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 THE
COMING TRADE WAR, Part 2
Dollar hegemony
against sovereign
credit
By Henry C K Liu
(For
other parts in the series, click
here)
Global trade has forced all countries to
adopt a market economy. Yet the market is not the
economy. It is only one aspect of the economy.
A market economy can be viewed as an
aberration of human civilization, as economist
Karl Polanyi (1886-1964) pointed out. The
principal theme of Polanyi's Origins of Our
Time: The Great Transformation (1945) was that
market economy was of very recent origin and had
emerged fully formed only as recently as the 19th
century, in conjunction with capitalistic
industrialization. The current globalization of
markets that followed the fall of the Soviet bloc
is also of recent post-Cold War origin, in
conjunction with the advent of the electronic
information age and deregulated finance
capitalism. A severe and prolonged depression
could trigger the end of the market economy, when
intelligent human beings are finally faced with
the realization that the business cycle inherent
in the market economy cannot be regulated
sufficiently to prevent its innate destructiveness
to human welfare and are forced to seek new
economic arrangements for human development. The
principle of diminishing returns will lead people
to reject the market economy, however
sophisticatedly regulated.
Prior to the
coming of capitalistic industrialization, the
market played only a minor part in the economic
life of societies. Even where marketplaces could
be seen to be operating, they were peripheral to
the main economic organization and activities of
society. In many pre-industrial economies, markets
met only twice a month. Polanyi argued that in
modern market economies, the needs of the market
determined social behavior, whereas in
pre-industrial and primitive economies the needs
of society determined market behavior. Polanyi
reintroduced to economics the concepts of
reciprocity and redistribution in human
interaction, which were the original aims of
trade.
Reciprocity implies that people
produce the goods and services they are best at
and enjoy producing the most, and share them with
others with joy. This is reciprocated by others
who are good at and enjoy producing other goods
and services. There is an unspoken agreement that
all would produce that which they could do best
and mutually share and share alike, not just sold
to the highest bidder or, worse, to produce what
they despise to meet the demands of the market.
The idea of sweatshops is totally unnatural to
human dignity and uneconomic to human welfare.
With reciprocity, there is no need for layers of
management, because workers happily practice their
livelihoods and need no coercive supervision.
Labor is not forced and workers do not merely sell
their time in jobs they hate, unrelated to their
inner callings. Prices are not fixed but vary
according to what different buyers with different
circumstances can afford or what the seller needs
in return from different buyers. The law of one
price is inhumane, unnatural, inflexible and
unfair. All workers find their separate personal
fulfillment in different productive livelihoods of
their choosing, without distortion by the need for
money. The motivation to produce and share is not
personal profit, but personal fulfillment, and
avoidance of public contempt, communal ostracism,
and loss of social prestige and moral standing.
This motivation, albeit distorted today by
the dominance of money, is still fundamental in
societies operating under finance capitalism. But
in a money society, the emphasis is on
accumulating the most financial wealth, which is
accorded the highest social prestige. The annual
report on the world's richest 100 as celebrities
by Forbes is clear evidence of this anomaly. The
opinions of figures such as Bill Gates and Warren
Buffet are regularly sought by the media on
matters beyond finance, as if the possession of
money itself represents a diploma of wisdom. In
the 1960s, wealth was an embarrassment among the
flower children in the US. It was only in the
1980s that the age of greed emerged to embrace
commercialism.
In a speech on June 3 at
the Take Back America conference in Washington,
DC, Bill Moyers drew attention to the conclusion
by the editors of The Economist, all friends of
business and advocates of capitalism and free
markets, that "the United States risks calcifying
into a European-style class-based society". A
front-page editorial in the May 13 Wall Street
Journal concluded that "as the gap between rich
and poor has widened since 1970, the odds that a
child born in poverty will climb to wealth - or
that a rich child will fall into middle class -
remain stuck ... Despite the widespread belief
that the US remains a more mobile society than
Europe, economists and sociologists say that in
recent decades the typical child starting out in
poverty in continental Europe (or in Canada) has
had a better chance at prosperity." The New York
Times ran a 12-day series this month under the
heading "Class Matters" that observed that class
is closely tied to money in the US and that "the
movement of families up and down the economic
ladder is the promise that lies at the heart of
the American dream. But it does not seem to be
happening quite as often as it used to." The myth
that free markets spread equality seems to be
facing a challenge in the heart of market
fundamentalism.
People trade to compensate
for deficiencies in their current state of
development. Free trade is not a license for
exploitation. Exploitation is slavery, not trade.
Imperialism is exploitation by systemic coercion
on an international level. Neo-imperialism after
the end of the Cold War takes the form of
neo-liberal globalization of systemic coercion.
Free trade is hampered by systemic coercion.
Resistance to systemic coercion is not to be
confused with protectionism. To participate in
free trade, a trader must have something with
which to trade voluntarily in a market free of
systemic coercion. All free trade participants
need to have basic pricing power that requires
that no one else commands monopolistic pricing
power. That tradable something comes from
development, which is a process of
self-betterment. Just as equality before the law
is a prerequisite for justice, equality in pricing
power in the market is a prerequisite for free
trade. Traders need basic pricing power for trade
to be free. Workers need pricing power for the
value of their labor to participate in free
trade.
Yet trade in a market economy by
definition is a game to acquire overwhelming
pricing power over one's trading partners.
Wal-Mart, for example, has enormous pricing power
both as a bulk buyer and as a mass retailer. But
it uses its overwhelming pricing power not to pay
the highest wages to workers in factories and in
its stores, but to deliver the lowest price to its
customers. The business model of Wal-Mart, whose
sales volume is greater than the gross domestic
product (GDP) of many small countries, is
anti-development. The trade-off between low income
and low retail price follows a downward spiral.
This downward spiral has been the main defect of
trade deregulation when low prices are achieved
through the lowering of wages. The economic
purpose of development is to raise income, not
merely to lower wages to reduce expenses by
lowering quality. International trade cannot be a
substitute for domestic development, or even
international development, although it can
contribute to both domestic and international
development if it is conducted on an equal basis
for the mutual benefit of both trading partners.
And the chief benefit is higher income.
The terms of international trade need to
take into consideration local conditions, not as a
reluctant tolerance but with respect for
diversity. The former Japanese vice finance
minister for international affairs, Eisuke
Sakakibara, in a speech titled "The End of Market
Fundamentalism" before the Foreign Correspondent's
Club in Tokyo on January 22, 1999, presented a
coherent and wide-ranging critique of global
macro-orthodoxy. His view, that each national
economic system must conform to agreed
international trade rules and regulations but need
not assimilate the domestic rules and regulations
of another country, is heresy to US-led,
one-size-fits-all globalization. In a computerized
world where output standardization has become
unnecessary, where the mass production of
customized one-of-a-kind products is routine,
one-size-fits-all hegemony is nothing more than
cultural imperialism. In a world of sovereign
states, domestic development must take precedence
over international trade, which is a system of
external transactions made supposedly to augment
domestic development. And domestic development
means every nation is free to choose its own
development path most appropriate to its
historical conditions and is not required to adopt
the US development model. But neo-liberal
international trade since the end of the Cold War
has increasingly preempted domestic development in
both the center and the periphery of the world
system. Quality of life is regularly compromised
in the name of efficiency.
