Page 4 of 5 THE ROAD TO HYPERINFLATION, Part 3
Inflation targeting
By Henry C K Liu
starved exporting economies in Asia were holding large amounts of US debt. The
Bretton Woods II theory says that this state of affairs is both desirable and
sustainable, a dubious claim clearly disproved by facts by now.
There may still be some who argue that dollar hegemony is desirable but no one
can deny it is clearly unsustainable. If this currency abuse is practiced by
any other government, the International Monetary Fund (IMF), a creation of the
Bretton Woods regime, would impose austere "conditionalities" on its fiscal
budget to restore the exchange value of the currency. With dollar hegemony, the
US, the nation with the longest continuous
current account deficit in history and the world largest
debtor, is exempt from such IMF imposed austerity discipline on its fiscal
budget.
The net result of the injurious effects of dollar hegemony is the emergence of
anti-trade protectionism even within the US, the supposedly lead beneficiary of
the Bretton Woods II regime, particularly the segment of the US population that
has unevenly borne the pain of free trade. For the exporting economies, there
are growing signs that political leaders are beginning to realize that
export-led growth is not the panacea that neoliberal market fundamentalism has
made it out to be. Exporting for dollars that cannot be invested at home has
left all exporting economies starved for capital for domestic development, with
serious disparity of income and wealth, and political instability resulting
from unbalance development. While much of domestic politics in the exporting
countries is distorted by uneven power held by special interests of the export
sector, a collapse in global trade will shift the balance of political power
back towards the domestic sector.
The circular fund flow from US current account deficit back into US capital
account surplus appeared to have come to a sudden halt in the summer of 2007.
The US Treasury International Capital System (TICS) data show a massive drop in
net foreign purchases of US long-term securities since the end of June,
dropping from $99.9 billion to $19.5 billion in July and to a negative $70.6
billion in August, bouncing back to a positive $26.4 billion in September. All
the while, US current account deficit has been running about $80 billion a
month.
What dollar hegemony does over time is to feed the US debt bubble and steadily
weaken the value of the dollar while it hollows out the US industrial core, as
US policymakers in both the Clinton and Bush administrations tirelessly assert
that a strong dollar is the national interest. Whenever the dollar debt bubble
burst in the last two decades, as it again did in August 2007, the Fed was
forced into the fad of a monetary easing mode, ie lowering dollar interest
rates not just temporarily but keeping it low for long periods. The effect has
been to force the purchasing power of the dollar to fall, which then induced
other central banks to let their currencies fall as well to protect their
competitive export market shares and to preserve the value of their dollar
holdings in local currency terms. A competitive currency devaluation war will
eventually unravel dollar hegemony in a disorderly fashion into a spiral of
global hyperinflation. That eventuality appears to be at hand in 2008.
The collapse of dollar hegemony can accelerate the emergence of an Asian
regional currency regime, along the lines of what happened in Europe after the
collapse of the Bretton Woods regime in 1971. There has been a lot of talk for
a long time about Asian monetary union, with little progress so far. See my
July 12, 2002 article,
The case for an Asian Monetary Fund, in Asia Times Online.
Prisoners' dilemma for foreign central banks
The dollar’s fall in exchange value relative to the euro is costly for all
central banks holding large amounts of dollar-denominated financial assets
whose economies also import from the euro-zone, even when dollar-denominated
commodities continue to appreciate in price.
By holding and continuing to accumulate large amounts of dollars from trade
surpluses, these central banks have a powerful incentive to ensure that their
dollar holdings retain their purchasing power and exchange value in relation to
their own currencies. Yet if these foreign central banks perceive the US Fed as
powerless to halt the fall of the dollar by its unwillingness to keep dollar
interest rates appropriately high, because the Fed prefers a robust market to a
strong economy, they would have an equally powerful incentive to sell off their
dollars while there is still a market for them or to compete to buy hard assets
that would cause prices to rise. Both of these moves will lead to dollar
hyperinflation.
This situation creates a well-known "prisoners’ dilemma" for central banks with
massive dollar holdings. Collectively, these central banks have a compelling
incentive to hold on to their dollars to avoid a massive sell off that hurts
everyone, so as to maintain the dollar’s value on world currency markets for
the common good. Yet individually, each central bank has an incentive to sell
dollars and diversify its holdings into other currencies or hard assets before
the market collapses from other central banks selling ahead of the others to
gain individual advantage. This fear of defection from a common interest leads
to a classic prisoners’ dilemma, and the risk that these dollar-holding central
banks will simultaneously try to diversify their currency portfolios poses the
greatest threat toward a run on the dollar.
The Western oil companies have been playing this game of the prisoners’ dilemma
against OPEC members for decades to induce individual producers to cheat for
advantage by selling more than its share of the allotted quota, causing Saudi
Arabia, the lead producer, to keep oil prices up by cutting its own production
below its allotted quota to minimize the effect of individual defection. The
Saudi’s role as swing producers held the cartel together. The US, unlike Saudi
Arabia, has thus far shown no inclination of cutting down the production of
fiat dollars.
The Triffin Dilemma of 1960
The Triffin dilemma, named after Belgian-American economist Robert Triffin who
first identified it in 1960, is the problem of fundamental currency imbalances
in the Bretton Woods regime. With dollars flowing overseas through the Marshall
Plan, US military spending and US citizens buying foreign goods and US tourists
spending aboard, the amount of euro-dollars in circulation soon exceeded the
amount of gold backing them. By the early 1960s, an ounce of gold could be
exchanged for $40 in London, even though the official price in the US remained
$35 by law. This difference showed that the market knew the dollar was
overvalued and that time for gold-backed dollar was running out.
