Page 2 of 5 MONEY AND COMMODITY MARKETS, Part 1
Integrity deficit has its price
By Henry CK Liu
In 1971, the US detached the dollar from gold and made it a fiat currency based
on the strength and large size of the US economy, which allowed the dollar to
continue to perform the role of the world's key reserve currency for
international trade. This was the beginning of dollar hegemony.
When Regulation Q was phased out by 1986, US banks were allowed to pay interest
on checking accounts - the NOW accounts - to lure depositors back from
interest-paying money markets. The traditional interest-rate advantage of
S&L associations over commercial banks was removed, to provide a "level
playing field" with commercial banks, forcing them to take the same risk as
commercial banks to survive.
Congress also lifted restrictions on S&L commercial lending, beyond
traditional home mortgages, which promptly got the whole
S&L industry into bad-debt troubles that would soon require an
unprecedented government tax-money bailout of depositors in the S&L crisis.
But the real-estate developers who made billions with S&L loans were
allowed to walk away with their profits, leaving S&L banks with foreclosed
properties, their market values way below the values of their mortgages. State
usury laws, stating how much interest can be charged before it is considered
unlawful, were unilaterally suspended by an act of Congress in a flagrant
intrusion on state rights.
A political coalition of powerful converging interests was evident. Virulently
high inflation had damaged the financial position of the holders of money,
including small savers, created by a period of benign low inflation earlier, so
that even progressives felt something had to be done to protect the propertied
middle class, the anchor of political democracy by virtue of their opposition
to economic democracy.
The solution was to export inflation to low-labor-cost economies in newly
industrialized countries (NICs) around the world, taming US domestic inflation
by outsourcing employment overseas and exorcising the domestic inflation devil
that came in the form of escalating US wages.
The rise of neo-liberalism
Neo-liberalism, as summarized by Susan George in her paper: "A Short History of
Neo-liberalism: Twenty Years of Elite Economics and Emerging Opportunities for
Structural Change", delivered at the Conference on Economic Sovereignty in a
Globalizing World in Bangkok in March 1999, is a belief that the market
mechanism should be allowed to direct the fate of human beings.
The economy should dictate its rules to society, not the other way around.
Neo-liberalism is a movement in support of free-market economics, globalized
deregulated free-trade and anti-welfare reform. The German term
"Ordoliberalism" (German neo-liberalism), originally coined by German economist
Alexander Rustow (1885-1963), stands for the need for the state to ensure that
the free market produces results close to its theoretical resource allocation
potential, not the US neo-liberal advocacy of no government intervention in
markets.
Rustow was the theoretical father of "social markets", a doctrine that
influenced the successful economic policies of Ludwig Wilhelm Erhard
(1897-1977), minister of economics under chancellor Konrad Adenauer after 1949.
Financial neo-liberalism was born with the twin midwives of dollar hegemony and
unregulated global financial markets, disguising economic neo-imperialism as
market fundamentalism. The debasement of the fiat dollar, dragging down all
other fiat currencies, found expression in the upward surge of commodities and
equity asset prices, which pushed down global wages to keep US inflation low.
This pathetic phenomenon of a downward economic spiral was celebrated as
economic growth by neo-liberals.
The emergence of an interbank deposit market
Payments in the real economy cause bank balances in the central bank to rise
and fall. A bank with a balance shortfall will need to borrow funds from a bank
with an excess, and hence is created an interbank deposit market, which is the
key money market.
This interbank deposit market exists, with maturities from one day to one year,
in every currency, and in the major currencies it exists both domestically and
in London. A market participant, by choosing to borrow or lend money at any
particular maturity, is implicitly speculating against the forward rates
implied by the spot rates.
Banks lend money against secured collateral, the rating of which reflects
credit risk, which in turn affects the interest rate. Central banks have fiat
control over short-term interest rates of the most secured collaterals,
generally rated AAA, as with US Treasury bills, motivated by monetary ideology
and perceived forward-looking economic conditions. The euro when first
introduced was a legal construct that made national currencies in euroland
irrelevant to wholesale financial markets.
The evolution of banks
Banking was not consciously or rationally designed. It evolved as an
institution by meeting the changing needs of stages of evolving economies that
have later become obsolete. The institution of banking frequently trails behind
current financial needs of a contemporary economy.
The earliest banks of Middle Ages Italy, where the name began from a bench for
counting money, were finance companies. The Bank of St George at Genoa, as with
other banks founded in imitation of it, was at first only a finance company for
making loans to and float loans for the governments of the city-states where it
operated.
Money is an urgent want of governments in all times, and it was seldom more
urgent than in the tumultuous Italian republics of the High Middle Ages. After
these banks had been well established as finance companies, they began to do
what today is referred to as banking business but was originally never
contemplated.
The great banks of Northern Europe had their origin in meeting a want still
more curious. The prime business of a bank was to give good coin. Adam Smith
(1723-1790), the Scottish moral philosopher whose ideas so influenced US
free-market believers, describes it clearly:
The currency of a great
state, such as France or England, generally consists almost entirely of its own
coin. Should this currency, therefore, be at any time worn, clipt, or otherwise
degraded below its standard value, the state by a reformation of its coin can
effectually re-establish its currency. But the currency of a small state, such
as Genoa or Hamburg, can seldom consist altogether in its own coin, but must be
made up, in a great measure, of the coins of all the neighboring states with
which its inhabitants have a continual intercourse. Such a state, therefore, by
reforming its coin, will not always be able to reform its currency. If foreign
bills of exchange are paid in this currency, the uncertain value of any sum, of
what is in its own nature so uncertain, must render the exchange always very
much against such a state, its currency being, in all foreign states,
necessarily valued even below what it is worth.
