the money game

The Fed Might Just Break the Global Economy

Photo-Illustration: Intelligencer. Source photo: Getty Images

These days, the global economy is about as anxious as Herschel Walker’s PR team.

Last week, a hiccup in the investment strategy of British pension funds nearly tanked the U.K. Treasury market, and sent ripples of financial panic across the Atlantic. In Europe, consumers are bracing for a cold winter as natural-gas supplies run scarce. In the most unfortunate developing countries, blackouts and food shortages are proliferating. In China — long the engine of global growth — economic activity is bogged down by zero-COVID policies and a giant real-estate bubble. Policymakers the world over are wringing their hands over the prospect of a worldwide recession.

Nevertheless, for now, widespread inflation persists. And the Federal Reserve remains committed to raising interest rates, even as major Wall Street banks warn that further hikes just might break the financial system’s fragile “plumbing.”

To make sense of our economy’s present — and assess the prospects for its future — I reached out to an expert on its past. Adam Tooze is among the world’s most prominent economic historians and prolific Substack commentators. He’s authored celebrated books on each of the world’s last two financial crises. We spoke about the inequities and instabilities of the existing financial system, the class politics of monetary policy, and why progressives should support the construction of new gas pipelines in the United States (for global justice’s sake).

What’s your nutshell summary of what’s been going wrong with the global economy in general, and global financial markets in particular?
In the real economy, the situation is actually finely balanced right now. The real stress is in the energy-supply system to certain parts of the world, notably Europe. But in the U.S., the real economy is still, at this point, not in crisis mode. There are some signs of a downturn, notably in the real-estate market. But in a sense, part of the problem is that the real economy is not slowing as fast as the Fed would like.

And that’s an issue because, of course, inflation soared to levels that people did not anticipate. So the Fed raised interest rates to counter inflation. And then the highly leveraged financial system, which had grown accustomed to more or less continuous support from the Fed since 2008, realized that such support was truly over: Given inflationary pressure, the Fed was actually going to persist with rate hikes this time. And that, since the spring, has sent a shock through financial markets from which they’ve not recovered.

Over the summer, there was some hope that equity markets might rebound. One never knows with stock markets but, in the last month or so, the mood seems to have significantly darkened. A recession is one thing; we’re not in one yet, but we could be headed in that direction. A fall in stock-market prices is another thing. Stocks are supposed to fall when the economy slows down. It’s the proper thing for them to do, since they reflect profit expectations. Painful but hydraulically necessary. The real worry is that something’s going to break.

Like Britain’s pension funds last week.
Yes. At first I pooh-poohed its significance, because I was in my Britain-hating mode. I thought that the U.K. Treasury market was too small to matter. But it’s been interpreted as a sign of how things can break down more broadly.

And what happened in Britain, to oversimplify is: Swiftly rising interest rates — prompted by the government’s tax-cut plan — exposed a vulnerability in pension funds’ investment strategy. And that, in turn, forced the pension funds to sell off their British Treasury bonds for cash, which pushed interest rates up further still, which exacerbated the problem in their investment strategy, which forced them to sell off more bonds, in a vicious cycle. Yeah?
Basically. And what the central bank was then forced to do in a hurry was to step back in and stabilize this system by buying up bonds. And that’s a problem. Because it’s contradictory.

Because the Bank of England is supposed to be fighting inflation by selling U.K. Treasury bonds.
And raising rates, yes. But here it was taking action that did the opposite. It got caught between doing what was necessary to stabilize inflation and doing what was necessary to stabilize the financial system. In that moment, it could not do both. When a central bank reaches that kind of impasse, then people get nervous.

And that’s where we’re at now. The worry is that there could be something in the U.S. financial system that could break too. We don’t know quite what it is. Now, we’ve been worrying about this for some time. So there is an element of crying wolf here. But if you wanted to dig into it, you’d start with the U.S. Treasury market and how poor liquidity has been there for the last couple of months.