The solution was to reduce the amount of dollars in circulation by cutting the
US balance of payments deficit and raising dollar interest rates to attract
dollars back into the country. But these moves would drag the US economy into
recession, a prospect President John F Kennedy found politically unacceptable.
This was posed as the famous Triffin dilemma to Congress as an explanation of
why the Bretton Woods regime had inevitably to collapse. Triffin noted that
there was a fundamental liquidity dilemma when one country’s national fiat
currency was used as a global reserve currency for trade. The very structural
advantage would cause that country to lose any resolve to maintain the value of
its fiat currency.
As the post-war world economy grew, more dollars were needed to finance it. To
supply global dollar liquidity, the US must run a deficit, as no other
government can produce dollars. But to maintain credibility of its currency,
the US must not run a deficit. That was the fundamental dilemma. In the end,
the US opted to continue to run a balance of payments deficit, which led to the
loss of credibility and the collapse of the Bretton Woods regime in 1971.
However, if the United States stopped running balance of payments deficits, the
global economy would lose its largest source to monetary reserves. The
resulting shortage of liquidity could pull the world economy into a contracting
spiral, leading to economic, social and political instability.
How long will central banks subsidize dollar hegemony?
Some argue that it is not the business of central banks to maximize the return
on their exchange reserve portfolio, but to protect and enhance the stability
of domestic financial markets and, in the case of central banks of large
economies, global financial stability. In other words, foreign central banks
that hold massive dollar reserves from trade surpluses are expected to pay the
price of exchange rate losses to sustain the current international global
financial infrastructure based on the fiat dollar.
Yet the profit made from the exchange rate losses sustained by the foreign
central banks went disproportionately to the international financial elite,
causing income disparity everywhere that held back consumption demand, which
became a critical structural problem when the global economy moved into an
overcapacity mode.
Whether and for how much longer this counter salutary arrangement can be
sustained depends on the degree and rate of decline of the dollar and the
disproportionately low purchasing power of workers in the US and the rest of
the world. Foreign central banks may become convinced that the US has neither
the intention nor the resolve to keep the dollar strong beyond rhetoric, nor
the ideology to let domestic and foreign workers have a larger share of global
corporate earnings. When that happens, the incentive for foreign central banks
to hold onto the dollar in hope of an eventual reversal of its declining value
may vanish very suddenly either as a result of financial logic or political
pressure.
Shortly after the outbreak of the credit crisis of August 2007, as supposedly
low-risk instruments became victims of unanticipated risk swelling from below,
the monetary policy establishment began looking for a scapegoat and found it in
the failure of the rating agencies to account properly for the complexity of
the securitized instruments, relying overly on faulty mathematical models to
override conventional prudent risk management.
It is true that rating agencies operate under a conflict of interest, their
fees being paid by the issuers of the debt instrument they rate. Yet the
underlying logic of the rating agencies’ permissive blessing rested on a
reasoned assumption: that the explosive growth in credit derivatives and
collateralized debt obligations (CDO) of recent years around the world had been
enabled, if not caused, by US-led monetary policy under the leadership of Alan
Greenspan at the Fed and Robert Rubin at the Treasury, and that this monetary
of easy money would continue. Dollar hegemony, though unavoidably presenting a
long-term threat to the US-controlled international finance architecture, was
as close to a free lunch in monetary economics as one can get.
Destructiveness of dollar hegemony
Dollar hegemony allowed the US to soak up the world’s wealth with persistent
negative real interest rates to finance US spending. After Clinton, the Bush
tax cuts, with the help of Greenspan’s loose monetary policy, sustained the
global debt bubble with reflation, the act of stimulating the economy
artificially by increasing the money supply during stagnant growth and by
regressive tax reduction during periods of rising fiscal deficits.
Global broad marketing of securitized debt instruments has shifted credit
monitoring from direct lender knowledge of the credit history of individual
borrowers to aggregate credit rating based on statistical probabilities
constructed from theoretical borrower profiles and behavior patterns, much like
the fundamental assumption of the rational economic man by neoclassical
economics. More and more mortgages were written on the assumption of home
prices continuing to rise, thus reducing concern for borrower credit rating to
near zero. The safety of mortgage-back securities depended entirely on expected
rising prices of homes and not on the credit worthiness of the borrower. In
fact, a subprime borrower is more likely to refinance regularly to siphon
rising home value into bank profits than a prime borrower.
As house prices stopped rising and began to fall, irresponsible borrower
behavior surprised the risk models. Many borrowers stopped mortgage payments
not because they were cash strapped but because they did not want to feed a
mortgage that would soon exceed the market value of their houses. The
abnormally rapid rise of distressed mortgages upset the statistical credit
hierarchy of the mathematical models and caused a sudden credit squeeze. As the
credit squeeze persisted, ratings agencies were being forced to downgrade
hundreds of thousands of debt securities, after failing to foresee the
on-coming waves of defaults initialized by subprime borrowers.
For example, on the last Wednesday night in January 2008 alone, Standard &
Poor’s reportedly downgraded more than 8,000 residential mortgage-related
securities with a market value of $534 billion. These downgrades in turn
triggered bitter recriminations, amid a wave of losses at asset management
firms and banks. The Financial Times quotes Wes Edens, head of Fortress
Investment Group, a leading fund with over $40 billion in assets under
management: "Much of the money lost has been held by people who held AAA
securities [that were downgraded]. That has caused a tremendous loss of
confidence."
At the root of the rating collapse was the reliance on risk management models
that assume human behavior to remain unchanged in times of financial distress
as during times of financial euphoria. Delinquency rates on home mortgages
jumped
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