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The Pitfalls of Dollar Hegemony

Although Keynesian economics has withstood repeated challenges and updated itself over the decades, it would be a mistake to conclude that it is sufficient for making sense of contemporary economic change. For that, we need to resurrect an alternative perspective on what money does and how it works.

CHICAGO – In Money and Empire, Perry Mehrling of Boston University recounts the remarkable moment, in 1965, when Congress summoned international monetary economist and historian Charles P. Kindleberger from MIT to testify on the troubling US balance-of-payments deficit. After World War II, the United States had persistently exported more than it imported. But by 1965, the reverse was true: West German goods were flooding the US domestic market, and Japanese imports were soon to follow. With dollars flowing overseas as payment for these imports, many had begun to ask if it was time to reform the post-war Bretton Woods international monetary system, which had pegged the US dollar directly to gold and tied other currencies more flexibly to the dollar.

Kindleberger’s answer was no: US trade could be financed, and the dominant international status of the US dollar secured, he argued, by an alliance of central banks led by the US Federal Reserve. “Many of my colleagues are terrified at the thought of collaboration of central bankers superseding [national] economic sovereignty and so on,” he observed. But central bankers “are technicians,” he said, “and this is the kind of problem they can handle easily.”

In hindsight, Kindleberger’s comment is uncanny, considering that central banks have since become economic policymaking’s “only game in town.” Fed Chair Paul Volcker’s 1979-82 interest-rate shock, which halted the high inflation of the 1970s, was followed a decade later by the ideological and policy triumph of “central bank independence,” with Fed Chair Alan Greenspan becoming something of a financial industry folk legend.

During the 2008 global financial crisis, central banks took charge again. Under Ben Bernanke, the Fed extended “swap lines” of dollar credit to other central banks around the world, and these were soon followed by “unconventional” monetary policies like quantitative easing – trillions of dollars in asset purchases over the course of more than a decade. In 2012, the president of the European Central Bank, Mario Draghi, famously backstopped the euro by pledging to do “whatever it takes” to ensure its survival.

All these unconventional and extraordinary measures turned out to be merely a dress rehearsal. When COVID-19 struck, central banks unleashed even larger waves of liquidity, and most governments opened the fiscal spigots. But then came the inflationary surge of 2021, and monetary authorities have found themselves tasked once again with restoring price stability, à la Volcker.

The MIT Connection

Neither Kindleberger nor anyone else could have seen all this coming. Back in 1965, the only game in town was fiscal policy: the US economy was roaring in the wake of President Lyndon Johnson’s vaunted income-tax cut (first proposed by his predecessor, John F. Kennedy).

This is also the moment that economist Alan S. Blinder chooses as the start of his A Monetary and Fiscal History of the United States, 1961-2021. In the late 1960s, Blinder was a doctoral student in the MIT economics department, where he presumably took Kindleberger’s classes in economic history. Today, Blinder warns that economics has become ignorant of its own past. Since his student days, the discipline has become more mathematical and less historical, and Kindleberger has been read less and less.

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Following his retirement in 1976, and until his death in 2003, Kindleberger devoted himself to writing history. According to Mehrling, “Charlie” (as he calls him) knew something fundamental about how the global economy works that many mainstream macroeconomists have never absorbed, partly because they have insisted on viewing macroeconomics within a strictly national context. Here, he has in mind those generations of economists who earned their PhDs from MIT in the decades after World War II under the supervision of lions of the discipline like Paul Samuelson, Franco Modigliani (Draghi’s doctoral adviser), or Robert Solow (Blinder’s doctoral adviser, and a member of Bernanke’s dissertation committee).

Back in those days, MIT was the center of American Keynesianism, and its economics PhDs were poised to rise to powerful government positions – as Draghi, Bernanke, and Blinder’s career paths all attest. Yet, as Mehrling shows in his own subtle critique of this school, even if Kindleberger’s economics is not what men like Draghi and Bernanke profess, it is what they practiced as central bankers – thereby creating the world we live in today.

Mehrling, by contrast, has never occupied a government post. Instead, he has tirelessly developed his own distinctive “money view,” claiming Kindleberger as a direct antecedent. Though his positions are not obscure (he has a substantial following in financial and online circles), they tend to receive much less consideration within mainstream economics departments, such as at Princeton, where Blinder has long been based.