So, to be clear, there’s two different kinds of worries. One is about “something breaking” in the sense of a 2008-style meltdown of the financial system. And I think there, the optimistic case is that we’re no longer in a world where that can happen; under the current system, central banks will simply do whatever’s necessary to plug the relevant holes. But then there’s the second worry that — even if the Fed can rescue the financial system from a crisis — it can’t simultaneously fight a financial crisis and inflation.
That’s the kind of dilemma which we might be impaled upon. I mean, obviously, we shouldn’t allow that to sit for very long because if the issue is financial stability, the answer is reform of financial structure.

If things do start to break, structural reform of the U.S. Treasury market should go way up the agenda, which is where it should have been really since at least the spring of 2020. It has actually been quite a while since we had a year in which there wasn’t anxiety about the Treasury market. Which is a problem, since the U.S. Treasury market is gigantic and, at least notionally, the platform of stability for all other private finance. Yet it no longer seems to have the stability properties that it’s supposed to.

What would structural reform of the Treasury market look like?
Start with transparency. We clearly don’t know enough. We’re still doing postmortems on who sold what where in the spring of 2020. That’s the place to start. And then you would want to look at the way in which the market is organized, and the key role played by a very small number of players, most notably J.P. Morgan, which anchors that entire market. And we need to think about whether it’s appropriate for a market of that significance to run through so few private hands. Because it puts them in a very dangerous position when things get rough, so it’s not really a function that a private balance sheet ought to be managing.

In concrete terms, what are the costs of the system as it’s currently arranged? Who loses out from an arrangement where private actors organize these markets in good times, while central banks stabilize them in bad ones? So long as the second part happens, at first glance, it can look like nothing is lost. Things got hairy for a minute in Britain last week. But no one actually lost their pension. Conditions returned to normal.
That’s a very important question. One shouldn’t confuse balance-sheet interventions with bailouts in the classic sense; no one’s taking a risky stake in anyone else’s business. But what the central banks are facilitating is highly leveraged profit-making by private actors. So it’s more, “Why do we subsidize this activity?” rather than, “Why do we bail them out?”

What we are really asking ourselves is: Why do we have a system that enables private actors to make huge profits in good times, and then in bad times, provides them with a safety net so that they never actually have to face the consequences of their own risk-taking? The major negative side effect of this is the volatility of interest rates to which regular citizens are exposed. And in the British case, this is making itself felt very dramatically in the shock to mortgage interest rates. In the U.K., everyone’s on flexible mortgages and those are all adjusting.

So if you have a crisis like this, if you have a shock — if you have a panic and interest rates surge — then the central bank can step in to prevent anyone going bankrupt in the private financial system. But in the meantime, interest rates have shot up and delivered a really painful shock to the housing market. And that’s when ordinary people begin to “feel the pain.”

Now, you could defend the system. In the U.K. example, you could say, “Well these are pension funds that we’re talking about. The central bank is just enabling the pension funds to manage the inherently problematic business of providing pension insurance to people, which is difficult to do because we don’t really know what the risks are going to be over 30 years.”

But the follow-on point is: Whose pensions are we talking about? And essentially, they are gold-plated, defined-benefit private-insurance schemes for the top 10 to one percent of the British population. So one could wonder, Why do we maintain a pension system that’s structured like this? In which essentially, a pension fund chases yield very aggressively because they are struggling to make this particular part of the upper-middle-class welfare state work.

So there is a wider entanglement here. Regular citizens are not just victims of this process in the same way as they were not just victims of the mortgage boom of 2007 and 2008. I mean, it was petty bourgeois middle-class speculation on multiple mortgages that drove some of the dodgier deals at the end phase of the housing boom.

If our system for managing financial stability is less-than-ideal, one might say the same of our system for managing inflation. To a layperson, the response of central banks to rising prices might seem paradoxical. On the one hand, the Fed argues that inflation is bad because it’s eroding the public’s living standards. On the other hand, it is pursuing policies whose deliberate consequence is an increase in unemployment, and a reduction of real wages and asset values; which is to say, a reduction in the public’s living standards. How does the Fed resolve that apparent contradiction? 
There are a few different ways of doing so. One is that asset price inflation is itself part of the inflation process. So, genuine “copper-bottomed” conservatism is skeptical about asset price growth as well as inflation. It’s skeptical of the radical centrism that has prevailed since the 1990s, which seeks to repress inflation while promoting unlimited upside in equity markets. It considers that a degenerate form of conservatism because true conservatism understood that there was a relationship between broader inflation and rising asset prices; that the two things are really just part of the same phenomenon.