This is the
reason the French and the Dutch voted against the
European Union constitution, as a resistance to
the US model of globalization. Britain has
suspended its own vote on the constitution to
avoid a likely voter rejection. In Italy, cabinet
ministers suggested abandoning the euro to return
to an independent currency in order to regain
monetary sovereignty. Bitter battles have erupted
among member nations in the EU over national
government budgets and subsidies. In that sense,
neo-liberal trade is being increasingly identified
as an obstacle, even a threat, to diversified
domestic development and national culture.
Global trade has become a vehicle for
exploitation of the weak to strengthen the strong
both domestically and internationally. Culturally,
US-style globalization is turning the world into a
dull market for unhealthy McDonald's fast food,
dreary Wal-Mart stores, and automated Coca-Cola
and bank machines. Every airport around the world
is a replica of a giant US department store with
familiar brand names, making it hard to know which
city one is in. Aside from being unjust and
culturally destructive, neo-liberal global trade
as it currently exists is unsustainable, because
the perpetual transfer of wealth from the poor to
the rich is no more sustainable than drawing from
a dry well is sustainable in a drought, nor can
stagnant consumer income sustain a consumer
economy. Neo-liberal claims of fair benefits of
free trade to the poor of the world, both in the
center and the periphery, are simply not supported
by facts. Everywhere, people who produce the goods
cannot afford to buy the same goods for themselves
and the profit is siphoned off to invisible
investors continents away.
Trade and
money
Trade is facilitated by money.
Mainstream monetary economists view
government-issued money as a sovereign-debt
instrument with zero maturity, historically
derived from the bill of exchange in free banking.
This view is valid only for specie money, which is
a debt certificate that entitles the holder to
claim on demand a prescribed amount of gold or
other specie of value. Government-issued fiat
money, on the other hand, is not a sovereign-debt
but a sovereign-credit instrument, backed by
government acceptance of it for payment of taxes.
This view of money is known as the State Theory of
Money, or Chartalism. The US dollar, a fiat
currency, entitles the holder to exchange for
another dollar at any US Federal Reserve Bank, no
more, no less. Sovereign government bonds are
sovereign debts denominated in money. Sovereign
bonds denominated in fiat money need never default
since sovereign government can print fiat money at
will. Local government bonds are not sovereign
debt and are subject to default because local
governments do not have the authority to print
money. When fiat money buys bonds, the transaction
represents credit canceling debt. The relationship
is rather straightforward, but of fundamental
importance.
Credit drives the economy, not
debt. Debt is the mirror reflection of credit.
Even the most accurate mirror does violence to the
symmetry of its reflection. Why does a mirror turn
an image right to left and not upside down as the
lens of a camera does? The scientific answer is
that a mirror image transforms front to back
rather than left to right as commonly assumed. Yet
we often accept this aberrant mirror distortion as
uncolored truth and we unthinkingly consider the
distorted reflection in the mirror as a perfect
representation. Mirror, mirror on the wall, who is
the fairest of them all? The answer is: your
backside.
In the language of monetary
economics, credit and debt are opposites but not
identical. In fact, credit and debt operate in
reverse relations. Credit requires a positive net
worth and debt does not. One can have good credit
and no debt. High debt lowers credit rating. When
one understands credit, one understands the main
force behind the modern finance economy, which is
driven by credit and stalled by debt.
Behaviorally, debt distorts marginal utility
calculations and rearranges disposable income.
Debt turns corporate shares into Giffen goods,
demand for which increases when their prices go
up, and creates what US Federal Reserve Board
chairman Alan Greenspan calls "irrational
exuberance", the economic man gone mad.
If
fiat money is not sovereign debt, then the entire
financial architecture of fiat-money capitalism is
subject to reordering, just as physics was subject
to reordering when man's world view changed with
the realization that the Earth is not stationary
nor is it the center of the universe. For one
thing, the need for capital formation to finance
socially useful development will be exposed as a
cruel hoax. With sovereign credit, there is no
need for capital formation for socially useful
development in a sovereign nation. For another,
savings are not necessary to finance domestic
development, since savings are not required for
the supply of sovereign credit. And since capital
formation through savings is the key systemic
rationale for income inequality, the proper use of
sovereign credit will lead to economic democracy.
Sovereign credit and
unemployment
In an
economy financed by sovereign credit, labor should
be in perpetual shortage, and the price of labor
should constantly rise. A vibrant economy is one
in which there is a persistent labor shortage and
labor enjoys basic, though not monopolistic,
pricing power. An economy should expand until a
labor shortage emerges and keep expanding through
productivity rises to maintain a slight labor
shortage. Unemployment is an indisputable sign
that the economy is underperforming and should be
avoided as an economic plague.
The
Phillips curve, formulated in 1958, describes the
systemic relationship between unemployment and
wage-pushed inflation in the business cycle. It
represented a milestone in the development of
macroeconomics. British economist A W H Phillips
observed that there was a consistent inverse
relationship between the rate of wage inflation
and the rate of unemployment in the United Kingdom
from 1861 to 1957. Whenever unemployment was low,
inflation tended to be high. Whenever unemployment
was high, inflation tended to be low. What
Phillips did was to accept a defective labor
market in a typical business cycle as natural law
and to use the tautological data of the flawed
regime to prove its validity, and made
unemployment respectable in macroeconomic
policymaking, in order to obscure the
irrationality of the business cycle. That is like
observing that the sick are found in hospitals and
concluding that hospitals cause sickness and that
a reduction in the number of hospitals will reduce
the number of the sick. This theory will be
validated by data if only hospital patients are
counted as being sick and the sick outside of
hospitals are viewed as "externalities" to the
system. This is precisely what has happened in the
United States, where an oversupply of hospital
beds has resulted from changes in the economics of
medical insurance, rather than a reduction of
people needing hospital care. Part of the economic
argument against illegal immigration is based on
the overload of non-paying patients in a
health-care system plagued with overcapacity.
Nevertheless, Nobel laureates
Paul Samuelson and Robert Solow led an army of
government economists in the 1960s in using the
Phillips curve as a guide for macro-policy
trade-offs between inflation and unemployment in
market economies. Later, Edmund Phelps and Milton
Friedman independently challenged the theoretical
underpinnings by pointing out separate effects
between the "short-run" and "long-run" Phillips
curves, arguing that the inflation-adjusted
purchasing power of money wages, or real wages,
would adjust to make the supply of labor equal to
the demand for labor, and the unemployment rate
would rest at the real wage level to moderate the
business cycle. This level of unemployment they
called the "natural rate" of unemployment. The
definitions of the natural rate of unemployment
and its associated rate of inflation are
circularly self-validating. The natural rate of
unemployment is that at which inflation is equal
to its associated inflation. The associated rate
of inflation is that which prevails when
unemployment is equal to its natural rate.
