BY MICHAEL HIRSH
Ten years ago this week, Lehman Brothers filed for bankruptcy, and the world suddenly changed. That date, Sept. 15, 2008, was hardly the starting point of the Depression-sized financial crisis that would soon threaten to sink the entire world economy; it had begun more than a year earlier. But most scholars agree Lehman’s failure marked the moment when everyone realized at once that the so-called experts had no idea how deep the interconnections ran. No one knew what the knock-on effects would be as the bank’s hundreds of thousands of trading counterparties around the world panicked; how that, in turn, would affect the next giant tumbling domino, AIG; that money markets would come close to collapse; or that credit would freeze almost instantly. It quickly emerged that Lehman was only the start of a systemic infection. Nearly every Wall Street firm had its dark secret: some obscure derivatives time bomb ticking in an off-balance-sheet closet somewhere in the building, one that few execs seemed to know about or even understand until it was too late.
The people running Wall Street as well as those overseeing the economy—such as Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke—simply could not keep up with the complexities of the global economic system they themselves had helped create.
A decade on, the financial system appears fairly stable, but some economists and policymakers fear that the next global crisis could hit us in a similar way—out of nowhere, that is—this time because of the escalating trade war. And once again, as the tit-for-tat tariff duels escalate between Washington and its major trading partners, no one seems to understand the deeper interconnections in the international system that could abruptly surface in malign ways.
Consider Case No. 1: the U.S.-China relationship. Ten years ago, as the financial crisis exploded after the Lehman collapse, the U.S.-China relationship was a bulwark of stability. Despite an overture from Russia to dump billions of dollars in Fannie Mae and Freddie Mac bonds, Beijing largely held on to them and to its vast holdings in U.S. Treasurys. It was one of many moves by the international system—including crucial coordination between Bernanke and the European Central Bank, as documented in Adam Tooze’s new book, Crashed—that prevented the Great Recession from becoming another Great Depression.
Today, it is precisely the U.S.-China relationship—now in turmoil—that could turn a low-level trade war into a full-blown international crisis, leading to another recession or worse, some observers say. Earlier this month, U.S. President Donald Trump announced he’s planning tariffs that would apply to nearly all of the more than $500 billion in China trade. The Chinese, while still cautious, can also be expected to max out their tariffs. But since U.S. exports to China are much smaller, their revenues won’t amount to anything close to America’s, leaving Beijing free to choose other forms of payback.
So how does China now take the conflict to the next level? “They’re going to retaliate in some other domain,” said Princeton University professor Alan Blinder, a former vice chairman of the Federal Reserve and the author of Advice and Dissent: Why America Suffers When Economics and Politics Collide. “One way would be to start doing what I’ve been assuring people for years they wouldn’t do: dumping Treasury bills. Or it could be nothing to do with economics: mischief in the South China Sea, or [something] having to do with North Korea.”
And of course, such moves could swiftly have economic impact, leading once again to a breakdown in trade, turmoil in U.S. financial markets, and possibly a recession.
It is just possible, of course, that if the trade war ends soon and the Chinese make concessions over long-simmering issues like market entry and intellectual property rights protections, Trump’s aggressive gambit could work.
But if the trade standoff lingers on, the law of unintended consequences could come into play. Another little-understood dimension of the growing trade war is the disruption of global supply chains. These have become vastly more complex since Trump first developed his enthusiasm for deploying tariffs as a negotiating tactic some three decades ago (when he was focused on punishing a protectionist Japan). Because the Trump administration wanted to avoid a direct hit on consumers, most of the tariff-targeted products are classified as either “capital goods” or “intermediate items”—in other words, parts or components rather than finished products in stores. The goal is apparently to pressure companies to shift their supply chains away from China.
But in the last few decades, as Nobel Prize-winning economist Michael Spence notes, many more developing countries have begun producing high-value-added components that once were the exclusive province of advanced economies, in “a permanent, irreversible change.”
Thus, if the trade war endures, major U.S. manufacturers such as Ford, GM, and Apple won’t have to race back to U.S. shores, as Trump would like; they could simply decide to develop supply chains for thousands of components in completely new places around the world—perhaps at even cheaper labor rates.