If you’re in that mode — and that is the mode that some central bankers are rediscovering — then there is no contradiction. Reducing wages and reducing asset values are part of the same process of returning the economy to some natural equilibrium. The point is to pop “bubbles” and restore the natural market balance. And once we’re back at that balance, the economy will grow in a more sustainable and ultimately more beneficial way.

The other argument is more straightforward, which is simply to say that inflation is bad, quashing it in the short run hurts, but we need to take some pain now to avoid more pain later. If inflation is allowed to build up in the system and become ingrained in it, then squeezing it out of the system later will be even more painful. And so take your medicine now so as to avoid the really radical surgery we’re going to have to do later on.

It seems to me that the whole left-right debate over inflation hinges on that claim. Progressives tend to oppose managing inflation by deliberately increasing unemployment as a matter of principle. They’re ideologically opposed to concentrating the burdens of economic adjustment on the most disempowered workers in our society — especially in a society with a safety net as threadbare as America’s. Conservatives and centrists generally disagree, but rarely in principle. They don’t argue that it’s good that the Fed’s approach to managing inflation requires increasing unemployment. But they insist that it’s a tragic necessity. Progressives might propose addressing inflation by increasing supply through public investment. But such interventions do not help in the immediate term; it takes a while to build stuff and bring it to market. And the left’s other primary proposal — simply ride out the inflation by waiting until supply grows to meet demand — also cannot immediately halt the inflation process. Which is a problem if inflation inevitably accelerates. If failing to act on inflation now means that it will accelerate to a point where only a severe recession can stop it, then jacking up interest rates to moderately increase unemployment might be the best of our bad options. It isn’t about class warfare. It’s just about pulling the one lever we have that works fast. 

So, what do you make of that idea? Is it rooted primarily in empirical evidence, or in its convenience as an alibi for disciplining labor?
In the advanced economy world, the idea derives its authority overwhelmingly from one historical example, which is the 1970s. And it involves, to my mind, an entirely unconvincing claim that we still have the underlying political economy that would generate a wage-price spiral.

A circumstance where rising prices cause workers to demand higher wages, which forces firms to charger higher prices, which causes workers to demand higher wages, etc.
Right. And I think that political economy was destroyed when organized labor was disarmed in the 1980s and 1990s. That doesn’t mean that you can’t get some wage pressure. But I don’t think you can really get a full blown wage-price spiral if you don’t have collective actors. My view is basically that a progressive politics requires nerves of steel. It requires making the wager that we can ride out the current surge in prices.

Now, I’m not going to say that central banks shouldn’t raise interest rates at all. I’m not a Post-Keynesian fundamentalist on this. I’m not persuaded that price controls are an evidently better way of controlling inflation.

But yes, as you say, it’s a kind of wager or historic test between two underlying hypotheses. One is the conservative one: Unless we act quickly, we risk returning to 1970s-style inflation. And the other one is the progressive gamble, which is that we can afford to ride this out actually, because that 1970s political economy is — regrettably — no longer with us. In fact, we have a degree of leeway here. And having crushed the trade unions, we should be able to be kinder on the unemployment variable, at the very least.

But there’s another important element to factor in here. Although the fear of unemployment is quite general, the pain of actual unemployment falls on — in the worst case, “hard landing” scenario — 6 or 7 or 8 percent of the American workforce. The Fed thinks it could be capped at 4.5 to 5 percent. Now, that would be a big increase in unemployment. But it would also only impact about one in 20 people in the workforce. Whereas, a general increase in prices affects literally everyone. It impacts 20 times more people. So if the idea is, as it were, to maximize the benefit for the greatest number, then you can see why inflation control has a kind of overwhelming logic.

It was only the mechanisms of collective politics and the collective imaginary that came out of the Great Depression that turned unemployment into something more than just the fate of unfortunate people in the shittiest slots of the labor market. White-collar people, generally speaking, don’t experience unemployment for protracted periods of time. It really is a blue-collar and sub-blue-collar, unskilled workers’ experience. And in America, of course, it’s highly racialized; it is above all the experience of Black men.

