(1:59 PM) | Adam Kotsko:

The Coming Orgeia

The terms of the deal are obvious in retrospect. Even at the time, economists discussed the arrangement endlessly in their journals. The oddity was that so few politicians picked up on what they said. The heart of the matter, as we now know, was this simple equation: each time Congress raised benefits, reduced taxes, or encouraged more borrowing by consumers, it shifted part of the U.S. manufacturing base to China.

Of course this shift had something to do with "unfair" trade, undereducated American workers, dirt-cheap Chinese sweatshops, and all the other things that American politicians chose to yammer about. But the "jobless recovery" of the early 2000s and the "jobless collapse" at the end of the decade could never have occurred without the strange intersection of American and Chinese (plus Japanese and Korean) plans. The Chinese government was determined to keep the value of its yuan as low as possible, thus making Chinese exports as attractive as possible, so that Chinese factories could expand as quickly as possible, to provide work for the tens of millions of people trooping every year to Shanghai or Guangzhou to enter the labor force. To this end, Chinese banks sent their extra dollars right back to the U.S. Treasury, in loans to cover the U.S. budget deficit; if they hadn't, normal market pressures would have driven up the yuan's value.12 This, in turn, would have made it harder for China to keep creating jobs and easier for America to retain them. But Americans would have had to tax themselves to cover the deficit.

This arrangement was called "Bretton Woods Two," after the regime that kept the world economy afloat for twenty-five years after World War II. The question economists debated was how long it could last. One group said it could go on indefinitely, because it gave each country's government what it really wanted (for China, booming exports and therefore a less dissatisfied population; for America, the ability to spend more while saving and taxing less). But by Bush's second term the warning signals were getting louder. "This is starting to resemble a pyramid scheme," the Financial Times warned early in 2005.13 The danger was that the system was fundamentally unstable. Almost overnight it could go from working well to collapsing. If any one of the Asian countries piling up dollars (and most were doing so) began to suspect that any other was about to unload them, all the countries would have an incentive to sell dollars as fast as possible, before they got stuck with worthless currency. Economists in the "soft landing" camp said that adjustments would be gradual, and that Chinese self-interest would prevent a panic. The "hard landing" camp—well, we know all too well what they were concerned about.

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