A
monetary purist, Friedman correctly concluded that
money is all-important, but as a social
conservative, he left the path to truth
half-traveled by not having much to say about the
importance of the fair distribution of money in
the market economy, the flow of which is largely
determined by the terms of trade. Contrary to the
theoretical relationship described by the Phillips
curve, higher inflation was associated with
higher, not lower, unemployment in the US in the
1970s and, contrary to Friedman's claim, deflation
was associated also with high unemployment in
Japan in the 1990s. The fact that both inflation
and deflation accompanied high unemployment ought
to discredit the Phillips curve and Friedman's
notion of a natural unemployment rate. Yet most
mainstream economists continue to accept a central
tenet of the Friedman-Phelps analysis that there
is some rate of unemployment that, if maintained,
would be compatible with a constant rate of
inflation. This they call the "non-accelerating
inflation rate of unemployment" (NAIRU), which
over the years has crept up from 4% to 6%.
NAIRU means that the price of
sound money for the US is 6% unemployment. The US
Labor Department reported the "good news" that in
May 7.6 million persons, or 5.1% of the workforce,
were unemployed in the United States, well within
NAIRU range. Since low-income people tend to have
more children than the national norm, that
translates to households with more than 20 million
children with unemployed parents. On the shoulders
of these unfortunate, innocent souls rests the
systemic cost of sound money, defined as having a
non-accelerating inflation rate, paying for highly
irresponsible government fiscal policies of
deficits and a flawed monetary policy that leads
to skyrocketing trade deficits and debts. That is
equivalent to saying that if 6% of the world
population dies from starvation, the price of food
can be stabilized. And unfortunately, such are the
terms of global agricultural trade. No government
economist has bothered to find out what would be
the natural inflation rate for real full
employment.
It is hard to see how sound
money can ever lead to full employment when
unemployment is necessary to keep money sound.
Within limits and within reason, unemployment
hurts people and inflation hurts money. And if
money exists to serve people, then the choice
between inflation and unemployment becomes
obvious. The theory of comparative advantage in
world trade is merely Say's Law internationalized.
It requires full employment to be operative.
Wages and profits
And neo-classical economics
does not allow the prospect of employers having an
objective of raising wages, as Henry Ford did,
instead of minimizing wages as current corporate
management, such as the Ford Motor Co, routinely
practices. Henry Ford raised wages to increase
profits by selling more cars to workers, while the
Ford Motor Co today cuts wages to maximize profit
while adding to overcapacity. Therein resides the
cancer of market capitalism: falling wages will
lead to the collapse of an overcapacity economy.
This is why global wage
arbitrage is economically destructive unless and
until it is structured to raise wages everywhere
rather than to keep prices low in the developed
economies. That is done by not chasing after the
lowest price made possible by the lowest wages,
but by chasing after a bigger market made possible
by rising wages. The terms of global trade need to
be restructured to reward companies that aim at
raising wages and benefits globally through
internationally coordinated transitional
government subsidies, rather than the regressive
approach of protective tariffs to cut off trade
that exploits wage arbitrage. This will enable the
low-wage economies to begin to be able to afford
the products they produce and to import more
products from the high wage economies to move
toward balanced trade.
Eventually, certainly within
a decade, wage arbitrage will cease to be the
driving force in global trade as wage levels
around the world equalize. When the population of
the developing economies achieves per capita
income that matches that in developed economies,
the world economy will be rid of the modern curse
of overcapacity caused by the flawed neoclassical
economics of scarcity. When top executives are
paid tens of million of dollars in bonuses to cut
wages and worker benefits, it is not fair reward
for good management; it is legalized theft.
Executives should only receive bonuses if both
profit and wages in their companies rise as a
result of their management strategies.
Sovereign credit and dollar
hegemony
In an economy
that can operate on sovereign credit, free from
dollar hegemony, private savings are needed only
for private investment that has no clear socially
redeeming purpose or value.
Savings are deflationary
without full employment, as savings reduce current
consumption to provide investment to increase
future supply. Savings for capital formation serve
only the purpose of bridging the gap between new
investment and new revenue from rising
productivity and increased capacity from the new
investment. With sovereign credit, private savings
are not needed for this bridge financing. Private
savings are also not needed for rainy days or
future retirement in an economy that has freed
itself from the tyranny of the business cycle
through planning.
Say's Law of supply creating
its own demand is a very special situation that is
operative only under full employment, as eminent
post-Keynesian economist Paul Davidson has pointed
out. Say's Law ignores a critical time lag between
supply and demand that can be fatal to a
fast-moving modern economy without demand
management. Savings require interest payments, the
compounding of which will regressively make any
financial system unsustainable by tilting it
toward overcapacity caused by overinvestment.
Religions forbade usury for very practical
reasons. Yet interest on money is the very
foundation of finance capitalism, held up by the
neo-classical economic notion that money is more
valuable when it is scarce. Aggregate poverty,
then, is necessary for sound money. This was what
US president Ronald Reagan meant when he said that
there are always going to be poor people.
The
Bank for International Settlements (BIS) estimated
that as of the end of 2004, the notional value of
global OTC (over the counter) interest-rate
derivatives is about US$185 trillion, with a
market risk exposure of more than $5 trillion,
which is almost half of 2004 US GDP. Interest-rate
derivatives are by far the largest category of
structured finance contracts, taking up $185
trillion of the total $250 trillion of notional
values. The $185 trillion notional value of
interest-rate derivatives is 41 times the
outstanding value of US Treasury bonds. This means
that interest-rate volatility will have a
disproportioned impact of the global financial
system in ways that historical data cannot
project.
Fiat money issued by
government is now legal tender in all modern
national economies since the 1971 collapse of the
Bretton Woods regime of fixed exchange rates
linked to a gold-backed US dollar. Chartalism
holds that the general acceptance of
government-issued fiat currency rests
fundamentally on government's authority to tax.
Government's willingness to accept the currency it
issues for payment of taxes gives the issuance
currency within a national economy. That currency
is sovereign credit for tax liabilities, which are
dischargeable by credit instruments issued by
government, known as fiat money. When issuing fiat
money, the government owes no one anything except
to make good a promise to accept its money for tax
payment.
A central banking regime
operates on the notion of government-issued fiat
money as sovereign credit. That is the essential
difference between central banking with
government-issued fiat money, which is a
sovereign-credit instrument, and free banking with
privately issued specie money, which is a bank IOU
that allows the holder to claim the gold behind
it.