When the Great Depression still loomed large in popular memory, it made sense to treat inflation and unemployment as equivalent problems. Unemployment was a mass tragedy that affected everyone, and so everyone should care about it as much as they care about inflation. In a sense, what we’ve discovered is that that’s not an empirically reasonable description of the unemployment problem in the current day. Because, it wasn’t ever really.

This speaks to concerns I’ve had about the politics of today’s inflation. In the left’s traditional paradigm, the class politics of monetary austerity are straightforward: It sacrifices the welfare of the many to that of the few, both by reducing labor’s bargaining power through higher unemployment, and by shoring up the financial interests of creditors while exacerbating the burdens of debtors. And yet, some of the financial industry’s most powerful actors — including BlackRock and Bank of America — are among the leading voices calling for the Fed to refrain from steep interest-rate hikes, for the sake of preserving financial stability and growth. And it’s quite plain that capital owners as a whole are not deriving much benefit from the current policy path, which has shaved $36 trillion off their collective asset values.

Meanwhile, at least in the U.S., it was not merely elites but the broad middle class who saw little worth celebrating in Biden’s hot economy. Even as the American worker enjoyed the most favorable labor market in decades, polling data found overwhelming disapproval of the economy. Indeed, popular discontent with economic conditions has been significantly higher than it was during much of the tepid recovery that followed the 2008 crash. So, it seems plausible to me that the revealed preference of the American middle class is for a slow-growth economy with moderately high unemployment, in which low-skill labor is hyper-exploitable — and thus, contractors are easy to find, gig workers are abundant, fast-food restaurants are all fully staffed, etc. If true, the implications seem somewhat bleak for the progressive project. 
I think that’s a fantastic analysis, especially if we are clear that “middle class” is not a euphemism for working class. If we take “middle class” to mean what it says, then yes, I think that the “it’s so difficult to get good servants these days” problem is real. I think that’s a really nice way of formulating the problem, the fact that Uber doesn’t work anymore, these kinds of phenomena.

Separately, in the American context, energy prices are hugely salient. We know that the Michigan Consumer Survey Indices, which are often cited as an indicator of how dissatisfied people are, are heavily biased towards gas prices. And those skyrocketed. So that helped to damage consumer confidence. There’s clearly more going on than that though.

The resistance of the working class to inflation, properly understood, has to do with the fact that they’re in a weak position structurally. If you don’t have collective bargaining power, if you don’t have cost-of-living adjustment mechanisms, if you have very little reason to believe that collective action will actually yield much benefit, then you quite rationally fear inflation.

I spent some time in Argentina this year, which has 100 percent inflation. They’re remarkably sanguine about it because they know perfectly well that across the board, across a very wide range of sectors, wages will be fully adjusted at the end of the year with compensation. That’s just built into the system because of the power of collective action there.

By contrast, look at the real wage hits that workers have taken both in the U.S. and in Europe. There’s very little prospect of redress, in which case you do become hostage to the situation and desperate for the lid to be kept on. Which I agree is depressing. In the low-inflation era of the 2010s, I used to argue that we should aim for a 4 percent inflation target precisely because inflation of that kind provides workers with a gradual yet persistent incentive to organize.

And I think that logic is still sound. And the Bank of International Settlements actually openly argued that one of the reasons why central banks ought to stamp on the break in 2022 is that if this inflation is allowed to continue, it will in fact cause people to begin to try and organize themselves. Frankly, from my progressive political view, I think they may be too alarmist. There isn’t actually much evidence of that yet. But it’s theoretically sound.

It seems like we’re in a bind then where, if we don’t have strong collective-bargaining rights, then working-class voters will have little patience for inflation, even in cases where tolerating price increases might be in their enlightened long-term interest. But if we do have strong collective bargaining rights, then central bankers’ tolerance for inflation would be even lower than it is now. 
Yes. As you were saying, the argument for hawkish monetary policy is all about avoiding a situation in which wages adjust rapidly to price increases.

You referenced American consumers’ hypersensitivity to energy prices. I know that you’ve been critical of the Biden administration’s efforts to increase the supply of fossil fuels on the world market. But some progressive analysts — who take climate change seriously — have made the case for increasing short-term fossil-fuel production in the U.S. I think the broad argument for their position has two parts.