Hence, in his recent book, Blinder has 19 citations to works by the conservative University of Chicago economist Milton Friedman – the foil to his own liberal Keynesianism – but no reference to Mehrling’s scholarship, and only one passing mention (in a footnote) of Kindleberger’s 1978 classic, Manias, Panics, and Crashes: A History of Financial Crises.

So, while both books are about the same subject – monetary policy and history – they are like ships passing in the night. The question, then, is what might be learned from reading them together. If Mehrling’s book is a love letter to Kindleberger, Blinder’s book could be called a love letter to Kindleberger’s MIT colleagues – that is, to Blinder’s teachers and the architects of post-war American Keynesianism. These men, Blinder contends, basically got it right.

The Other Game in Town

Fiscal policy is a powerful instrument, and it is often an appropriate way for governments to intervene in the business cycle to manage macroeconomic conditions. When national economies are in recessions (or depressions), a “fiscal multiplier” validates countercyclical government spending aimed at increasing aggregate demand, output, and employment. According to Keynesian theory, each dollar of additional fiscal stimulus (spending or tax cuts) will yield more than a dollar in economic output, because the extra dollars in people’s pockets will create demand for even more products and services.

But, of course, fiscal-led expansions run the risk of causing inflation. Thus, the job of monetary policy is to manage the tradeoff – depicted in the classic “Phillips curve” – between price stability and employment by positioning the economy at a point on the curve where there is neither too much inflation nor too much unemployment.

This is the admittedly simplistic distillation of both post-war American Keynesianism and Blinder’s view. In his book, Blinder goes much further to offer a judicious assessment of the many historical events and intellectual fads in mainstream economics that have challenged its basic framework between the 1960s and the 2020s. Through it all, he concludes, the original framework held: “Rival doctrines to Keynesianism have come and gone over the decades covered in this volume: monetarism, the new classical economics of ‘rational expectations,’ supply-side economics, and others. But only one survived.”

Competitors to Blinder’s Keynesianism either stumbled on their own, like Friedman’s monetarism, or were absorbed into the “New Keynesianism,” which incorporates rational expectations. Today, supply-side economics lives on only as an embarrassing political canard. MIT Keynesianism survives, but with an important twist: the game shifted from fiscal to monetary policy. The three milestones were the inflation of the 1970s, President Ronald Reagan’s budget deficits in the 1980s, and the triumph of “central bank independence” in the 1990s, which set the stage for the “unconventional” monetary policies that have defined the post-2008 era.

In macroeconomics, the double-digit inflation of the 1970s was a boon for monetarism, which held that “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Blinder counters this famous remark by Friedman by noting that the inflation of the 1970s resulted largely from energy and food “supply shocks.” Still, other critics of Keynesianism, like Robert Lucas of the University of Chicago, correctly criticized its standard models for not sufficiently considering the expectations of economic agents.

When Volcker was appointed Fed chair in 1979, inflation had been running high for almost a decade. In a show of resolve, he pivoted US monetary policy toward Friedman’s preferred approach: managing the quantity, or stock, of money. By targeting a lower stock, Volcker relinquished the Fed’s discretionary control over short-term interest rates, which duly skyrocketed.

But Volcker soon abandoned that effort, partly because the US economy had fallen into a steep recession by 1982, and partly because it had proven practically impossible to measure – let alone adjust – the stock of money. After all, the quantity of money is determined as much by the elusive demand for it as by its raw supply. Although price inflation was reined in, monetarism was discredited, and liberal Keynesianism learned to appreciate the importance of “inflation expectations.”

The Deficit Factor

Volcker ended his term as Fed chair under Reagan, who subsequently appointed Greenspan. Reagan’s focus was not on monetary policy but rather on taxes. Invoking the supply-side gospel, he promised that tax cuts would increase business investment and lead to higher rates of productivity, economic growth, government revenue, and hence lower budget deficits. But none of this happened after Reagan’s 1981 tax cut. Instead, budget deficits ballooned.