With the fall of the Union of
Soviet Socialist Republics, the US attitude toward
the rest of the world changed. It now no longer
needs to compete for the hearts and minds of the
masses of the Third and Fourth Worlds. So trade
has replaced aid. The US has embarked on a
strategy to use cheap Third/Fourth World labor and
non-existent environmental regulation to compete
with its former Cold War allies, now
industrialized rivals in trade, taking advantage
of traditional US anti-labor ideology to outsource
low-paying jobs, playing against the strong
pro-labor tradition of social welfare in Europe
and Japan. In the meantime, the US pushed for
global financial deregulation based on dollar
hegemony and emerged as a 500-pound gorilla in the
globalized financial market that left the Japanese
and Europeans in the dust, playing catch-up in an
unwinnable game. In the game of finance
capitalism, those with capital in the form of fiat
money they can print freely will win hands down.
The tool of this US strategy
is the privileged role of the dollar as the key
reserve currency for world trade, otherwise known
as dollar hegemony. Out of this emerges an
international financial architecture that does
real damage to the actual producer economies for
the benefit of the financier economies. The
dollar, instead of being a neutral agent of
exchange, has become a weapon of massive economic
destruction (WMED) more lethal than nuclear bombs
and with more blackmail power, which is exercised
ruthlessly by the International Monetary Fund
(IMF) on behalf of the Washington Consensus. Trade
wars are fought through volatile currency
valuations. Dollar hegemony enables the United
States to use its trade deficits as the bait for
its capital account surplus.
Foreign direct investment
under dollar hegemony has changed the face of the
international economy. Since the early 1970s, FDI
has grown along with global merchandise trade and
is the single most important source of capital for
developing countries, not net savings or sovereign
credit. FDI is mostly denominated in dollars, a
fiat currency that the US can produce at will
since 1971, or in dollar derivatives such as the
yen or the euro, which are not really independent
currencies. Thus FDI is by necessity concentrated
in exports-related development, mainly destined
for US markets or markets that also sell to US
markets for dollars with which to provide the
return on dollar-denominated FDI. US economic
policy is shifting from trade promotion to FDI
promotion. The US trade deficit is financed by the
US capital account surplus which in turn provides
the dollars for FDI in the exporting economies. A
trade spat with the EU over beef and bananas, for
example, risks large US investment stakes in
Europe. And the suggestion to devalue the dollar
to promote US exports is misleading for it would
only make it more expensive for US affiliates to
do business abroad while making it cheaper for
foreign companies to buy dollar assets. An attempt
to improve the trade balance, then, would actually
end up hurting the FDI balance. This is the
rationale behind the slogan: a strong dollar is in
the US national interest.
Between 1996 and 2003, the
monetary value of US equities rose around 80%
compared with 60% for Europeans and a decline of
30% for Japanese. The 1997 Asian financial crisis
cut the values of Asian equities by more than
half, some as much as 80% in dollar terms even
after drastic devaluation of local currencies.
Even though the United States has been a net
debtor since 1986, its net income on the
international investment position has remained
positive, as the rate of return on US investments
abroad continues to exceed that on foreign
investments in the US. This reflects the overall
strength of the US economy, and that strength is
derived from the US being the only nation that can
enjoy the benefits of sovereign-credit utilization
while amassing external debt, largely due to
dollar hegemony.
In the US, and now also
increasingly so in Europe and Asia, capital
markets are rapidly displacing banks as both
savings venues and sources of funds for corporate
finance. This shift, along with the growing global
integration of financial markets, is supposed to
create promising new opportunities for investors
around the globe. Neo-liberals even claim that
these changes could help head off the looming
pension crises facing many nations. But so far it
has only created sudden and recurring financial
crises like those that started in Mexico in 1982,
then in the United Kingdom in 1992, again in
Mexico in 1994, in Asia in 1997, and Russia,
Brazil, Argentina and Turkey subsequently.
The
introduction of the euro has accelerated the
growth of the EU financial markets. For the
current 25 members of the European Union, the
common currency nullified national requirements
for pension and insurance assets to be invested in
the same currencies as their local liabilities, a
restriction that had long locked the bulk of
Europe's long-term savings into domestic assets.
Freed from foreign-exchange transaction costs and
risks of currency fluctuations, these savings
fueled the rise of larger, more liquid European
stock and bond markets, including the recent
emergence of a substantial euro junk bond market.
These more dynamic capital markets, in turn, have
placed increased competitive pressure on banks by
giving corporations new financing options and thus
lowering the cost of capital within euroland. How
this will interact with the euro-dollar market is
still indeterminate. Euro-dollars are dollars
outside of US borders everywhere and not
necessarily Europe, generally pre-taxed and
subject to US taxes if they return to US soil or
accounts. The term also applies to euro-yen and
euro-euros. But the idea of French retirement
accounts investing in non-French assets is both
distasteful and irrational for the average French
worker, particularly if such investment leads to
decreased job security in France and jeopardizes
the jealously guarded 35-hour work-week with 30
days of paid annual vacation that has been part of
French life.
Take the Japanese economy as
an example, the world's largest creditor economy.
It holds more than $800 billion in dollar
reserves. The Bank of Japan (BOJ), the central
bank, has bought more than 300 billion dollars
with yen from currency markets in the past two
years in an effort to stabilize the exchange value
of the yen, which continued to appreciate against
the dollar. Now, the BOJ is faced with a dilemma:
continue buying dollars in a futile effort to keep
the yen from rising, or sell dollars to try to
recoup yen losses on its dollar reserves. Japan
has officially pledged not to diversify its dollar
reserves into other currencies, so as not to roil
currency markets, but many hedge funds expect
Japan to run out of options soon.
Now
if the BOJ sells dollars at the rate of $4 billion
a day, it will take some 200 trading days to get
out of its dollar reserves. After the initial two
days of sale, the remaining unsold $792 billion
reserves would have a market value of 20% less
than before the sales program began. So the BOJ
would suffer a substantial net yen paper loss of
$160 billion. If the BOJ continues its sell-dollar
program, every day 400 billion yen will leave the
yen money supply to return to the BOJ if it sells
dollars for yen, or the equivalent in euros if it
sells dollars for euros. This will push the dollar
further down against the yen or euro, in which
case the value of its remaining dollar reserves
will fall even further, not to mention a sharp
contraction in the yen money supply, which will
push the Japanese economy into a deeper recession.
If the BOJ sells dollars for
gold, two things may happen. There may not be
enough sellers because no one has enough gold to
sell to absorb the dollars at current gold prices.
Instead, while the price of gold will rise, the
gold market may simply freeze, with no
transactions. Gold holders will not have to sell
their gold; they can profit from gold derivatives
on notional values. Also, the reverse market
effect that faces the dollar would hit gold. After
two days of Japanese gold buying, everyone would
hold on to his gold in anticipation of
still-higher gold prices. There would be no market
makers. Part of the reason central banks have been
leasing out their gold in recent years is to
provide liquidity to the gold market.