Smith was
giving an early description of currency hegemony, linking great statehood with
sound money. It was the opposite of former Federal Reserve chairman Alan
Greenspan's approach of debasing the US fiat dollar through over-issuance to
maintaining the economy of a great state, notwithstanding Greenspan's repeated
expression of fidelity to the ideas of Adam Smith.
Smith went on to observe that:
In order to remedy the inconvenience to
which this disadvantageous exchange must have subjected their merchants, such
small states, when they began to attend to the interest of trade, have
frequently enacted that foreign bills of exchange of a certain value should be
paid not in common currency, but by an order upon, or by a transfer in the
books of a certain bank, established upon the credit, and under the protection
of the state, this bank being always obliged to pay, in good and true money,
exactly according to the standard of the state.
Thus fixed
exchange rates set by governments are a necessity for small states to overcome
the adverse effects of market forces on the value of their currencies.
Before the Bank of Amsterdam, also known as the Wissel Bank, was founded in
1609, an important date in the history of banking, the great quantity of
clipped and worn foreign coins, which the extensive trade of Amsterdam brought
from all parts of Europe, reduced the value of its currency about 9% below that
of good money fresh from the mint.
Such fresh good money no sooner appeared than it was melted down or carried
away from general circulation, as prescribed by Gresham's Law of bad money
driving out good. Nobel laureate economist Robert Mundell asserts that the
correct expression of Gresham's Law is: "Cheap money drives out dear, if they
exchange for the same price."
It is a proposition that defines the relation between paper money and specie
money based on precious metals. David Hume, writing in 1752, went to great
pains to demonstrate that the existence of paper credit would mean a
correspondingly lower quantity of gold, and that an increase in paper credit
would drive out a corresponding quantity of gold. Hume went on to explain why
some countries had more gold - in proportion to population and wealth - than
others: it was because there was no credit to displace gold.
Paper money is essentially an government instrument of sovereign credit, not an
instrument of sovereign debt, as many monetary economists mistake. Only
entities of good credit can issue paper money because it is an instrument of
credit. Debtors cannot issue money; they can only issue IOUs. While IOUs are
frequently traded, they are not currency. Money issued by sovereign states is
sovereign credit, not sovereign debt, which comes in the form of bonds. Money
buys bonds in a transaction of credit canceling debt.
Adam Smith developed the same idea in The Wealth of Nations with the use
of paper money and applauded its use in the nation:
The substitution of
paper in the room of gold and silver money, replaces a very expensive
instrument of commerce with one much less costly, and sometimes equally
convenient. Circulation comes to be carried on by a new wheel, which it costs
less both to erect and to maintain than the old one.
But by
accepting the use of paper money, Smith was not necessarily advocating debasing
money. Smith went on to say that merchants, with plenty of currency, could not
always find a sufficient quantity of good money to pay their bills of exchange;
and the value of those bills, in spite of several regulations that were made to
prevent it, became in a great measure uncertain.
To remedy these inconveniences, a bank was established in 1609 under the
guarantee of the City of Amsterdam. This bank received both foreign coin and
the light and worn coin of the country at its real intrinsic value in the good
standard money of the country, deducting only so much as was necessary for
defraying the expense of coinage, and the other necessary expense of
management. For the value that remained, after this small deduction was made,
it gave a credit in its books. This credit was called bank money, which, as it
represented money exactly according to the standard of the mint, was always of
the same real value, and intrinsically worth more than current money.
It was at the same time enacted that all bills drawn upon or negotiated at
Amsterdam of the value of 600 guilders and upward should be paid in bank money,
which at once took away all uncertainty in the value of those bills. Every
merchant, in consequence of this regulation, was obliged to keep an account
with the bank in order to pay his foreign bills of exchange, which necessarily
occasioned a certain demand for bank money.
Bretton Woods and financing international trade
On this simple principle, the Bretton Woods regime set out in 1944 a
gold-backed dollar as the reserve currency for postwar international trade.
Since then, the central bank of every trading nation has been obliged to keep a
dollar reserve account with the US Federal Reserve to support the value of its
currency, even when the dollar was taken off the gold standard in 1971.
Henceforth, sovereign states were deprived of their sovereign prerogative to
employ sovereign credit for development of their national economy and had to
depend on trade to earn foreign exchange denominated in dollars as capital. And
as international trade favors the strong market participant with superior
market power, particularly the monetary hegemon, post-Cold War global trade
morphed into a new form of economic imperialism through which the strong
advanced economies exploit the weak underdeveloped economies.
This is accomplished by denying sovereign governments their right to deploy
sovereign credit for national development and forced them to depend on foreign
capital denominated in the fiat currency of the monetary hegemon.
An important function of early banks, which modern banks have retained, is the
function of remitting money to facilitate trade. A customer brings money to the
bank to meet a payment obligation at a great distance, and the bank, having a
connection with other banks at that location, causes the destination bank to
pay by debiting the account of the originating bank. The instant and regular
remittance of money is an early necessity of growing trade. By providing these
services, banks gained the credit rating that over time enabled them to make
profits as deposit banks.
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