Global Economy, Repeating Mistakes of the 1930s

There is general agreement among economists that the financial relationship between the United States and China is unsustainable over the long-term. At present, this country relies on foreigners, specifically China, to finance our trade deficits — thereby allowing us to maintain our standard of living and expand entitlement programs without significant tax increases. At the same time, China and others are able to maintain their export-oriented economies, even at the expense of their citizens.

According to a working paper by Jeffrey Frieden published on the Council on Foreign Relations website, the last time the same situation occurred was in the 1930s. It not only led to the Great Depression but was one of the most significant causes of World War Two. Then the debtor nation was Weimar Germany and the export-oriented country that financed Germany’s debt was the United States. Frieden’s description of their relationship has an eerie ring to it. “The German-American financial relationship rested on weak political foundations, as neither country was really prepared for the implications of the capital flows. The United States was not willing to provide an open market for German goods that would facilitate debt service, or any government measures to deal with eventual financial distress, and the Germans were unwilling or unable to make the sacrifices necessary to provide prompt debt service.” When the global economy went into recession in 1929, economic nationalism trumped globalization. The results for Germany were economic collapse, hyperinflation and the downfall of its democracy.

Frieden’s historical analysis provides a serious warning for today’s governments in Washington and Beijing. “The symbiotic surplus-deficit relationships — that is,
foreign borrowing and lending — are popular in the upswing, but the adjustments necessary when it comes time to rebalance can be most difficult.” But the consequences of waiting until circumstances force a readjustment can be far worse. Moreover, the German and American governments had more in common politically than do China and the United States today. Those who worry about China using its creditor position to establish strategic leverage over the United States explicitly recognize that the weakness in the relationship is political, not economic.

The surplus-deficit problem trumps every other facing the Obama Administration. Even if its efforts to make health care reform “deficit neutral” succeed, the White House faces trillion dollar deficits as far as the eye can see. Unlike Germany in the 1930s, however, the United States is a global power as well as a debtor nation. This makes the situation particularly fragile since we must simultaneously restrain China’s geo-strategic ambitions while trying to maintain the existing economic relationship.