Money Markets and Commodity Markets

Henry C.K. Liu

Part I: Money Markets - Integrity Deficit Has Its Price

This article appeared in AToL on August 19, 2009

In a global financial architecture of national fiat currencies, the role of a reserve currency in international trade is to keep all trading nations monetarily honest. This is done by requiring each and every currency issuer to adopt monetary policies that will protect and maintain the exchange value of their separate fiat currencies to the reserve currency. Thus for the exchange rate regime to work, it is imperative for the reserve currency itself to hold constant purchasing power.

The purchasing power of a fiat currency is dependent on the monetary and fiscal discipline of the issuing government and the balance of payments discipline of the underlying economy. Thus the issuer of a reserve currency cannot itself violate the laws of monetary integrity to finance recurring fiscal and trade deficits and expects to keep the reserve status for its fiat currency. This is the primary reason why the dollar has been having increasing difficulty with keeping its role as the prime reserve currency for international trade as established by the Bretton Woods regime of 1944, which has been defunct since 1971 when President Nixon de-pegged the dollar from gold fixed at $35 per ounce.
The Bretton Woods regime of fixed exchange rates established in 1944 was based on the dollar pegged to gold as a reserve currency in an international trade regime that disallowed free flow of funds across national borders outside of transactions between central banks.
Since 1971 when President Nixon suspended the dollar’s linkage to gold, acceptance of the fiat dollar as the preferred reserved currency for international trade has been essentially and increasingly anchored on US geopolitical power rather than on sound monetary, fiscal and trade principles.
After the Cold War, with the end of hostility between capitalism and socialism, the global geopolitical order has been increasingly shaped by geo-economics that reflects the fluctuating strength of interconnected national economies. As the US economy declines from persistent loss of monetary, fiscal and balance of payment discipline, the ability of the US to hold on the dollar’s status as a reserve currency for international trade is directly affected.
The superpower status of the US is also being increasingly eroded by the recent precipitous decline of its super economy since mid 2007 both in relative terms and in absolute terms. Still, the size of the US economy remains the largest in the world, a fact that underlines the residual strength of the dollar, not to mention the unfair advantage of dollar hegemony. But the secular decline of the dollar cannot go on indefinitely without causing fatal harm to even the world’s largest economy. The official declarative slogan that “a strong dollar is in the US national interest” is being modified by developing events to a normative warning of “a strong dollar is needed to protect the US national interest.” The famous announcement to the world by former Treasury Secretary James Baker III during the 1985 Plaza Accord negotiations that “the dollar is our currency but your problem” is no longer operative. The weakening dollar has reverted to being fundamentally a US problem.

The Nature of Supply and Demand

The global market mechanism is mediated through a price structure denominated in a designated reserve currency acceptable to all trading nations. Textbook economics of market fundamentalism asserts that market prices are determined by supply and demand. Theoretically, the law of marginal utility states that price in a free market at any moment in time is set by the point at which the moving supply and demand curves intersect, driven by the quest for marginal utility on th epart of all market participants. The theory of marginal utility is anchored with the calculus of disaggregated arbitrage on changing supply and demand relationships.

But in addition to supply of and demand for commodities, price when denominated in money is also determined by the supply of and demand for money. A controversy exists relating to whether money is a commodity, a medium of exchange, a store of value or a unit of deferred payment with something of specific prescribed value. The fact is that money can be all of the above mentioned, but in varying degrees, depending of the legal-political regime. Since 1913, supply of money in the US monetary system has been controlled by the Federal Reserve, the central bank, through the commercial banking systems that it regulates. Supply of money is imposed on the economy, not determined by market forces. Instead, the supply of money drives market forces.
Money Creation and Financialization of the Economy
With “financialization” of the economy, money markets have grown beyond the regulated banking system to usurp the otherwise exclusive authority of central banks to control the supply and thus the price of money in relation to demand. Money now can be created by market participants who are incentivized solely by the quest for speculative profit in volatile markets. Stability spells depression for speculators who thrive on volatility.
With global financial deregulation, money is no longer only created by central banks to facilitate the financial needs of a healthy economy by maintaining market stability.  Central banks are constantly at war with speculative traders in a losing struggle to maintain currency and money market stability.

