Chapter 1

The "Wrong Crisis"

On April 5, 2006, the youthful junior senator from Illinois Barack Obama took time out from discussion of an India nuclear deal on Capitol Hill to attend the opening of a new think tank project at Brookings. The Brookings Institution is widely regarded as the most influential social science research center in the world. Obama's Brookings appearance was an audition that would define his presidency. The keynote he delivered was for a new initiative-the Hamilton Project-launched by Robert Rubin, one of the kingmakers of the Democratic Party. Rubin personified the link forged in the 1990s between centrist Democrats and globally minded bankers that reshaped the American economic policy agenda. In 1993 Rubin had moved from his position at the top of Wall Street, as cochairman at Goldman Sachs, to serve as the first head of the National Economic Council, which Bill Clinton had called into existence as a counterpart to the National Security Council. Two years later Rubin was appointed Treasury secretary. Alongside Rubin presiding over the Brookings meeting in April 2006 was a youthful economist by the name of Peter Orszag, also a veteran of the Clinton administration, who would go on to become Obama's budget director. It was from among the veterans of Rubin's Treasury that Obama would recruit virtually his entire economics team in 2008. Twelve months ahead of the financial crisis, two and a half years before Obama took office, the launch of the Hamilton Project presents the worldview of some of his most influential advisers in microcosm. It reveals both what they could see and what they could not.

I

Having returned to the business world in 1999, Rubin was worried about the drift in Washington. Globalization had been the central challenge of the 1990s. In the new millennium it was even more so. But two years into President Bush's second term, the policies of the Republican administration were putting America at risk. Rather than mitigating the pressures of global competition, they were dividing American society. This risked provoking both an antiglobalization backlash and a catastrophic financial crisis that would call into question America's monetary stability and the global standing of the dollar.

Not that Rubin and his circle were doing badly out of a world of globalization. After the Treasury, Rubin had retired to an influential sinecure as a nonexecutive chairman of the board at Citigroup. Orszag, who started his career bouncing back and forth among academia, government and consulting, would in due course end up at Citigroup too. But for average Americans the story was different. There had been good moments. The Clintonites still celebrated the 1990s and the twin booms of tech and Wall Street. But since the 1970s wages had not kept up with productivity. For the meritocrats of the Hamilton Project it was clear where the finger of blame pointed. America's schools were failing to give its young people the education essential to stay ahead of the game. The first reports issued by the Hamilton Project bristled with proposals to improve the recruitment of teachers and make better use of kids' summer vacations. It was the kind of nuts-and-bolts, "evidence-based," nonideological approach to productivity improvement that dominated economic policy discussion of the era. Its purpose, however, was eminently political. As Obama put it in his keynote:

"When you invest in education and health care and benefits for working Americans, it pays dividends throughout every level of our economy. . . . I think that if you polled many of the people in this room, most of us are strong free traders and most of us believe in markets. Bob [Rubin] and I have had a running debate now for about a year about how do we, in fact, deal with the losers in a globalized economy. There has been a tendency in the past for us to say, well, look, we have got to grow the pie, and we will retrain those who need retraining. But, in fact, we have never taken that side of the equation as seriously as we need to take it. . . . Just remember . . . [t]here are people in places like Decatur, Illinois, or Galesburg, Illinois, who have seen their jobs eliminated. They have lost their health care. They have lost their retirement security. . . . They believe that this may be the first generation in which their children do worse than they do."

This was a betrayal of the American Dream of endless uplift, and that risked spilling over into a political backlash. As Obama put it: "Some of that, then, will end up manifesting itself in the sort of nativist sentiment, protectionism, and anti-immigration sentiment that we are debating here in Washington. So there are real consequences to the work that is being done here. This is not a bloodless process."

Amid the fears about globalization and the risk of populist revolt already evident in 2006, there was one note of economic nationalism that Obama himself was not afraid to strike: "When you keep the deficit low and our debt out of the hands of foreign nations, then we can all win." Alongside global competitiveness, the other preoccupation that defined the Hamilton team was the question of debt.