First, there is the political argument: We are a long way from the point in the energy transition where fossil fuels are no longer essential to the functioning of the global economy. Renewable-heavy grids still generally rely on gas plants to compensate for their intermittency. The electric-vehicle revolution is in its infancy. And when we do reach the point where drivers in the global north have fully forfeited internal-combustion vehicles, those vehicles will be sold used in developing countries and driven there for another decade. Given these realities, reducing the supply of fossil fuels means, in the short term, increasing the price of energy — which is both the single most salient price to voting publics, and a driver of inflation in the cost of myriad manufactured goods. Therefore, a commitment to throttling fossil-fuel production undermines the left’s efforts to offer an alternative vision for controlling inflation. It puts progressives in the position of saying, “We shouldn’t reduce prices by throttling demand through interest-rate hikes. But we also shouldn’t reduce prices by increasing the supply of the commodity that you care about most.”

So, that’s the political argument. Separately, there is a substantive one: Limiting U.S. fossil-fuel exports does not necessarily reduce the carbon-intensity of energy use. In Europe and Asia, we’ve seen that a scarcity of natural gas has led to an increase in coal burning. Given that global demand for fossil energy isn’t going to disappear in the medium term, how do we know that reducing U.S. natural-gas exports won’t just lead to them being replaced by dirtier fossil fuels? 
So, if the Biden administration had responded to the situation in 2022 by saying, “We need to focus on natural gas. We need to build out energy liquefaction and assist the Europeans in building off-take capacity,” then I think their position would have been perfectly defensible. Both of us know perfectly well that that’s not what it was about though, right?

They were trying to reduce the price of gasoline for American consumers at the pump and were willing to do practically goddamn anything to get that done. And all that does is reinforce the belief and expectation on the part of American consumers that they should expect that the full force of the American state will be used, even at the global level, to ensure that they get the ridiculously cheap gasoline that they’re used to. So that’s what my criticism centered on. It was about their meddling in OPEC policy and all of that. The distinction between oil and gasoline on the one hand, and natural gas on the other, has become more and more salient as the crisis of 2022 has gone on. What I think has become absolutely evident is that collectively, not just in Europe, but collectively, we have an interest in having a global gas market that works. And we currently don’t have an integrated global gas market.

And that’s because key elements of physical infrastructure are missing. We’re currently in a situation where the American natural-gas price is ridiculously low because it can’t be exported. There just isn’t the liquefaction capacity. So the fracking gas just circulates around the U.S. economy, and keeps America’s natural-gas prices ridiculously low by global standards.

Meanwhile, as energy prices began to surge all over the world last year, poor-country consumers of liquified natural gas found themselves squeezed out of the market altogether. And so, we don’t need to produce any more gas. We don’t need to expand gas production. What we need is a deeply integrated global gas market — not in the interest of subsidizing rich countries to go on doing what they’re doing, but in the interest of stabilizing energy costs in poor countries.

Having spent time now in India, the fury — that’s not the wrong word — at the hypocrisy of the European environmentalists over the issue of boycotting spending on gas infrastructure abroad is something to behold. I mean, it’s really fairly intense, especially now that the Europeans themselves are outbidding everyone else for the gas that they need. So I think the case for gas as a transition fuel is strong. The case for expanding gas production is not. The case for investing in gas infrastructure is, at this point, unanswerable.

So then, in your view, U.S. environmentalists are mistaken for opposing gas pipelines that facilitate exports? Because fundamentally, we need to build out such infrastructure if we’re going to have an equitable global gas market, in which Americans pay slightly more for energy, and the global poor pay much less?
The pipeline problem within the U.S. may matter to local environmentalist struggles and land rights and so on. But from a global point of view, they’re trivial. Build the pipeline some other way. But clearly, yes, in the interest of global balance, the resources of American gas need to be made available. It’s a bit like the reason why famines don’t happen anymore, right? If you have really integrated grain markets, you don’t get famines in the same way as you do if you have market disintegration.