Volatility in markets, particularly involving foreign exchange and interest rates, gave rise to the need by market participants for financial derivatives to hedge against market risks. In time, derivatives have morphed from hedging instruments against risk into profit centers of speculation. A new financial sector known as structured finance has grown rapidly and extensively. Money creation through the excess issuance of money by either central banks and through excess issuance of debt by structured financiers can cause dilapidating impacts on an economy. And it did in systemic dimensions in the summer of 2007.

Manipulation of Supply and Demand
Within commodities markets, with free supply of money, the cost of which declines in proportion to its abundance, both supply and demand are no longer merely endogenous (within the system) components of the market economy.  Both supply and demand are highly vulnerable to exogenous (external) purposeful manipulation by five major groups of market participants.
Four of the five groups: end-users, source-producers, traders and speculators depend on ready access to money at affordable prices to make profit. They create money by extending credit to each other for the purpose of making profit. The fifth group, currency issuers, mainly central banks, are not profit motivated but have the power to control both the supply and price of money to implement national policy regardless of profitability. Together, the five groups of market participants created a new capitalism in which capital is replaced by debt.

While market power is seldom equally distributed among market participants, a fact that renders the idea of a free market an oxymoron, any one of these five groups of market participants can manipulate separately or jointly unregulated markets for unfair advantage through sub-optimization. With globalization, these groups can also manipulate prices through regulatory arbitrage in unevenly regulated markets around world.

The Anti-labor Bias of Free Trade
Since trade globalization endorses the free cross-border movement of capital while it restricts free cross-border movement of workers, the structural anti-labor pitfall is blatantly obvious. In disconnected labor markets under trade globalization, demand for workers internationally is determined by cross-border wage arbitrage while demand for workers domestically is governed by uneven market power between capital and labor as dictated by traditional market conditions generated from capitalist ideological fixations.

Capital can cross national borders to where cost and wages are lowest but workers cannot go where wages are highest because of immigration restrictions. The net effect is global wage stagnation in the midst of spectacular multinational corporate profits that results in global overcapacity. To the chagrin of supply-siders, supply outraced demand even when demand was held up with a debt bubble.
The Manipulation of Prices
End-users can manipulate short-term prices by drawing on inventory to affect demand temporarily or manipulate long-term prices by using substitutes to affect demand permanently. Source-producers can manipulate short-term prices by reducing production rate or manipulate inventory levels temporarily to affect supply. They can also manipulate long-term prices through below-threshold pricing to deny profitable development of competing substitutes.
Traders can manipulate prices by market timing and speculators can manipulate prices by hoarding or flooding the market. Cartels can be formed in unregulated markets by agreement among market participating groups to create monopolies with unfair market power. Currency issuers can manipulate exchange rates by central bank adjustment of monetary policy measures such as interest rate policies to manage quantitative easing or tightening. Money market participants can manipulate prices by interest rate arbitrage.

Thus free markets require sophisticated, complex and dynamic regulations to restrict the ability of market participants to manipulate prices through monopolistic practices, rendering highly problematic the literal meaning of an unregulated free market. Totally free markets tend to end in market failures. This is particularly true in money markets as finance is infinitely more pliant that physical goods.

Market Fundamentalism
Market fundamentalism is the belief that the optimum common interest is only achievable through a free market equilibrium created by the effect of countless individual decisions of all market participants each freely seeking to maximize his/her own private gain and that such market equilibrium should not be distorted by any collective measures in the name of the common good.