The
second thing that may happen is that the price of
gold will skyrocket in currency terms, causing a
great deflation in gold terms. The US national
debt as of June 1 was $7.787 trillion. US
government gold holding is about 261 million
ounces. The price of gold required to pay back the
national debt with US-held gold is $29,835 per
ounce. At that price, an ounce of gold would buy a
car. Meanwhile, the market price of gold as of
June 4 was $423.50 per ounce. Gold peaked at $850
per ounce in 1980 and bottomed at $252 in 1999
when oil was below $10 a barrel. At $30,000 per
ounce, governments would have to make gold trading
illegal, as US president Franklin Roosevelt did in
1930, and we would be back to Square 1. It is much
easier for a government to outlaw the trading of
gold within its borders than it is for it to
outlaw the trading of its currency in world
markets. It does not take much to conclude that
anyone who advises any strategy of long-term
holding of gold will not get to the top of the
class.
Heavily indebted poor
countries need debt relief to get out of virtual
financial slavery. Some African governments spend
three times as much on debt service as they do on
health care. Britain has proposed a half-measure
that would have the International Monetary Fund
(IMF) sell about $12 billion worth of its gold
reserves, which have a total current market value
of about $43 billion, to finance debt relief. The
United States has veto power over gold decisions
in the IMF. Thus the US Congress holds the key.
However, the mining-industry lobby has blocked a
vote. In January, a letter opposing the sale of
IMF gold was signed by 12 US senators from western
mining states, arguing that the sale could drive
down the price of gold. A similar letter was
signed in March by 30 members of the House of
Representatives. Lobbyists from the National
Mining Association and gold-mining companies such
as Newmont Mining and Barrick Gold Corp persuaded
the congressional leadership that the gold
proposal would not pass in Congress, even before
it came up for debate.
The
Bank for International Settlements (BIS) reports
that gold derivatives took up 26% of the world's
commodity derivatives market, yet gold only
composes 1% of the world's annual commodity
production value, with 26 times as many
derivatives structured against gold as against
other commodities, including oil. The Bush
administration, at first apparently unwilling to
take on a congressional fight, began in April to
oppose gold sales outright. But President George W
Bush and British Prime Minister Tony Blair
announced on June 7 that the US and UK are "well
on their way" to a deal that would provide 100%
debt cancellation for some poor nations to the
World Bank and African Development Fund as a sign
of progress in the Group of Eight (G8) debate over
debt cancellation.
Jude Wanniski, a former
editor of the Wall Street Journal, commenting in
his "Memo on the margin" on the Internet on June
15, on the headline of Pat Buchanan's syndicated
column of the same date, "Reviving the foreign-aid
racket", wrote:
This not a
bailout of Africa's poor or Latin American
peasants. This is a bailout of the IMF, the
World Bank and the African Development Bank ...
The second part of the racket is that in
exchange for getting debt relief, the poor
countries will have to spend the money they save
on debt service on "infrastructure projects", to
directly help their poor people with water and
sewer lines, etc, which will be constructed by
contractors from the wealthiest nations ... What
comes next? One of the worst economists in the
world, Jeffrey Sachs, is in charge of the United
Nations scheme to raise mega-billions from
Western taxpayers for the second leg of this
scheme. He wants $25 billion a year for the
indefinite future, as I recall, and he has the
fervent backing of the New York Times, which
always weeps crocodile tears for the racketeers.
It was Jeffrey Sachs, in case you forgot, who
with the backing of the NY Times persuaded
Moscow under Mikhail Gorbachev to engage in
"shock therapy" to convert from communism to
capitalism. It produced the worst inflation in
the history of Russia, caused the collapse of
the Soviet federation, and sank the Russian
people into a poverty they had never experienced
under communism. The dollar cannot go
up or down more than 20% against any other major
currencies within a short time without causing a
major global financial crisis. Yet, against the US
equity markets, the dollar appreciated about 40%
in purchasing power in the 2000-02 market crash.
And against real-estate prices between 2002 and
2005, the dollar has depreciated 60% or more.
According to Greenspan's figures, the Fed can
print $8 trillion more fiat dollars without
causing inflation. The problem is not the
money-printing. The problem is where that $8
trillion is injected. If it is injected into the
banking system, then the Fed will have to print $3
trillion every subsequent year just to keep
running in place. If the $8 trillion is injected
into the real economy in the form of full
employment and higher wages, the US will have a
very good economy, and much less need for paranoia
against Asia or the EU. But US wages cannot rise
as long as global wage arbitrage is operative.
This is one of the arguments behind protectionism.
It led Greenspan to say on May 5 he feared what
appeared to be a growing move toward trade
protectionism, saying it could lessen the ability
of the US and the world economy to withstand
shock. Yet if democracy works in the US,
protectionism will be unstoppable as long as free
trade benefits the elite at the expense of the
voting masses.
Fiat
money is sovereign credit
Money is like power: use it
or lose it. Money unused (not circulated) is
defunct wealth. Fiat money not circulated is not
wealth but merely pieces of printed paper sitting
in a safe. Gold unused as money is merely a shiny
metal good only as an ornamental gift for weddings
and birthdays. The usefulness of money to the
economy is dependent on its circulation, like the
circulation of blood to bring oxygen and nutrients
to the living organism. The rate of money
circulation is called velocity by monetary
economists. A vibrant economy requires a high
velocity of money. Money, like most
representational instruments, is subject to
declaratory definition. In semantics, a
declaratory statement is self-validating. For
example: "I am king" is a statement that makes the
declarer king, albeit in a kingdom of one citizen.
What gives weight to the declaration is the number
of others accepting that declaration. When
sufficient people within a jurisdiction accept the
kingship declaration, the declarer becomes king of
that jurisdiction instead of just his own house.
When an issuer of money declares it to be credit
it will be credit, or when he declares it to be
debt it will be debt. But the social validity of
the declaration depends on the acceptance of
others.
Anyone can issue money, but
only sovereign government can issue legal tender
for all debts, public and private, universally
accepted with the force of law within the
sovereign domain. The issuer of private money must
back that money with some substance of value, such
as gold, or the commitment for future service,
etc. Others who accept that money have provided
something of value for that money, and have
received that money instead of something of
similar value in return. So the issuer of that
money has given an instrument of credit to the
holder in the form of that money, redeemable with
something of value on a later date.
When
the state issues fiat money under the principle of
Chartalism, the something of value behind it is
the fulfillment of tax obligations. Thus the state
issues a credit instrument, called (fiat) money,
good for the cancellation of tax liabilities. By
issuing fiat money, the state is not borrowing
from anyone. It is issuing tax credit to the
economy.
Even if money is declared as
debt assumed by an issuer who is not a sovereign
who has the power to tax, anyone accepting that
money expects to collect what is owed him as a
creditor. When that money is used in a subsequent
transaction, the spender is parting with his
creditor right to buy something of similar value
from a third party, thus passing the "debt" of the
issuer to the third party. Thus no matter what
money is declared to be, its function is a credit
instrument in transactions. When one gives money
to another, the giver is giving credit and the
receiver is incurring a debt unless value is
received immediately for that money. When debt is
repaid with money, money acts as a credit
instrument. When government buys back government
bonds, which is sovereign debt, it cannot do so
with fiat money it issues unless fiat money is
sovereign credit.
