The SDR itself is valued relative to a currency basket that includes the dollar but with significant weight given to the euro, sterling, and the yen. Importantly, the IMF retains the ability to change the SDR basket composition periodically, adding new currencies to better reflect trade patterns, changes in comparative advantage, and the relative economic performance of the countries whose currencies are included in the basket. An SDR peg would align the future GCC currency more closely with the economies of its trading partners and decrease the Fed’s impact on GCC monetary policy.

GCC member economies are highly dependent on oil exports for revenue and growth. Volatility in the dollar price of oil translates into volatility in economic performance when the GCC currency is pegged to the dollar. A logical extension, then, of the SDR basket approach would be to include the dollar price of oil in the basket. By doing so, the exchange value of the GCC currency would move in tandem with the dollar price of oil. If the Fed pursued a cheap-dollar policy and the dollar price of oil increased due to the resulting inflation, the GCC currency would appreciate automatically, mitigating inflation in the GCC. This way the GCC currency can be both pegged and free of the Fed’s cheap-dollar policy.

A more intriguing solution to the peg issue—and one with large implications for the future of the international monetary system—is more radical: to price oil and natural gas exports in the GCC currency itself, thereby allowing the GCC currency to float relative to other currencies. This could truly mark the beginning of the dollar’s demise as the benchmark currency for oil prices, and it would create immediate global demand for the GCC currency.

This trend toward the abandonment of the dollar as the benchmark for pricing oil was dramatically accelerated in late 2013 as a result of White House efforts to legitimize Iran as the regional hegemon of the Middle East. Implicitly since 1945 and explicitly since 1974, the United States has guaranteed Saudi Arabia’s security in exchange for Saudi support for the dollar as the sole medium of exchange for energy exports and for Saudi promises to purchase weapons and infrastructure from the United States. This nearly seventy-year-long relationship was thrown into grave doubt in late 2013 by President Obama’s modus vivendi with Iran and implicit tolerance of Iranian nuclear ambitions.

The U.S.-Iranian rapprochement occurred after Saudi-U.S. relations had already been badly strained by President Obama’s abandonment of Saudi ally Hosni Mubarak in Egypt in 2011 during the Arab Spring uprisings, and by the president’s failure to support Saudi rebel allies in the Syrian Civil War. The Saudis then spent billions of dollars to help restore military rule in Egypt and to crush the Egyptian Muslim Brotherhood favored by President Obama. More recently the Saudis publicly displayed their displeasure with the United States and moved decisively to secure weapons from Russia, nuclear technology from Pakistan, and security assistance from Israel. The resulting Saudi-Russian-Egyptian alliance removes another prop from under the dollar and creates a community of interest between Saudi Arabia and Russia, which had already announced its preference for an international monetary system free from dollar hegemony.

For a GCC currency to become a true global reserve currency as opposed to a trade currency, further deepening of GCC financial markets and infrastructure would be needed. However, Saudi Arabia’s reevaluation of its security relations with the United States combined with the euro’s expansion and the efforts of the BRICS and the SCO to acquire gold and escape dollar dominance could presage a quite rapid diminution in the dollar’s international reserve-currency role.

■ The Island Twins

Two nations stand apart from this survey of monetary multilateralism and rising discontent with the international monetary system: the U.K. and Japan. The U.K. is a member of NATO and the EU, while Japan is an important and long-standing treaty ally of the United States.

Neither nation has joined in a monetary union or spoken out vociferously against U.S. dominance in international monetary institutions. Both Japan and the U.K. maintain their own currencies and their own central banks; they host the respective financial centers of Tokyo and London. The Japanese yen and the U.K. pound sterling are both officially recognized as reserve currencies by the IMF, and both Japan and the U.K. have the large, robust bond markets needed to support that designation.

Still, Japan and the U.K. are weak in gold reserves, with only about 25 percent of the gold needed to equal the United States or Russia in a gold-to-GDP ratio; Japan and the U.K. have an even lower gold-to-GDP ratio than China, which is itself short of gold. The United States, the Eurozone, and Russia all have sufficient gold to sustain confidence in their currencies in the event of a crisis. In contrast, Japan and the U.K. represent the purest cases of reliance on fiat money. Both countries are out on a limb, with printing presses, insufficient gold, no monetary allies, and no Plan B.