Yet market participants seldom act with equal information or full understanding of the effects of their actions. Market fundamentalism is a theory that suggests the right path to a watering hole can best be found by blind men pulling at different directions for uncoordinated reasons. The fundamental problem with market fundamentalism is the ability of market participants to maximize advantage by externalizing cost or penalties outside of the market onto the real economy. Free markets require regulation to remain free.
Increasingly, it has become obvious that what is good for Goldman Sachs, a highly profitable global investment bank headquartered in New York, is not necessarily good for the US or for that matter the world. Thousands of Goldman Sachs do not add up to a healthy world economy, solid evidence that market fundamentalism does not work.
Price Stability
Generally, end-users desire low and stable prices; source producers desire sustainably high and stable prices. Both end users and source producers want stable markets. Traders desire price volatility to profit by buying low and selling high. Speculators desire cyclical price divergence and convergence so that they can go long on technical price depressions or go short on price bubbles. Speculators also perform a role of reducing risk exposure for other market participants by betting on uncertain outcomes. Each group of market participants separately plays a needed role to keep markets functioning with winners and losers. Ideally, a regulated market aims at producing only winners with no losers, or at least more winners than losers.
Yet many modern large industrial enterprises are vertically integrated, so that they are simultaneously end-users, producers, traders and speculators. These large, vertically integrated enterprises are forced to seek optimum resolution of conflicting price objectives in commodities and financial markets. Large financial institutions are all globalized to the degree that their profitability is increasingly derived from predatory manipulation to exploit weak points in all national economies through under-regulated financial markets.

Evolution of Money Markets

Until the late 1950s, a currency’s money market was based only in the issuing nation’s financial center: US dollars in New York, sterling in London, yen in Tokyo, Swiss francs in Zurich, etc. The Bretton Woods monetary regime of fixed exchange rates built around a gold-backed dollar did not consider unrestricted cross-border flow of funds desirable or necessary for facilitating international trade.

At the height of the Cold War, the Soviet Union became concerned that its dollar deposits in New York needed for arms-related procurement might be frozen by a hostile US government, as happened to the funds held in the US by the People’s Republic of China after the Korean War broke out. The USSR opened dollar accounts with European banks as a remedy.

The Impact of Regulation Q

In 1963, the US introduced the populist Regulation Q, which for subsequent decades imposed limits and ceilings on bank and savings-and-loan (S&L) interest rates. Regulation Q created incentives for US banks to do business outside the reach of US law in quest of high interest rates, and London came to dominate this offshore dollar business.

Bank accounts in London are subject only to British laws so US sanctions, restrictions and taxes cannot apply to the dollars deposited in them. British law on international finance is well developed on account of the financial hegemony of the British Empire after the fall of Napoleon. In time, banks in London, often branches of US banks, started actively trading deposits in other currencies besides dollars as well, as it became possible for them to accept deposit in one currency in one country and lend in another currency in another country profitably.

Up to the current financial crisis that broke out in mid 2007, financial regulation had become increasingly lighter, so money could and still can be moved to and from London with little cost; therefore the price of London money generally tracks very closely that of domestic money in many countries. But there have been differences between domestic and London interest rates. These differences have had different causes at different times: monetary policy, tax laws, bank regulations, the possibility that a country might introduce exchange controls, and the differences between the creditworthiness of the banks in London and those in the domestic market. The London money and foreign-exchange markets are dominant for trading currencies, raising capital and selling debt.

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 account - 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 required an unprecedented government tax money bailout of depositors in a 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 with market values way below the values of their mortgages. State usury laws 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 has 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 Conference on Economic Sovereignty in a Globalizing World, Bangkok, 24-26 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-liberalsim), originally coined by German economist Alexander Rüstow (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 downward economic spiral was celebrated as economic growth by neo-liberals.

The Emergence of 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 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 Banking
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 Age 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 seldom more urgent than it was 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 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.

The Bretton Woods Regime for 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 of 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.

Being trusted for one purpose, banks came to be trusted for another purpose quite different, ultimately far more important, as depository and intermediary of money and credit. But these services only affect customers. The real function deposit banks perform is the supply of paper-money circulation to the economy. Up to 1830 in England, the main profit of banks was derived from circulation, and for many years after that deposits were treated as very minor matters, and the whole of so-called banking discussion turned on questions of circulation.