An example: On Sept. 9, Trump triumphantly tweeted that “Ford has abruptly killed a plan to sell a Chinese-made small vehicle in the U.S. because of the prospect of higher U.S. Tariffs.” He added: “This is just the beginning. This car can now be BUILT IN THE U.S.A. and Ford will pay no tariffs!” But Ford later issued a statement saying “it would not be profitable to build the Focus Active in the U.S.,” given forecast yearly sales below 50,000. Analysts said Ford could build the hatchback in many other countries around the world.
Such corporate decisions could have long-term impact, far outlasting the trade war. “When anything like this happens, companies make investments that have a life of 20 or 30 years,” said Mauro Guillén, a political economist at Trump’s alma mater, the University of Pennsylvania’s Wharton School. Those decisions also could harden into long-term price rises. “If there are more barriers to trade, more and more companies are going to think twice about very complex value chains,” Guillén said. “At the end of day, companies cannot set up their supply chains in the most efficient way.”
Less efficiency in supply chains would mean higher-priced goods at the store down the line, which in turn hurts the poor and working class the most. That outcome could, in turn, exacerbate income inequality and possibly intensify the political backlash against globalization—thus, once again in an unforeseen way, turning the current trends into a vicious cycle. Another wrinkle is that just because many of the tariffs are aimed at the middle of the supply chain, it could take much longer for the pain to be felt by consumers. By the time higher prices at the store show up, it could be too late to arrest the reversal of free-trade norms or the onset of other crises.
According to Guillén, the trade theories behind the tariff war are outdated: “Trade is no longer just trade in final goods. Only about half of the bilateral trade between China and the United States is really between China and us. The rest is components from elsewhere. So you don’t know what all the effects will be. Supply-chain disruptions are unpredictable. When the earthquake happened in Japan 10 years ago, all of a sudden factories abroad had to stop because they couldn’t get the parts.”
Even so, the president himself shows no signs of relenting or changing his view of trade as a zero-sum game, in defiance of nearly 250 years of economic wisdom going back to Adam Smith. On Thursday, Trump tweeted that “we are under no pressure to make a deal with China, they are under pressure to make a deal with us. Our markets are surging, theirs are collapsing.”
There are profound differences, of course, between what happened to Lehman a decade ago and what is happening now. Unlike finance, goods exports exist on the margins of economies, accounting for a tiny amount of the gross domestic product of both the United States and China. Financial markets are more globally interlinked and much faster; they are far more prone to panics and manias, and they can destroy an economy much more quickly.
Beyond that, whereas the crisis of 10 years ago arose out of the laissez faire delusion that Wall Street could police itself—a generation of deregulation that created a dangerously leveraged, unmonitored market in crazily complex securities—today’s trade war is the product of the opposite delusion: that a somewhat dated view of protectionism can restore the United States to industrial greatness.
Moreover, the global economy does have built-in stabilities that stem from what policymakers learned after the 2008 crisis. Though the too-big-to-fail problem remains and in some ways has grown even worse—with even fewer mega-banks holding more assets—they’re stocked with much more capital. The global financial system is also less interconnected. Cross-border “hot money,” short-term lending, and interbank activity—all culprits in the 2008 crisis—have dried up considerably, and financial markets and banks are more insulated from each other, according to a new report by the McKinsey Global Institute.
And despite the bad blood between Trump and European and other national leaders, and the threat to globalization, institutional cooperation among the major central banks remains strong—another sort of deep state. “The central banks are still talking to each other as if Donald Trump never walked the earth,” Blinder said.
What hasn’t changed, however, is that the debt of governments, nonfinancial corporations, and households continues to grow by astonishing amounts, some $72 trillion in the past decade, said McKinsey economist Susan Lund. China’s corporate debt growth accounted for a third of the total, more than quadrupling in that period. Thus, a trade war could lead to slower growth and “a spike in nonperforming loans in China,” she said.
If China’s economy takes a dive, Trump might rejoice once again at its misfortune, but he probably wouldn’t be very happy about the global recession to follow.
Hence there remains one common link between Lehman and today’s ongoing trade war: No one has any idea of what lies just over the horizon.
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