From American Affairs Journal, Volume VIII, Number 4/ Winter 2024:
Something changed in America in the 1990s. The U.S. federal funds rate began a decline from above 5 percent to reach the effective zero bound by 2009. U.S. ten-year Treasury yields declined from above 6 percent to levels not even recorded during the Great Depression. Credit to the U.S. nonfinancial corporate sector rose from 56 percent of GDP to a new all-time high of 87 percent, and U.S. Government debt rose from 60 percent of GDP to a recent high of 106 percent, very near the peak level recorded during World War II.1 The valuation of U.S. equities rose from a cyclically adjusted price-to-earnings ratio (CAPE) of 15x to the current level of 34x, having reached a new all-time high of 44x in 2000.2 U.S. tangible investment declined from 7 percent of GDP to as low as just 1 percent of GDP, a level only previously recorded in the Great Depression and briefly in the hiatus of investment after World War II.3 The nature and scale of these adjustments are strongly suggestive of a structural change, rather than merely the rotations of any business cycle.
The key structural change that led to these distortions was the creation of a new international monetary system in 1994, when China devalued its exchange rate and, through prolonged and extensive exchange rate management, imposed an international monetary order on the world. This international monetary system is now collapsing under the weight of its own debt and the geopolitical tensions that it played a key role in creating.
The Non-System
In previous eras, we had an international monetary system that could have been named by any financier or businessperson and by many members of the public. Whether that system was called the gold standard, the Bretton Woods system, or something else, its name confirmed its existence. Most people took time to understand the system’s operation and its consequences for credit, money, asset prices, and the economy.
Today, we have an international monetary system that does not have a name. Just because something does not have a name does not mean that it does not exist, yet the lack of a name has obscured the profound impact that this system has had on distorting credit, money, asset prices, and the economy. Paul Volcker, who spent many years at the U.S. Treasury coping with the breakdown of the Bretton Woods system, referred to our current international monetary system as the “non-system.” It is a non-system to the extent that its terms and conditions were never agreed upon by all the parties involved, but instead it was born from choices made by a few, most notably China, that the other parties accepted and adjusted to. The extremes of interest rates, debt levels, asset price valuation, and investment in tangible assets in the United States are just part of that global adjustment to the new international monetary system that grew from China’s unilateral decision to manage its exchange rate beginning in 1994. This system would never have been agreed to in any negotiation, as it was a system replete with distortions that would lead to dangerously large imbalances with dangerous political ramifications. Indeed, briefly, in the wake of the Asian Financial Crisis in 1998, there was a seeming realization that the international monetary system needed to be negotiated and reformed. Speaking at the meeting of the World Bank and the IMF in Washington, D.C., on October 6, 1998, President Clinton warned of the likely consequences should an “international financial architecture” not be agreed to as part of greater globalization:
Creating a global, financial architecture for the 21st century; promoting national economic reform; making certain that social protections are in place; encouraging democracy and democratic participation in international institutions—these are ambitious goals. But as the links among our nations grow ever tighter we must act together to address problems that will otherwise set back all our aspirations. If we’re going to have a truly global marketplace, with global flows of capital, we have no choice but to find ways to build a truly international financial architecture to support it—a system that is open, stable and prosperous.
To meet these challenges, I have asked the finance ministers and central bankers of the world’s leading economies and the world’s most important emerging economies to recommend the next steps. There is no task more urgent for the future of our people. For at stake is more than the spread of free markets, more than the integration of the global economy. The forces behind the global economy are also those that deepen liberty, the free flow of ideas and information, open borders and easy travel, the rule of law, fair and even-handed enforcement, protection for consumers, a skilled and educated work force. Each of these things matters not only to the wealth of nations, but to the health of nations.
If citizens tire of waiting for democracy and free markets to deliver a better life for themselves and their children, there is a risk that democracy and free markets, instead of continuing to thrive together, will shrivel together.4
Nothing was done. We are now living with the imbalances that followed this failure to move away from the Chinese-imposed system, and we will have to create a new international monetary system that can unwind those imbalances while sustaining, hopefully, both democracy and free markets. Given the current breakdown in relations between China and the West, it is most likely that we are moving toward the establishment of two global monetary systems, much as we did in our last Cold War. The separation of China from the current international monetary system will be, given the country’s integration into the global trading regime and its large holding of reserve assets, much more impactful than the exclusion of an already isolated Soviet economy in the aftermath of World War II. As President Clinton stated in 1998, there is more than money at stake as we develop this new system, and there is a risk that “democracy and free markets, instead of continuing to thrive together, will shrivel together.”
Unstable Arrangements
The crucial distortion imposed by China’s decision in 1994 was a decoupling of developed world growth rates from interest rates, the discount rates used in asset valuations, which many assumed to be a new normal. When interest rates appear to be permanently depressed relative to growth rates, asset valuations rise, leverage increases, and investors are incentivized to pursue gain through rising asset prices rather than through investment in new productive capacity. The decoupling of growth and interest rates was driven by the People’s Bank of China’s (PBOC) appearance as a non-price-sensitive buyer of U.S. Treasury securities, and indirectly by the role China’s excessive fixed-asset investment played in reducing global inflation and hence interest rates....
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