When Bill Clinton took office in early 1993, Blinder joined the administration as a member of the White House Council of Economic Advisers, and the budget deficit took center stage. Robert Rubin, a former co-chair of Goldman Sachs, took charge of Clinton’s economic team and convinced the president to balance the budget to assuage the bond market. A bond-market rally, he reasoned, would cause long-term interest rates to fall, inducing greater private investment in the “New Economy” of high tech. Clinton balanced the budget, and investment surged, owing partly to accommodative monetary policies from the Greenspan Fed, which wisely bet on the power of the New Economy to increase productivity growth.

It was in this context of catering to financial markets that the Clintonites trumpeted “central bank independence.” Blinder, defending his brand of Keynesianism, insists that the 1990s boom was an exceptional occurrence, while many liberals, like Rubin, mistakenly took it as an indication that the fiscal multiplier was “negative,” implying that it is always best to balance the budget to win private investors’ confidence.

When Blinder recounts the 2000 dot-com bubble, he makes his passing reference to Kindleberger’s Manias, Panics, and Crashes, but then quickly moves on to President George W. Bush’s tax cuts. Like Reagan’s cuts, these predictably created large budget deficits in the run-up to the 2008 financial crisis. Then, vindicating Keynesian arguments about the fiscal multiplier, the Obama administration passed the largest fiscal stimulus that was politically possible (though it still was not sufficient) in 2009, and the Bernanke Fed rode to the rescue, innovating its monetary policy on the fly. In the end, the federal government managed to stave off something worse than the Great Recession.

This pattern was then repeated over the last decade. Like Reagan and Bush before him, Donald Trump passed a large tax cut based on the same supply-side reasoning. The promised benefits mostly did not materialize, and deficits ballooned. When COVID-19 struck, the Trump-appointed Fed chair, Jerome Powell, put the post-2008 monetary policies on steroids, adding roughly $4 trillion to the Fed’s balance sheet, and the Trump and Biden administrations’ fiscal stimulus policies once again demonstrated the positive Keynesian fiscal multiplier.

Trump, being Trump, often browbeat Powell. But when Joe Biden took office, he restored the august principle of central bank independence. Blinder ends his history in 2021, with the Powell Fed pivoting to tackle inflation.

Blind Spots

These are the basic outlines of Blinder’s unfailingly lucid, informed, and authoritative history. But no book can cover everything. While Blinder offers a compelling insider’s history of American Keynesian macroeconomics, his narrative leaves out some important things.

For example, though he starts in 1961, his book makes no mention of the civil rights movement, the rapid economic rise of the US Sun Belt region, or climate change. Similarly, it makes only passing reference to women’s historic entry into the remunerated US labor force, the deindustrialization of the US manufacturing belt, the rise of services employment, or the role of defense spending in fiscal expenditure. Blinder acknowledges that, with the exception of the 1990s boom, US productivity has slowed since the 1970s; but he offers no real explanation for it, nor for the trend of “jobless recoveries.”

Accordingly, there is no mention of the decimation of the US labor movement, the rise of monopsony in labor markets, or the decline of market competition and the growth of corporate monopolies over this period. Nor is there a discussion of the explosion of income and wealth inequality since 1980, or any reference to the Cold War, developing economies, globalization, or the rise of China. Economists and historians have much to say about these issues. But if Blinder is any guide, mainstream Keynesian macroeconomics has not considered them relevant.

This is not to suggest that Blinder’s brand of macroeconomics has nothing important to offer. On the contrary, he and other MIT Keynesians are right that in the face of a recession, the state should spend more (all things being equal). But that insight takes us only so far, and judging by Blinder’s book, this brand of Keynesianism has astonishingly little to say about many of the things that matter most to our economic lives. That is worrisome, given the power and influence that expert macroeconomists like Blinder have enjoyed since the 1960s. For half a century, they have shaped our economic life through their privileged access to the highest policymaking circles.

To be sure, Blinder claims that he has given due consideration to politics, and he concludes his book with a “fearless prediction” that “fiscal policy decisions will continue to be made largely on political grounds while monetary policy decisions will continue to turn on technocratic, economic considerations.” Along the way, he scores many political points against crude monetarists and feckless Republicans. Ultimately, though, his political analysis does not delve much deeper than newspaper headlines. And even then, he buries the lede.