Today, circulation is handled electronically as virtual money instead of paper money. Banks are in fact a retail network for the central banks for circulating the money central banks issue. The US Federal Reserve, with its unlimited power to create money as a lender of last resort, is owned by its member banks, not by the people of the United States. This arrangement is the key obstacle to economic/financial democracy in the US.

The Fed and the Value of Money

The Federal Reserve, though not part of the US government, and not collectively owned by the people but by member commercial banks, enjoys a monopoly on the creation of money backed by the full faith and credit of the nation. The Fed has meta-constitutional power to fix the value of money, through the setting of short-term interest rates and its control of the money supply not to facilitate market needs but to direct the economy through its control of the money market. The Fed sets and adjusts the minimum rate of discount from time to time that all banks must accept.

Since the beginning of the financial market turmoil in August 2007, the Federal Reserve’s balance sheet has doubled in size and has changed in composition from normal times. Total assets of the Federal Reserve have increased significantly from $869 billion on August 8, 2007 to $2.24 trillion by the end of 2008. More importantly, much of this increased assets in the Fed’s balance sheet are toxic with no ready buyers in the market. Thus the Fed expanded its balance sheet to keep markets from functioning, despite the tedious claim that it acted to keep markets functioning. The Fed has injected some $1.4 trillion into the financial market, about 10% of 2008 GDP, to bail out the distressed banks by buying the toxic assets that was worth less than 10 cents on the dollar. It in effect insulated banks from market forces.

Neo-liberal economists view money as a commodity, and only a commodity. Why then is its value fixed by fiat and not the way in which the values of all other commodities are fixed, by supply and demand in the market? The answer is that the issuing of money as a legal tender is a government monopoly that gives government pricing power over money. This makes money more than a commodity. Money is in fact a political instrument with financial dimensions.

But the Fed, by its own definition of being politically independent, is not part of the government or even the democratic political process. The Fed, owned by its member banks, is a living example of a political institution with monopolistic monetary powers captured by a financial oligarchy. While the Fed claims that its monetary-policy measures are designed to sustain the health of the whole economy, it sees the maintenance of the health of the economy’s financial heart, the banks in the Federal Reserve System, as its paramount policy objective. 

Humphrey-Hawkins Full Employment and Balanced Growth
To rein in the political independence of the Fed, the Full Employment and Balanced Growth Act was signed into law by President Jimmy Carter on October 27, 1978, known generally as the Humphrey-Hawkins Full Employment Act, named for its liberal sponsors, Senator Hubert Humphrey and Representative Augustus Hawkins. The Act was allowed to expire in 2000. The Act required the Federal Open Market Committee to report to Congress on the economy and monetary policy twice a year.
Humphrey-Hawkins explicitly instructs the executive branch of the government to strive toward four mandated policy goals: full employment, economic growth, price stability, and a twin balance of trade and fiscal budget. By explicitly setting requirements and goals for the executive ranch to attain, the Act is markedly stronger than its predecessor, the post-WWII Full Employment Act of 1946. Yet the 1946 Full Employment Act focused on full employment as a primary national economic goal, while Humphrey-Hawkins, by specifying four competing and conflicting goals, reduced full employment to just a component factor of economic policy.
Government Responsibility for Full Employment

In a dynamic modern economy in which employment has replaced livelihood as a means of economic survival for the average individual, employment is a systemic political issue the responsibility for providing which lies with the institutions that operate the economy, not on individuals with livelihoods as in the static economy of the past. In the past, a baker or a blacksmith would inherit his trade from his father in a communal economy organized on cooperative principles. In the modern economy, workers are employed in piecemeal jobs defined by the division of labor in support of assembly lines in factories in a society organized on competitive principles.  

Only a small number of individuals are self-employed in a modern economy. Jobs are provided for workers by the economic system regulated by government. Unemployment then is the result of dysfunctional economic policy, and not the personal fault of the unemployed. Once full employment is reduced from a prime policy priority to merely one factor among many in connected government policy objectives, failed statehood will follow. In the modern economy, unemployment is a political problem with economic dimensions. 