Japan and the U.K. are part of a global monetary experiment orchestrated by the U.S. Federal Reserve and articulated by former Fed chairman Ben Bernanke in two speeches, one given in Tokyo on October 14, 2012, and one given in London on March 25, 2013. In his 2012 Tokyo speech, Bernanke stated that the United States would continue its loose monetary policy through quantitative easing for the foreseeable future. Trading partners therefore had two choices. They could peg their currencies to the dollar, which would cause inflation—exactly what the GCC was experiencing. Or, according to Bernanke, those trading partners could allow their currencies to appreciate—the desired outcome under his cheap-dollar policy—in which case their exports would suffer. For trading partners that complained that this was a Hobson’s choice between inflation and reduced exports, Bernanke explained that if the Fed did not ease, the result would be even worse for them: a collapsing U.S. economy that would hurt world demand as well as world trade and sink developed and emerging markets into a global depression.

Despite Bernanke’s rationale, his cheap-dollar policy had the potential to ignite beggar-thy-neighbor rounds of currency devaluations—a currency war that could lead to a trade war, as happened in the 1930s. Bernanke addressed this concern in his 2013 London speech. One problem with the 1930s devaluations, he said, was that they were sequential rather than contemporaneous. Each country that devalued in the 1930s might have gained growth and export market share, but it came at the expense of the countries that had not devalued. The desired growth from devaluation was suboptimal because it came with high costs. Bernanke’s solution was for simultaneous rather than sequential ease by the United States, Japan, the U.K., and the ECB. In theory, this would produce stimulus in the major economies without imposing temporary costs on trading partners:

Bernanke’s “enrich-thy-neighbor” rhetoric ignored the neighbors in emerging markets such as China, Korea, Brazil, Thailand, and elsewhere whose currencies would have to appreciate (and their exports suffer) in order for Bernanke’s “stimulus” to work in the developed economies. In other words, Japanese exports might benefit, but this could come at the expense of Korea’s exports, and so on. It might not be a currency war of all against all, but it was still one that pitted the United States, the U.K., and Japan against the remaining G20 members.

Japan and the U.K. had another reason to support the money printing and resultant devaluation being urged by the Fed. Money printing was being done not only to promote exports but to increase import prices. These more expensive imports would cause inflation to offset deflation, which was a danger to the United States and the U.K. and had long existed in Japan. In Japan’s case, inflation would come primarily through higher prices for energy imports, and in the cases of the United States and the U.K., it would come from higher prices for clothing, electronics, and certain raw materials and foodstuffs.

The United States and the U.K. both have debt-to-GDP ratios of approximately 100 percent and rising, while Japan’s debt-to-GDP ratio is over 220 percent. These levels are historically high. The trend in these ratios is more important to investors than the absolute levels, and the trend is worsening. All three nations are moving toward a sovereign debt crisis if their policies cannot be adjusted to put these debt-to-GDP ratios on a declining path.

Debt-to-GDP ratios are calculated in nominal rather than real terms. Nominal debt needs to be repaid with nominal growth in income. Nominal growth equals real growth plus inflation. Since real growth is anemic, the central banks must cause inflation to have any hope of increasing nominal growth and reducing these debt-to-GDP ratios. When policy interest-rate cuts are no longer possible because the rates are effectively zero, quantitative easing, designed in part to import inflation through currency devaluation, is the central bankers’ preferred technique.

The Bank of England (BOE) has engaged in four rounds of quantitative easing (QE), beginning in March 2009. Subsequent rounds were launched in October 2011, February 2012, and July 2012. Increased asset purchases have ceased for the time being, but the BOE’s near-zero-interest-rate policy has continued. The BOE is refreshingly candid about the fact that it is targeting nominal rather than real growth, although it hopes that real growth might be a by-product. Its official explanation on the bond purchases to carry out QE states, “The purpose of the purchases was and is to inject money directly into the economy in order to boost nominal demand. Despite this different means of implementing monetary policy, the objective remains unchanged—to meet the inflation target of 2 percent on the CPI measure of consumer prices.”