As Clinton's Treasury secretary, Robert Rubin's great boast was to have turned the deficits of the Reagan era into substantial budget surpluses. Since then under the Republicans, America was headed fast in the wrong direction. In June 2001, in the wake of the dot-com bust and a disputed election, the Bush administration had delivered a tax cut estimated to cost the federal government $1.35 trillion over ten years. This paid off key constituencies, but it also wiped out Rubin's surpluses and it did so deliberately. The Republicans had convinced themselves that surpluses tended to encourage more government spending. Their approach was the obverse, what Republican strategists of the Reagan era first dubbed "starving the beast." By entrenching tax cuts and courting a fiscal crisis they would create an irresistible imperative to slash spending, curb entitlements to social welfare and shrink the footprint of government.

The problem was that the spending cuts that were supposed to follow the tax cuts never happened. The terrorist attack of September 11, 2001, put America on a war footing. The Bush administration responded with a huge surge in defense and security spending. In a manner horribly reminiscent of Vietnam, it then plunged America into the Iraq quagmire. In 2006, as the Hamilton group met, Iraq was on the edge of a bloody sectarian civil war. The question now was how to get out. Iraq was not only demoralizing and humiliating. It was also hugely expensive. The Bush administration did its best to keep the costs of the war off the regular budget. So a cottage industry of Democratic Party experts set itself to doing the sums. By 2008 the bill for Afghanistan and Iraq alone was at least $904 billion. Less conservative estimates put the bill as high as $3 trillion. It was certainly more than the United States had spent on any war since World War II.

Of course it could have been paid for. America was far richer than it was at the time of Pearl Harbor. But the Bush administration was not only not going to reverse its tax cuts; in May 2003 it doubled down, introducing a further round of tax relief. Given that the military budget was sacrosanct and the rest of discretionary expenditure was not large enough to make a difference, the Republicans proposed to close the gap with grossly inequitable cuts to welfare "entitlements." Those, however, could not pass the Senate, where the Republican majority was wafer thin and "moderates" held the balance. It was this logjam that turned Rubin's budget surplus of $86.4 billion in 2000 into a record deficit of $568 billion in 2004 with no end in sight.

The original inspiration for the Hamilton Project was a paper written in 2004 by Orszag and Rubin sounding the alarm. First, the Bush deficits would drive up interest rates and squeeze private investment. Further down the line lurked a far more serious scenario. "Substantial deficits projected far into the future can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad," Rubin and Orszag drily remarked. "The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy." Conventional analysis, in short, was not sufficiently alarmist. What it did not "seriously entertain" was the possibility that America was headed toward "fiscal or financial disarray."

Veterans of the Clinton administration knew what they were talking about when they invoked a "negative cycle" of "underlying fiscal deficit, financial markets, and the real economy." This, in their view, is what they had inherited from the high-spending Reagan and Bush administrations. In 1993, faced with a bond market sell, Clinton had shelved ambitious plans for a stimulus. Egged on by Rubin and Fed chair Alan Greenspan, deficit reduction became a mantra of the Clinton team. Chief political adviser James Carville was left to ruminate: "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

In the 1980s and 1990s, the so-called bond vigilantes had their day in the sun. Ten years later they were still in the market. Indeed, the bond funds were bigger than ever. But, as Obama had hinted, what most worried the Rubinite crowd were not domestic investors. Foreign investors were the key concern. The Bush administration's deficits were financed overwhelmingly by bond buying from abroad. As Orszag and Rubin's paper remarked, United States Treasurys were still seen as the safest investment in the world. There was no chance of default or a sudden burst of inflation. "But if that expectation were to change and investors had difficulty seeing how the policy process could avoid extreme steps, the consequences could be much more severe than traditional estimates suggest." Nor was it just the Clinton crowd that worried. In 2003 the nonpartisan Congressional Budget Office saw fit to remind its audience of an extreme scenario in which foreign investors stopped buying US securities, the dollar plunged and interest rates and inflation shot up. "Amid the anticipation of declining profits and rising inflation and interest rates, stock markets could collapse and consumers might suddenly reduce their consumption. Moreover, economic problems in the United States could spill over to the rest of the world and seriously weaken the economies of US trading partners."