When money changes hands,
there is always a creditor and a debtor. Otherwise
there is no need for money, which stands for value
rather than being value intrinsically. When a cow
is exchanged for another cow, that is bartering,
but when a cow is bought with money, the buyer
parts with money (an instrument of value) while
the seller parts with the cow (the substance of
value). The seller puts himself in the position of
being a new creditor for receiving the money in
exchange for his cow. The buyer exchanges his
creditor position for possession of the cow. In
this transaction, money is an instrument of
credit, not a debt.
When private money is issued,
the only way it will be accepted generally is that
the money is redeemable for the substance of value
behind it based on the strong credit of the
issuer. The issuer of private money is a custodian
of the substance of value, not a debtor. All that
is logic, and it does not matter how many
mainstream monetary economists say money is debt.
Economist Hyman P Minsky
(1919-96) observed correctly that money is created
whenever credit is issued. He did not say money is
created when debt is incurred. Only entities with
good credit can issue credit or create money.
Debtors cannot create money, or they would not
have to borrow. However, a creditor can only be
created by the existence of a debtor. So both a
creditor and a debtor are needed to create money.
But only the creditor can issue money, the debtor
accepts the money so created, which puts him in
debt.
The difference with the state
is that its power to levy taxes exempts it from
having to back its creation of fiat money with any
other assets of value. The state when issuing fiat
money is acting as a sovereign creditor. Those who
take the fiat money without exchanging it with
things of value are indebted to the state; and
because taxes are not always based only on income,
a taxpayer is a recurring debtor to the state by
virtue of his citizenship, even those with no
income. When the state provides transfer payments
in the form of fiat money, it relieves the
recipient of his tax liabilities or transfers the
exemption from others to the recipient to put the
recipient in a position of a creditor to the
economy through the possession of fiat money. The
holder of fiat money is then entitled to claim
goods and services from the economy. For things
that are not for sale, such as political office,
money is useless, at least in theory. The exercise
of the fiat money's claim on goods and services is
known as buying something that is for sale.
There is a difference between
buying a cow with fiat money and buying a cow with
private IOUs (notes). The transaction with fiat
money is complete. There is no further obligation
on either side after the transaction. With notes,
the buyer must either eventually pay with money,
which cancels the notes (debt), or return the cow.
The correct way to look at
sovereign-government-issued fiat money is that it
is not a sovereign debt, but a sovereign-credit
good for canceling tax obligations. When the
government redeems sovereign bonds (debt) with
fiat money (sovereign credit), it is not paying
off old debt with new debt, which would be a Ponzi
scheme.
Government does not become a
debtor by issuing fiat money, which in the US is a
Federal Reserve note, not an ordinary banknote.
The word "bank" does not appear on US dollars.
Zero maturity money (ZMM), which grew from $550
billion in 1971, when president Richard Nixon took
the dollar off gold, to $6.63 trillion as of May
30, 2005, is not a federal debt. It is a federal
credit to the economy acceptable for payment of
taxes and as legal tender for all debts, public
and private. Anyone refusing to accept dollars
within US jurisdiction is in violation of US law.
One is free to set market prices that determine
the value, or purchasing power, of the dollar, but
it is illegal on US soil to refuse to accept
dollars for the settlement of debts. Instruments
used for settling debts are credit instruments.
When fiat money is used to buy sovereign bonds
(debt), money cannot be anything but an instrument
of sovereign credit. If fiat money is sovereign
debt, there is no need to sell government bonds
for fiat money. When a sovereign government sells
a sovereign bond for fiat money issues, it is
withdrawing sovereign credit from the economy. And
if the government then spends the money, the money
supply remains unchanged. But if the government
allows a fiscal surplus by spending less than its
tax revenue, the money supply shrinks and the
economy slows. That was the effect of the Bill
Clinton surplus, which produced the recession of
2000. While runaway fiscal deficits are
inflationary, fiscal surpluses lead to recessions.
Conservatives who are fixated on fiscal surpluses
are simply uninformed on monetary economics.
For
euro-dollars, meaning fiat dollars outside the
United States, the reason those who are not
required to pay US taxes accept them is dollar
hegemony, not because dollars are IOUs of the US
government. Everyone accepts dollars because
dollars can buy oil and all other key commodities.
When the Fed injects money into the US banking
system, it is not issuing government debt; it is
expanding sovereign credit that would require
higher government tax revenue to redeem. But if
expanding sovereign credit expands the economy,
tax revenue will increase without changing the tax
rate. Dollar hegemony exempts the US dollar, and
only the US dollar, from foreign-exchange
implication on the State Theory of Money. To issue
sovereign debt, the Treasury issues Treasury
bonds. Thus under dollar hegemony, the United
States is the only nation that can practice and
benefit from sovereign credit under the principle
of Chartalism.
Money and bonds are opposite
instruments that cancel each other. That is how
the Fed Open Market Committee (FOMC) controls the
money supply, by buying or selling government
securities with fiat dollars to set a Fed Funds
Rate target. The Fed Funds Rate is the interest
rate at which US banks lend to each other
overnight. As such, it is a market interest rate
that influences market interest rates throughout
the world in all currencies through exchange
rates. Holders of a government bond can claim its
face value in fiat money at maturity, but the
holder of a fiat dollar can only claim a
fiat-dollar replacement at the Fed. Holders of
fiat dollars can buy new sovereign bonds at the
Treasury, or outstanding sovereign bonds in the
bond market, but not at the Fed. The Fed does not
issue debts, only credit in the form of fiat
money. When the FOMC buys or sells government
securities, it does so on behalf of the Treasury.
When the Fed increases the money supply, it is not
adding to the national debt. It is increasing
sovereign credit in the economy. That is why
monetary easing is not deficit financing.
Money and inflation
It is sometimes said that
war's legitimate child is revolution and war's
bastard child is inflation. World War I was no
exception. The US national debt multiplied 27
times to finance the nation's participation in
that war, from $1 billion to $27 billion. Far from
ruining the United States, the war catapulted the
country into the front ranks of the world's
leading economic and financial powers. The
national debt turned out to be a blessing, for
government securities are indispensable as anchors
for a vibrant credit market.