The situation in Japan differs. Japan has been in what may be described as a long depression since December 1989, when the 1980s stock and property bubbles collapsed. Japan relied primarily on fiscal stimulus through the 1990s to keep its economy afloat, but a more pernicious phase of the depression began in the late 1990s. Japan’s nominal GDP peaked in 1997, declining almost 12 percent by 2011. The Japanese consumer price index peaked in 1998 and has declined steadily since, with relatively few quarters of positive CPI readings. It is a truism, if not intuitive, that an economy with declining nominal GDP can still have real growth when inflation turns to deflation. But this type of real growth does nothing to help the government with debt, deficits, and tax collections since those functions are based on nominal growth.

The Bank of Japan’s (BOJ) relationship to QE, inflation, and nominal GDP targeting is more opaque than the Bank of England’s. The BOJ’s efforts at monetary ease prior to 2001 were desultory and controversial even within the BOJ. A modest QE program was begun in March 2001 but was too small to have much effect. A detailed IMF survey of the impact of QE in Japan from 2001 to 2011 concluded, “The impact on economic activity… was found to be limited.”

Suddenly on December 16, 2012, Japanese politics and monetary policy were transformed with Shinzo Abe’s election as prime minister, in a landslide victory for his Liberal Democratic Party. The election gave Abe’s party a supermajority in the Japanese Diet that could override vetoes by the Senate. Abe campaigned explicitly on a platform of money printing, including threats to amend the laws governing the Bank of Japan if it failed to print. “It’s very rare for monetary policy to be the focus of an election,” Abe said. “We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision.”

Even Abe’s election did not fully convince markets that the BOJ would actually take extraordinary measures, given the bank’s indifferent approach to monetary ease for the prior twenty years. On March 20, 2013, Abe’s handpicked candidate, Haruhiko Kuroda, became governor of the BOJ. Within days, Kuroda persuaded the BOJ’s policy board to implement the largest quantitative easing program the world had ever seen. The BOJ pledged to purchase $1.4 trillion of Japanese government bonds over the two-year period of 2013 and 2014 using printed money. Japan simultaneously announced a plan to lengthen the maturity structure of the bonds it purchased, comparable to the Fed’s “Operation Twist.” Relative to the size of the U.S. economy, Japan’s money-printing program was more than twice as large as the Fed’s QE3 program, announced in 2012. As was the case with the Bank of England, the Bank of Japan was explicit about its goal to increase inflation in order to increase nominal, if not real, GDP: “The Bank will achieve the… target of 2 percent in terms of the year-on-year rate of change in the consumer price index… at the earliest possible time.”

By 2014, it was as if the Federal Reserve, the BOJ, and the BOE were in a monetary poker game and had gone all in on their bet. All three central banks had used money printing and near-zero rates to create inflation in order to increase nominal GDP. Whether nominal GDP turned into real GDP was beside the point. In fact, real growth since 2009 was on a path characteristic of depression in all three countries. Inflation and nominal GDP were the explicit and primary goals of their respective monetary policies.

The U.S. dollar, the U.K. pound sterling, and the Japanese yen together comprise 70 percent of global allocated reserves and 65 percent of the SDR basket. If the Federal Reserve is the keystone of the international monetary system, the Bank of Japan and the Bank of England are adjacent arch stones. But all three central banks, now engaged in a monetary experiment on an unprecedented scale, face highly uncertain outcomes. Their announced goal is not real growth but inflation and nominal growth in order to pay their debts.

Creditors and reserve holders in the BRICS, the SCO, the GCC, and other emerging markets are watching this money-printing pageant with undisguised frustration and increasing determination to end an international monetary system that allows such economic free-riding at the cost of inflation, lost exports, and diminished wealth in their own countries. It remains to be seen whether the international monetary system collapses of its own weight or is overthrown by emerging-market losers in response to this crime of the century being perpetrated by the U.S., U.K., and Japanese central banks.