If I understand you correctly, you’re saying that U.S. policymakers should not do anything to reduce gasoline prices for U.S. consumers, but should take actions that will increase the heating bills of their constituents (while benefiting natural-gas companies, which would gain access to a vastly larger market). 
Yes. The upshot of all of this is that American gas prices have to triple probably. If you’re worried about the cost-of-living impact, we all know what to do, right? You just subsidize lower incomes. You don’t do it by manipulating the energy price.

I feel like it would be politically suicidal for the Democratic Party to unilaterally endorse increasing Americans’ energy costs. Although, I guess expanding natural-gas exports might not require much policy action.
Yeah. The price difference between the U.S. and global market is so gigantic that the pressure to build that liquefaction capacity is well-nigh irresistible. Insofar as political objections in the United States make it impossible to raise fossil-fuel prices — be it through carbon taxes or carbon markets or simply the operation of a global market for gas — well, let’s just say that all of the outcomes for the climate then are second- or third- or fourth-best.

Returning to the Fed: You’ve suggested that, just as America’s energy policies should take greater account of the global good, so should its monetary policy. And partly out of enlightened self-interest. Right now, when weighing the pros and cons of increasing interest rates, the Fed doesn’t put much weight on the ramification of rate hikes for foreign economies. But since the U.S. dollar is the world’s reserve currency, those implications are huge. Whenever America raises its interest rate, other nations need to raise their own or else see their currencies devalue, and thus, their inflation get worse. Meanwhile, as rising interest rates increase the dollar’s value, it becomes harder for emerging markets to keep up with their dollar-denominated debt payments. Which can produce debt crises. So, why doesn’t the Fed incorporate such risks into its analysis of the costs and benefits of rate hikes?
Fundamentally, on the record, they’re not going to say anything at all that contradicts the fact that they’re an American central bank and their job is to worry about the American economy. They have no mandate for global hegemony, and they’re only supposed to factor in the global effects of their policy to the extent that those effects reverberate to the U.S. economy. And that is manifestly the case with financial stability concerns. Like, if Credit Suisse does fail, that’s big news on Wall Street. So they have every reason to try and support the Swiss government in whatever support they might have to do for Credit Suisse. But, they have no mandate to consider the impact of interest-rate increases on Sri Lanka or India or Argentina. That’s just not their brief.

But there are ways that this stance could blowback on the U.S. economy. When the Americans hike, everyone else has to hike to keep their currency stable against the dollar. Which means that everyone squeezes their economy simultaneously. And then what you get is a ripple effect whereby the excess capacity in the countries that supply goods to America begin to weigh on the pricing of those goods. And so there’s a risk that you over-deflate because no one factors in the spillover effects of their deflation on other economies.

It’s worth saying that we are currently engaged in the most widespread increase in interest rates the world has ever seen. So we don’t actually have a lot of experience to go on. We don’t know how the world economy will react to this squeeze. But there’s reason to believe that it may be, through lack of coordination, too tight.

What’s your biggest worry about the global economic situation right now?
I think it’s not the most likely scenario, but the biggest risk is the financial system breaking down. The more likely bad outcome is a worldwide recession. Which would be a disaster. If you look at the drivers of inflation, I believe that they’re transitory. I think a lot of it will fade out in due course. I think we’re hitting the television too hard with a hammer. We don’t really understand how it works. And I have to say, as a father of a young person who’s about to graduate college, who went through the total disruption of her life through COVID, if you think about the fate of that entire cohort of young people — and we’re talking hundreds of millions of people around the world whose education was disrupted by COVID lockdowns and who are now exiting education into a labor market that might be disrupted by a post-COVID recession — I think there’s a very strong case for running the global economy hot. There’s a matter of intergenerational justice.

Now, obviously, there are cost-of-living concerns too. But for young people, the crucial thing is to get a foothold in the labor market and not to fall into an unemployment track. Because we know that a big shock to the labor market has an enduring, almost lifelong effect on people’s careers.

In China right now, they have almost 20 percent youth unemployment. I mean, that’s a staggering phenomenon for them to be dealing with. From a global point of view, we have already seen what the worst case is; it’s something like Sri Lanka. And the question really is how many more seriously weak, fragile, emerging-market, low-income countries there are. And we’re going to find out. We’re going to crash-test the entire system.

This interview has been edited and condensed for clarity.

The Fed Might Just Break the Global Economy