Inflation was a different
story. By the end of World War I, in 1919, US
prices were rising at the rate of 15% annually,
but the economy roared ahead. In response, the
Federal Reserve Board raised the discount rate in
quick succession, from 4% to 7%, and kept it there
for 18 months to try to rein in inflation. The
discount rate is the interest rate charged to
commercial banks and other depository institutions
on loans they receive from their regional Federal
Reserve Bank's lending facility - the discount
window. The result was that in 1921, 506 banks
failed. Deflation descended on the economy like a
perfect storm, with commodity prices falling 50%
from their 1920 peak, throwing farmers into mass
bankruptcies. Business activity fell by one-third;
manufacturing output fell by 42%; unemployment
rose fivefold to 11.9%, adding 4 million to the
jobless count. The economy came to a screeching
halt. From the Fed's perspective, declining prices
were the goal, not the problem; unemployment was
necessary to restore US industry to a sound
footing, freeing it from wage-pushed inflation.
Potent medicine always came with a bitter taste,
the central bankers explained.
At
this point, a technical process inadvertently gave
the New York Federal Reserve Bank, which was
closely allied with internationalist banking
interest, pre-eminent influence over the Federal
Reserve Board in Washington, the composition of
which represented a more balanced national
interest. The initial operation of the Fed did not
use the open-market operation of purchasing or
selling government securities to set interest-rate
policy as a method of managing the money supply.
The Fed could not simply print money to buy
government securities to inject money into the
money supply because the dollar was based on gold
and the amount of gold held by the government was
relatively fixed. Money in the banking system was
created entirely through the discount window at
the regional Federal Reserve banks. Instead of
buying or selling government bonds, the regional
Feds accepted "real bills" of trade, which when
paid off would extinguish money in the banking
system, making the money supply self-regulating in
accordance with the "real bills" doctrine to
maintain the gold standard. The regional Feds
bought government securities not to adjust money
supply, but to enhance their separate operating
profit by parking idle funds in interest-bearing
yet super-safe government securities, the way
institutional money managers do today.
Bank
economists at that time did not understand that
when the regional Feds independently bought
government securities, the aggregate effect would
result in macroeconomic implications of injecting
"high power" money into the banking system, with
which commercial banks could create more money in
multiple by lending recycles based on the partial
reserve principle. When the government sold bonds,
the reverse would happen. When the Fed made
open-market transactions, interest rates would
rise or fall accordingly in financial markets. And
when the regional Feds did not act in unison, the
credit market could become confused or
disaggregated, as one regional Fed might buy while
another might sell government securities in its
open-market operations.
Benjamin Strong, first
president of the New York Federal Reserve Bank,
saw the problem and persuaded the other 11
regional Feds to let the New York Fed handle all
their transactions in a coordinated manner. The
regional Feds formed an Open Market Investment
Committee, to be run by the New York Fed for the
purpose of maximizing overall profit for the whole
system. This committee became dominated by the New
York Fed, which was closely linked to big-money
central-bank interests, which in turn were closely
tied to international financial markets. The
Federal Reserve Board approved the arrangement
without full understanding of its implication:
that the Fed was falling under the undue influence
of the New York internationalist bankers. For the
United States, this was the beginning of financial
globalization. This fatal flaw would reveal itself
in the Fed's role in causing and its impotence in
dealing with the 1929 stock market crash.
The
deep 1920-21 depression eventually recovered by
the lowering of the Fed discount rate into the
Roaring Twenties, which, like the New Economy
bubble of the 1990s, left some segments of the US
economy and the population in them lingering in a
depressed state. Farmers remained victimized by
depressed commodity prices and factory workers
shared in the prosperity only by working longer
hours and assuming debt with the easy money that
the banks provided. Unions lost 30% of their
membership because of high unemployment in boom
times. The prosperity was entirely fueled by the
wealth effect of a speculative boom in the stock
market that by the end of the decade would face
the 1929 crash and land the nation and the world
in the Great Depression. Historical data showed
that when New York Fed president Strong leaned on
the regional Feds to ease the discount rate on an
already overheated economy in 1927, the Fed lost
its last window of opportunity to prevent the 1929
crash. Some historians claimed that Strong did so
to fulfill his internationalist vision at the risk
of endangering the national interest. It is an
issue of debate that continues in the US Congress
today. Like Greenspan, Strong argued that it was
preferable to deal with post-crash crisis
management by adding liquidity than to pop a
bubble prematurely with preventive measures of
tight money. It is a strategy that requires
letting a bubble pop only inside a bigger bubble.
The speculative boom of easy
credit in the 1920s attracted many to buy stocks
with borrowed money and used the rising price of
stocks as new collateral for borrowing more to buy
more stocks. Brokers' loans went from under $5
million in mid-1928 to $850 million in September
of 1929. The market capitalization of the 846
listed companies of the New York Stock Exchange
was $89.7 billion, at 1.24 times 1929 GDP. By
current standards, a case could be built that
stocks in 1929 were in fact technically
undervalued. The 2,750 companies listed in the New
York Stock Exchange had total global market
capitalization exceeding $18 trillion in 2004,
1.53 times 2004 GDP of $11.75 trillion.
On
January 14, 2001, the Dow Jones Industrial Average
reached its all-time high to date at 11,723, not
withstanding Greenspan's warning of "irrational
exuberance" on December 6, 1996, when the DJIA was
at 6,381. From its August 12, 1982, low of 777,
the DJIA began its most spectacular bull market in
history. It was interrupted briefly only by the
abrupt and frightening crash on October 19, 1987,
when the DJIA lost 22.6% on Black Monday, falling
to 1,739. That represented a 1,021-point drop from
its previous peak of 2,760 reached less than two
months earlier on August 21. But Greenspan's
easy-money policy lifted the DJIA to 11,723 in 13
years, a 674% increase. In 1929 the top came on
September 4, with the DJIA at 386. A headline in
the New York Times on October 22, 1929, reported
highly respected economist Irving Fisher as
saying, "Prices of stocks are low." Two days
later, the stock market crashed, and by the end of
November, the New York Stock Exchange shares index
was down 30%. The index did not return to the
September 3, 1929, level until November 1954. At
its worst level, the index dropped to 40.56 in
July 1932, a drop of 89%. Fisher had based his
statement on strong earnings reports, few
industrial disputes, and evidence of high
investment in research and development (R&D)
and in other intangible capital. Theory and
supportive data not withstanding, the reality was
that the stock-market boom was based on borrowed
money and false optimism. In hindsight, many
economists have since concluded that stock prices
were overvalued by 30% in 1929. But when the crash
came, the overshoot dropped the index by 89% in
less than three years.
Money and gold
When money is not backed by
gold, its exchange value must be managed by
government, more specifically by the monetary
policies of the central bank. No responsible
government will voluntarily let the market set the
exchange value of its currency, market
fundamentalism notwithstanding. Yet central
bankers tend to be attracted to the gold standard
because it can relieve them of the unpleasant and
thankless responsibility of unpopular monetary
policies to sustain the value of money. Central
bankers have been caricatured as party spoilers
who take away the punch bowl just when the party
gets going.
Yet even a gold standard is
based on a fixed value of money to gold, set by
someone to reflect the underlying economic
conditions at the time of its setting. Therein
lies the inescapable need for human judgment.
