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March 27, 2023

Even if "Lehman Crisis 2,0" occurs, the U.S. will not lose its hegemony 

 The world is on the brink of a financial panic similar to the Lehman crisis of 2008, triggered by the collapse of several large U.S. and European banks.

Panic is a rather psychological phenomenon
. It occurs when the flow of money comes to a halt because people begin to suspect each other that their counterparties are zombies, that is, actually dead and incapable of doing business with them.

As long as everyone thinks, "No, they are fine," and continues to trade, the financial system and the economy will continue to operate, regardless of the accumulation of non-performing assets in society. Stock prices will continue to rise amid the money glut. This has been the case for the past several years, and despite all the talk of danger and risk, the U.S. stock market has grown to a level about five times higher than it was in 2009.
And now everyone is beginning to doubt everyone else. If that happens, the grand post-2008 Ponzi scheme will be crushed with a bang.

Will there be panic this time? If so, what will happen? Will it mean the end of U.S. hegemony and dollar dominance? Let us look back at what has happened in the world since 2008 and consider the near future.

The Case of the United States

After the Lehman crisis in September 2008, the U.S. injected public funds to bail out large financial institutions and some major corporations. Financial institutions and companies repaid the public funds within a few years, though, to avoid further government intervention.

 The U.S. government and the Federal Reserve Bank stimulated the economy with increased fiscal spending and monetary easing, and the economy returned to positive growth in 2010. However, much of the fruit of the growth went to the wealthy, which increased inequality and helped Trump win the 2016 presidential election.

 The Lehman crisis paralyzed U.S. banks, clogging global trade and investment settlements (most of which are conducted using dollars). The world vied for dollars, which led to a strange thing: the effective exchange rate of the U.S. dollar, the currency of the U.S. in the midst of a depression, skyrocketed (http://honkawa2.sakura.ne.jp/5072.html). So the Federal Reserve Bank of the United States issued a lot of dollars (but only on its books) and "distributed" them to the central banks of the major countries to stave off the crisis. The massive issuance of dollars was only a temporary replacement for the dollars that were stuck and unusable in various parts of the world, so they were soon repaid to the Fed and did not become an inflationary factor.

 Later, following the logics of economy, the effective exchange rate of the dollar fell after 2009, but began to rise again after Japan's "extra-dimensional easing" in April 2013 (which led to the depreciation of the yen and appreciation of the dollar), and has continued to rise to the present. During this period, Japan would go through a period of yen appreciation around 2009, inversely proportional to the dollar, and a then period of yen depreciation starting in 2013.
The basic dilemma facing the U.S. today is that monetary easing to escape a financial crisis is unstoppable. Monetary easing tends to cause inflation, and raising interest rates to control it causes bonds and stock prices to fall, creating a panic.

This is what is happening in the EU and Japan, too. If growth is chosen, financial bubbles and their collapse are likely to occur. On the other hand, if one chooses stability, it will lead to a deflationary spiral.

The point is to walk a tightrope, striking a balance between these two dangers. The general direction should be set for growth, because it is difficult to maintain democratic politics in a shrinking economy. Financial collapse or disparity that occurs on this path can be alleviated by injecting public funds. However, those who speculate excessively and cause bankruptcies will be punished. This would maintain the vitality of society rather than excessive austerity measures.

The Case of China

 Until 2008, China's economic growth depended on trade surpluses and inflow of foreign direct investment. Fearing that both would disappear in the wake of the Lehman Brothers crisis, the Chinese government announced measures (part budget, part national bank loans) to expand domestic demand totaling around 500 billion US dollars (China's GDP at the time was about 4 trillion US dollars).

Much of the money went toward construction on state-owned and publicly-owned land and infrastructure building. This helped China maintain a high growth rate. At the time, China was touted as "the only major power to survive the Lehman Brothers crisis," and by 2010 it had overtaken Japan in terms of GDP, becoming a dominant economic power. However, the structure of the economy was distorted, with private consumption still only about 45% of the size of the U.S. economy, and the surplus funds flowed into real estate, creating a real estate bubble. The bubble burst, and now local governments and real estate giants are going bankrupt.

 China is still in the process of cleaning up the mess from the 2008 debacle. If Lehman 2.0 hits here, there will be nothing to do. The budget deficit (including local government finances) is expected to be an unprecedented 600 billion US dollars in 2023. This is equivalent to 3% of GDP.

 Whenever the U.S. stumbles, China and Russia always shout, "The end of U.S. unipolar dominance". When the U.S. economy stumbles, however, the Chinese and Russian economies are in full-blown collapse. China's exports to the U.S. will drop sharply (in 2021 it was 577 billion dollars), and Russia will be hit by a sharp drop in oil prices.

The case of Russia

 In August 2008, just before the Lehman Brothers crisis, Russian troops invaded Georgia and gobbled part of its territory. The U.S. did not sanction Russia, but a month later, the Lehman crisis caused world oil prices to plummet, and Russia's GDP had to shrink 6% in 2009. The Russian government injected public funds to bail out Russian banks and companies.

In the West, private companies try to repay public funds as quickly as possible. If they do not do so, their ratings will suffer and the government officials will keep meddling in their business.

In Russia, however, few companies and banks thought in this way. Rather, it was common for the presidents and chairmen of these companies to remain quasi-government employees, taking comfort in the public funds and not repaying them. Under Soviet socialism, everything was moved by "public funds" and run by officials, so this was also natural.

The share of state-owned enterprises in the Russian economy had declined with the collapse of the Soviet Union and subsequent privatization, but increased again in the wake of the Lehman crisis and continues to this day; the IMF calculated that in 2019, 33% of Russia's GDP was produced by state-owned enterprises, but various agencies have suggested an even higher figure.