Framing central banking as merely technical, Blinder underplays the drama of the shift from fiscal policy toward monetary policy in recent decades, barely noting just how radical the Fed’s unconventional monetary policies have become, relative to those of 1961. While he acknowledges that new “financial stability” policies have come to the fore, this is putting it mildly. Monetary policy in recent decades has been so transformed as to change the character of money itself. Viewed in this context, 1960s-era MIT Keynesianism cannot fail to look vintage, regardless of how much it has been updated.

What Charlie Saw

By contrast, Mehrling insists that Kindleberger’s brand of monetary economics – which his postwar MIT colleagues Samuelson and Solow shunned as quaint and insufficiently mathematical – was and remains fully equipped to make sense of contemporary economic change.

Kindleberger earned his PhD in economics from Columbia University, but his own economics was not forged in any university library or lecture hall. He worked at the US Treasury before filing his doctoral thesis, and then joined the Federal Reserve Bank of New York full-time in 1936. He took a job with the Bank for International Settlements in Switzerland in 1939, before returning to the Fed in 1940. In 1942, he joined the war effort at the Office of Strategic Services, and then worked for the US Department of State, where he was heavily involved in the Marshall Plan.

In 1948, Kindleberger joined the still-fledgling economics faculty at MIT. He might have continued doing government work, except that several of his friends and associates were caught up in the Red Scare, and the FBI therefore denied his requests for a security clearance.

By the time he reached MIT, Kindleberger had developed what Mehrling calls a “central banker’s” view of the economy. Two aspects of this view stand out. First, he saw the economy fundamentally as a global, border-crossing network of public and private balance sheets. One can imagine this domain as a meso-layer between Blinder’s standard macroeconomics of national aggregates and the microeconomics of individuals and firms maximizing utility and choice. All public and private entities – from government bodies like central banks to corporations, banks, households, and individuals – hold assets and liabilities on their balance sheets, which are in turn connected by flows of capital, income, and payment.

After WWII, Kindleberger was most concerned with long-term capital formation in the developing world. In 1945, that included war-ravaged Western Europe. As a cosmopolitan New Deal liberal, he believed the US government had a responsibility to ensure long-term capital flows to the rest of the world. That would allow countries to build (or rebuild) their economies’ productive capacity and benefit from trade.

Kindleberger saw that money was the key to this mission. It is the means of payment linking the world’s balance sheets, and it sits on those balance sheets as an asset. As Mehrling puts it, there is always a “hierarchy of monies” and thus of related credits, too. The money at the top – the ultimate means of payment, or what Kindleberger called the “hegemonic” currency – determines the liquidity of the entire global system (hence the title of Mehrling’s book).

One of Kindleberger’s most influential academic arguments was that there must always be one – and only one – hegemonic currency at the top of the global hierarchy. Successful hegemons are necessary to backstop the entire system, even for non-hegemonic players. That is done by granting occasional liquidity to key financial institutions to ensure that money and credit flow across the payments hierarchy. These transactions link the economy together and enable employment, production, trade, and consumption, but they must constantly be financed and cleared. This is the practical business of banking. Central bankers learn it almost by osmosis. Modeling it mathematically is not the kind of thing for which the macroeconomists in Blinder’s tradition have won Nobel Prizes.

The Dollar System

When Kindleberger was young, the world was in transition between two key currencies: the British pound sterling and the US dollar. As a university student, he watched as the British-backed international gold system collapsed during the Great Depression, when short-term capital (“hot money”) whipsawed around the world and brought down the international financial system. What Kindleberger took away from this was that the US had abdicated its responsibility as the world’s largest economic power after WWI. It should have seized the mantle of hegemony and installed the dollar as the world’s hegemonic currency; but it did not.

Based on this conviction, Kindleberger used all the influence he had within the State Department after WWII to advocate for the creation of a new “dollar system.” To act responsibly within such a system, the US government would have to furnish the world with enough liquidity (in the form of short-term financing and, equally important, long-term productive investment) to kickstart economic development.

Since that is exactly what the Marshall Plan did, Kindleberger viewed the program as a great success. Blessed with US dollars, Europe’s economic recovery commenced in earnest. Looking ahead, Kindleberger’s hope was that the world economy would reach a new equilibrium, wherein private international capital markets, anchored to the dollar, would do the job of short-term and long-term financing. But that would come later, and only if governments did what was necessary to make it happen.