The scale of America's deficits made it vulnerable to bond market pressure. The fact that foreign investors might suddenly turn away from Treasurys evoked the nightmare of a sudden stop to external financing of America's imbalances. But it was the identity of the foreign investors that infused the scenario with real terror. Until the 1980s the major foreign investors in the United States had been European. Then Japan, with its giant trade surpluses, had taken over. Still in the new century it was one of America's largest creditors. But in the 1990s, with a surging yen and a domestic economy crippled by a devastating real estate bust, Japan's competitive threat had faded. Since the millennium, globalization had acquired a new Asian face. In April 2006, when Obama spoke about keeping our "debt out of the hands of foreign nations," everyone knew it was China and its Communist regime that he was talking about.

II

Since the 1970s China had been a cornerstone of US geopolitics. Nixon and Kissinger had unhinged the fronts of the cold war by breaking China out of the Soviet embrace. Now the Soviet Union had faded from view, and the European theater of the cold war had faded along with it. The Pacific was the new horizon of American power and China the future rival. For the first time since the rise of Nazi Germany, the United States faced a power that was, at one and the same time, a potential geopolitical competitor, a hostile political regime type and a capitalist economic success story. The fact that Obama came to the Brookings meeting from talks about a nuclear deal with India was a telling coincidence. America was looking for new allies in Asia. But what mattered more than nukes, at least as far as the Hamilton crowd was concerned, was economics.

The Clinton administration had midwifed China into globalization. In November 1995, Washington encouraged Beijing's application to join the newly founded World Trade Organization (WTO). America had done this before, of course, with Western Europe after 1945, with Japan and East Asia in the 1950s and 1960s and with Eastern Europe in the 1990s. Opening markets was good for American business, for American investors and for American consumers. America's economic interests were so widespread that they were de facto identical with global capitalism. By the mid-1990s Washington had abandoned any frontal challenge to the Chinese Communist regime over human rights, the rule of law or democracy. Instead, globalists of both the Democratic and Republican parties wagered that the powerful and impersonal force of commercial integration would in due time make China into a biddable and congenial "stakeholder" in the world order.

China's growth was spectacular. Huge profits were to be made for American investors. American manufacturers like GM would stake their future on China. After a brief storm over the Taiwan Strait in 1995-1996, diplomatic relations calmed. But China's sheer size made it a contender. With the Tiananmen crackdown of 1989, the Communist Party had signaled its intent not to abandon its one-party leadership. Since then it had fashioned a popular ideology that was as much nationalist as Communist. If Washington was betting on international trade and globalization to "Westernize" China, the Chinese Communist Party took the other side of the bet. The party's leaders wagered that supercharged growth would not weaken them but would consolidate their position as the successful helmsmen of their nation's spectacular comeback. Beijing took advantage of trading opportunities. But it never subscribed to fully open markets. It decided who would invest and on what terms. It controlled movement of funds in and out. That, in turn, allowed the People's Bank of China to fix its exchange rate, and since 1994 it had done so by pegging against the dollar.

In choosing a dollar peg, China was far from unique. Despite the reigning narrative of market liberalization, the financial world was not flat. The global monetary system was hierarchical with the key currency, the dollar, at the top of the pyramid. The twenty-first century began with a network of dollar-linked currencies accounting for c. 65 percent of the world economy (weighted by GDP). Those currencies that were not pegged to the dollar tended to be hooked to the euro. Often pegging was a sign of weakness. In many cases the exchange rate was set at an aspirational, overvalued rate. This created short-term advantages. It made imports cheap. Local oligarchs could snap up prestige foreign real estate at a discount. But it also harbored huge risk. The peg could break and frequently it would do so with a bang. The appearance of stability offered by a fixed exchange rate encouraged a large inflow of foreign funds, which helped to stoke up domestic economic activity, creating an unbalanced trade account funded from abroad. Banks that acted as the conduit for foreign funds boomed. This set up the crisis. When international investors lost confidence, the result was a devastating sudden stop. Then the central bank's foreign exchange reserves would drain and it would have no option but to let the currency peg go. Stability would give way to a disastrous devaluation. Those who got their money out first would be saved. Those who had borrowed in foreign currency would face bankruptcy.