The recovery and rise in international oil prices in 2010 was a bonus for the Russian economy (the price of Brent crude oil, which fell to $62 a barrel in 2009, nearly doubled to $112 in 2012), and Putin used the money to sharply increase defense spending and modernize weapons (or so he thought). Defense spending grew 72,7% from 2013 to its peak in 2016.

But the recent war in Ukraine clearly showed that Russia's defense spending increase (with the exception of new missiles) has been a waste of money.
The most obvious laggard in modernization is communications. The U.S. military has entered the 21st century with Network-Centric Warfare (NCW), a system of communications between comrades on the front lines and between the front lines and headquarters (sometimes with command centers on the U.S. mainland ordering attacks on Afghan drones in real time) that makes its mobility and deployment capabilities unmatched in the world.

The Russian military, in the recent war in Ukraine, lacked the ability to communicate between Moscow and the front lines, as well as between friendly forces on the front lines. Voices of "We don't know who is doing what or where" have been leaking out from among the Russian military. Moreover, the communications and reconnaissance satellite network GLONASS, which is supposed to support this communication, is overdue for renewal due in part to the unavailability of advanced microchips, and many of the satellites have become obsolete.

The reason for this may be that the Russian military did not think that there would be a classic land war like this one, and overlooked the fact that the budget was allocated to focus on the development of new missiles. It is also possible that part of the budget was embezzled.

Furthermore, the current upper echelons of the Russian military are those who were educated as military officers during the chaos of the 1990s. At that time, when the budget for the military was drastically cut and instructors and young officers turned to "business," today's military leaders may have lacked the qualities and failed to properly modernize the military's equipment.

In the current war in Ukraine, nearly 1,000 Russian tanks have been destroyed by the West's Javelin and other mobile missiles. And now Russia feels that it has used up missiles and even artillery shells, and the fighting is going downhill.
After all Russia neither lost nor benefitted much from the Lehman 1,0.

The Case of Japan

 What about Japan? During the Lehman crisis in September 2008, people were first at ease, saying "Japanese banks are fine. They did not invest much on speculative bonds." However, the crisis soon reached Japan when orders for Japanese products from overseas plummeted. Japan's GDP fell by 6,3% in 2009.

 The U.S. and Europe weathered the Lehman crisis with massive fiscal spending and monetary easing. Japan did not do so at first, which led to a widening interest rate gap with the U.S. and Europe and to excessive appreciation of the yen. Furthermore, after the Great East Japan Earthquake in March 2011, companies pulled their overseas holdings back to their headquarters as a contingency reserve fund. This led to a large amount of dollars being converted into yen, which spurred the yen appreciation and the accompanying deflationary trend became even more intense. The public began to show strong opposition to the price hikes of commodities.

Prime Minister Abe and Bank of Japan Governor Kuroda broke this trend with monetary easing that was a lap or two behind that of the U.S. and Europe. Interest rates temporarily fell into negative territory and the yen weakened excessively.

This policy belatedly took effect when the current Kishida administration came to power and prices began to rise. This was amplified by the surge in energy prices due to the war in Ukraine, and in one swoop Japan entered an inflationary era of over 4% (in January of this year). This year, large corporations across the board are raising wages substantially.

Immediate Outlook

The immediate outlook can be broadly divided into two scenarios. The first is to somehow weather the financial collapse. The artificial economic stimulus regime will linger on, with the Central Bank pouring out paper money and the Ministry of Finance and the big banks pumping it into society. Every decade or so, the financial sector would lose its balance and a financial crisis strikes, but each time this happens, public funds are injected and monetary and fiscal easing takes place to further boost the economy. The value of currencies will decline permanently, but the dollar, the yen, and the euro will all decline in tandem, so the U.S. will not lose its monetary hegemony.

The second scenario is the immediate advent of a financial Armageddon. Some big bank will collapse again (It may well happen in Asia. Asian banks have invested a lot in U.S. and other bonds), and Lehman 2.0 will happen. In that case, in the U.S., the Fed will ease or even stop raising interest rates, which it has been doing for the past year. There would even be a resumption of monetary easing. This would increase inflation and further depreciate the value of the dollar. However, the euro and other currencies will also fall in value, making gold the sole winner.
Will this change the world pecking order? Drastic changes did occur when the U.S. became the dominant economic and monetary power in World War II. And Dutch capital movement to England in the late 17th century helped the UK to snatch the Dutch economic hegemony.

 Such a thing will not happen this time around. In the 16th and 17th centuries, capital from Venice, Genoa, and other Mediterranean cities moved to Antwerp and Amsterdam, giving rise to the Dutch hegemony in the 17th century. At the end of the 17th century, Dutch capital flowed to the United Kingdom, and at the end of the 19th century, capital from the United Kingdom and other Western European countries flowed to the United States, contributing to their respective hegemony.

This time, there are no new investment destinations to which U.S. money can be directed. Some say that China and India are the answer, but these two countries lack the autonomous growth potential of the Netherlands, the U.K., and the U.S. in the past, so they cannot replace the U.S.

 The renminbi also cannot gain hegemony, even if it becomes a digital currency. The Chinese authorities will resist at all costs the free use of the yuan by foreigners over whom they have no control.

 The world has not broken free of the managed currency paradigm that has been prevailing since the 17th century. The postwar dollar system will continue. Whether or not Lehman Brothers 2,0 happens this time, forced growth will continue to be maintained using a managed currency. The challenge will be to improve living standards and mitigate disparities even in such a situation. I believe this can be achieved by not overly tilting the balance between growth and distribution in either direction.