Instead of focusing on the appropriateness of the
level of money valuation under changing economic
conditions, central banks often become fixated on
merely maintaining a previously set exchange rate
between money and gold, doing serious damage in
the process to any economy temporarily out of sync
with that fixed rate. It seldom occurs to central
bankers that the fixed rate was the problem, not
the dynamic economy. When the exchange value of a
currency falls, central bankers often feel a
personal sense of failure, while they merely shrug
their shoulders to refer to natural laws of
finance when the economy collapses from an
overvalued currency.
The return to the gold
standard in war-torn Europe in the 1920s was
engineered by a coalition of internationalist
central bankers on both sides of the Atlantic as a
prerequisite for postwar economic reconstruction.
Lenders wanted to make sure that their loans would
be repaid in money equally valuable as the money
they lent out, pretty much the way the IMF deals
with the debt problem today. President Strong of
the New York Fed and his former partners at the
House of Morgan were closely associated with the
Bank of England, the Banque de France, the
Reichsbank, and the central banks of Austria, the
Netherlands, Italy and Belgium, as well as with
leading internationalist private bankers in those
countries. Montagu Norman, governor of the Bank of
England from 1920-44, enjoyed a long and close
personal friendship with Strong as well as an
ideological alliance. Their joint commitment to
restore the gold standard in Europe and so to
bring about a return to the "international
financial normalcy" of the prewar years was well
documented. Norman recognized that the impairment
of British financial hegemony meant that, to
accomplish postwar economic reconstruction that
would preserve prewar British interests, Europe
would "need the active cooperation of our friends
in the United States".
Like
other New York bankers, Strong perceived World War
I as an opportunity to expand US participation in
international finance, allowing New York to move
toward coveted international-finance-center status
to rival London's historical pre-eminence, through
the development of a commercial paper market, or
bankers' acceptances in British finance parlance,
breaking London's long monopoly. The Federal
Reserve Act of 1913 permitted the Federal Reserve
Banks to buy, or rediscount, such paper. This
allowed US banks in New York to play an
increasingly central role in international finance
in competition with the London market.
Herbert Hoover, after losing
his second-term US presidential election to
Franklin D Roosevelt as a result of the 1929
crash, criticized Strong as "a mental annex to
Europe", and blamed Strong's internationalist
commitment to facilitating Europe's postwar
economic recovery for the US stock-market crash of
1929 and the subsequent Great Depression that
robbed Hoover of a second term. Europe's return to
the gold standard, with Britain's insistence on
what Hoover termed a "fictitious rate" of US$4.86
to the pound sterling, required Strong to expand
US credit by keeping the discount rate
unrealistically low and to manipulate the Fed's
open market operations to keep US interest rate
low to ease market pressures on the overvalued
pound sterling. Hoover, with justification,
ascribed Strong's internationalist policies to
what he viewed as the malign persuasions of Norman
and other European central bankers, especially
Hjalmar Schacht of the Reichsbank and Charles Rist
of the Bank of France. From the mid-1920s onward,
the United States experienced credit-pushed
inflation, which fueled the stock-market bubble
that finally collapsed in 1929.
Within the Federal Reserve
System, Strong's low-rate policies of the
mid-1920s also provoked substantial regional
opposition, particularly from Midwestern and
agricultural elements, who generally endorsed
Hoover's subsequent critical analysis. Throughout
the 1920s, two of the Federal Reserve Board's
directors, Adolph C Miller, a professional
economist, and Charles S Hamlin, perennially
disapproved of the degree to which they believed
Strong subordinated domestic to international
considerations.
The fairness of Hoover's
allegation is subject to debate, but the fact that
there was a divergence of priority between the
White House and the Fed is beyond dispute, as is
the fact that what is good for the international
financial system may not always be good for a
national economy. This is evidenced today by the
collapse of one economy after another under the
current international finance architecture that
all central banks support instinctively out of a
sense of institutional solidarity. The same issue
has surfaced in today's China where regional
financial centers such as Hong Kong and Shanghai
are vying for the role of world financial center.
To do this, they must play by the rules of the
international financial system which imposes a
cost on the national economy. The nationalist vs
internationalist conflict, as exemplified by the
Hoover vs Strong conflict of the 1930s, is also
threatening the further integration of the
European Union. Behind the fundamental rationale
of protectionism is the rejection of the claim
that internationalist finance places national
development as its priority. The Richardian theory
of comparative advantage of free trade is not the
issue.
The issue of government
control over foreign loans also brought the Fed,
dominated by Strong, into direct conflict with
Hoover when the latter was secretary of commerce.
Hoover believed that the US government should have
right of approval on foreign loans based on
national-interest considerations and that the
proceeds of US loans should be spent on US goods
and services. Strong opposed all such restrictions
as undesirable government intervention in free
trade and international finance and
counterproductively protectionist. Businesses
should be not only allowed but encouraged to buy
when it is cheapest anywhere in the world,
including shopping for funds to borrow, a refrain
that is heard tirelessly from free traders also
today. Of course, the expanding application of the
law of one price to more and more commodities,
including the price of money, ie interest rates
adjusted by exchange rates, makes such dispute
academic. The only commodity exempt from the law
of one price is labor. This exemption makes the
trade theory of comparative advantage a fantasy.
In July and August 1927,
Strong, despite ominous data on mounting market
speculation and inflation, pushed the Fed to lower
the discount rate from 4% to 3% to relieve market
pressures again on the overvalued British pound.
In July 1927, the central bankers of Britain, the
United States, France and Weimar Germany met on
Long Island in the US to discuss means of
increasing Britain's gold reserves and stabilizing
the European currency situation. Strong's
reduction of the discount rate and purchase of 12
million pounds sterling, for which he paid the
Bank of England in gold, appeared to come directly
from that meeting. One of the French bankers in
attendance, Charles Rist, reported that Strong
said that US authorities would reduce the discount
rate as "un petit coup de whisky for the stock
exchange". Strong pushed this reduction through
the Fed despite strong opposition from Miller and
fellow board member James McDougal of the Chicago
Fed, who represented Midwestern bankers, who
generally did not share New York's
internationalist preoccupation.
Frank Altschul, partner in
the New York branch of the transnational
investment bank Lazard Freres, told Emile Moreau,
the governor of the Bank of France, that "the
reasons given by Mr Strong as justification for
the reduction in the discount rate are being taken
seriously by no one, and that everyone in the
United States is convinced that Mr Strong wanted
to aid Mr Norman by supporting the pound". Other
correspondence in Strong's own files suggests that
he was giving priority to international monetary
conditions rather than to US export needs,
contrary to his public arguments. Writing to
Norman, who praised his handling of the affair as
"masterly", Strong described the US discount rate
reduction as "our year's contribution to
reconstruction." The Fed's ease in 1927 forced
money to flow not into the overheated real
economy, which was unable to absorb further
investment, but into the speculative financial
market, which led to the crash of 1929. Strong
died in October 1928, one year before the cr | | | |