By the time Kindleberger was called to Congress in 1965, a lot had changed. Much of the world had recovered or developed further after the war, and the US was no longer the net exporter of goods that it once was. Many of Kindleberger’s academic peers – including Modigliani at MIT and, most prominently, Robert Triffin at Yale – were sounding the alarm about the fate of the dollar. With US trading partners holding so many dollars, might there not be a run on the gold stores at Fort Knox? If so, the entire Bretton Woods system would unravel.

Kindleberger objected that these economists had the wrong picture of the global economy. They saw national economies as encased, discrete entities that trade with each other and become linked by capital flows. But Kindleberger pointed out that countries typically do not trade with one another. That is done by firms, which are financed by banks. The relevant question, then, was whether all the trade could be financed. The answer was that it could be, and that it was. The dollar system worked.

This meant there was nothing wrong with the US trade deficit, per se. On the contrary, it was an artifact of the world’s rapid economic development since the war – an outcome to be celebrated and a testament to the dollar system’s success. Even if private finance proved unequal to the task of clearing all world trade, Kindleberger explained, central bankers would be there to backstop the system with liquidity. No one in Washington was listening, however, and by the 1970s, Kindleberger had largely abandoned public economic discourse to focus on writing a series of large-scale works of economic history.

A Clarifying Lens

Mehrling’s overall conclusion is certainly correct. The events of the twenty-first century demand a return to Kindleberger’s historically informed, globally oriented perspective. Consider his theory of a “hegemonic currency.” Ever since the 1960s, there have been constant warnings that the dollar’s preeminence cannot last for long, given the relative decline of the US as a share of the global economy. Yet dollar hegemony lives on, just as Kindleberger would have anticipated. Moreover, as Kindleberger always understood, the monetary and currency system is fundamentally global, and thus incomprehensible within a strictly national frame of reference.

Retracing Blinder’s economic history from this perspective is illuminating. It shows that among the many significant consequences of the Volcker interest-rate shock, one was to secure the dollar’s status as the world’s reserve currency. Wherever you look, those with wealth (private and public) want to hold dollars, especially in times of trouble. Much of the capital that Japan had amassed was financed by the Reagan budget deficits, just as much of China’s savings would be financed by Bush’s budget deficits.

When these countries exported goods to the US, they were paid in dollars, which they then used to purchase Treasuries. By keeping the dollar’s value high (through increased demand), these trends contributed to the gutting of the US manufacturing base, which had become increasingly exposed to trade competition from export-led Asian economies. Then came the 2000s US housing bubble, which was financed partly by European – especially German – banks that were eager to hold dollar-denominated assets on their balance sheets.

As we have seen, the Fed’s balance sheet has since become the only game in town. In essential scholarship on this topic, Mehrling details how the US central bank became not only the “lender” of last resort, but also the “dealer,” injecting liquidity and making markets across different levels of payments, from Wall Street to Main Street, after 2008. The response to COVID-19 simply pushed the trend forward (as did the Fed’s response to the Silicon Valley Bank and Signature Bank failure).

This is not to suggest that the global character of the dollar system is always the single best explanation for what is happening in national settings. The point, rather, is that one cannot offer a full economic history of the US over the past half-century without applying the logic of the global dollar system, as foretold, however dimly, by Kindleberger’s oeuvre.

That said, if Blinder’s study sometimes suffers from narrowness, so, too, does Mehrling’s. In discussing the technicalities of banking and finance, Mehrling’s prose sometimes gets awfully far into the weeds; and nearly all the aforementioned topics that receive short shrift from Blinder are also excluded in Mehrling’s book.

Moreover, while Mehrling’s book bears the provocative title of Money and Empire, there is no sustained account of empire or the features of US global hegemony. One is thus left with lingering doubts about whether the dollar system really can keep holding on. Just how much of the financial sector and the rest of the economy can the Fed backstop and finance through its unconventional policies? Won’t there be mounting political protests over the moral hazard implicit in these responses?

Mehrling offers a savvy explanation of the logic of the global system. But is it truly the best system on offer? Does it really have no limits? Will the national “economic sovereignty” that Kindleberger mentioned in his congressional testimony return to the fore? The next chapters of US monetary and fiscal history will hinge on the answers to these questions.