Government Mandate to Regulate Private Enterprise 

Humphrey-Hawkins explicitly states that the federal government will rely primarily on private enterprise to achieve the four goals of full employment, growth, price stability, and balance of trade and budget. Implicitly, private enterprise must be regulated so that corporate profit is structurally aligned with the achievement of the four policy goals. The private sector cannot be allowed to prosper with counterproductive activities that negate the four policy goals and treat social costs as externalities to business. In welfare economics, an externality is a socio-economic cost created by one actor, the payment for which is imposed on others. 

Humphrey-Hawkins also instructs the executive branch to strive towards a balanced budget over an economic cycle; maintain trade balance to avoid surpluses or deficits; mandates the Board of Governors of the Federal Reserve to establish a monetary policy that maintains long-term growth with price stability; and instructs the Board of Governors of the Federal Reserve to transmit a mandatory Policy Report to Congress twice a year on its monetary policy; requires the President to set numerical goals for the economy of the next fiscal year in the Economic Report of the President and to suggest policies that will achieve these goals; and requires the Chairman of the Federal Reserve to connect the monetary policy with the Presidential economic policy.

Humphrey-Hawkins sets specific numerical goals for the executive branch to attain, mandating that within five years, by 1983, unemployment rates should be less than 3% for persons aged 20 and over and less than 4% for persons aged 16 and over. In August 2009, the national unemployment rate reached 9.4%. Unemployment of people ages 16 to 19 was a seasonally adjusted 23.8% in July after hitting a quarter-century high of 24% in June 2009.

Humphrey-Hawkins mandates inflation rates to be less than 4%, and within ten years after the legislation became law, by 1988, inflation rates should be 0%, a goal never reached except in recession years. More than a year after the financial crisis broke out in August 2007, the inflation rate through 2008 was 3.8% before disinflation hit in 2009 to bring the inflation rate down to a negative -2.1%.  Humphrey-Hawkins also allows Congress to revise these goals as time progresses.

If private enterprise fails to achieve these employment goals, Humphrey-Hawkins expressly allows the government to create a “reservoir of public employment.” These jobs are required to be in the lower ranges of skill and pay so as to not draw the workforce away from the private sector.

In the same spirit, a way to achieve full employment with price and currency stability has been proposed in a Public Service Employment (PSE) Program at the University of Missouri at Kansas City (UMKC) under Professor Randall Wray. PSE programs have been proposed to several governments. (Please see A full employment program for Hong Kong by Wray and Liu - March 30, 2002.)  

How the Fed Controls Short-term Interest rate

In normal times, there is usually not enough money in the money markets to discount all the bills outstanding without taking money from the Fed. As soon as the Fed Funds rate target is fixed, market participants who have bills to discount try to discount these bills cheaper than the Fed Funds rate. But they seldom can get them discounted cheaper, for if they did everyone would leave the Fed, and the outer market would have more bills than it could handle and the rate would rise to the rate set by the Fed. Thus the Fed Funds rate is always a target toward which the Fed will use its own funds to maintain.

In practice, when the Fed finds this process happening, and sees its market share shrinking, it lowers the Fed Funds rate target, so as to secure a reasonable portion of the money market for itself, and to keep a fair part of its deposits employed. At Dutch auctions, an upset or maximum price is fixed by the seller, and he comes down in his bidding until he finds a buyer. The value of money is fixed in the money market in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, the Fed, some part of whose supply is essential to set the market rate.

The notion that the Fed has control over the money market, and can fix the rate of discount as it deems necessary, has survived from before 1844, when the Bank of England could issue as many notes as it liked.

But even then the notion was a misconception. A bank with a monopoly of note issue has great sudden temporary power in the money market, but no permanent power, as it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is that any momentary fall in money, caused by fiat action of such a bank, of itself tends to create an immediate and equal rise, so that upon an average the value is not altered. Also the amount of outstanding long-term debt is always infinitely greater than short-term debt, making it difficult for short-term interest rates to dictate long-term rates. This is the root cause of what Greenspan calls the interest-rate conundrum.

Money of Constant Value

Money of constant value allows its owners, or by banks that did not pay an interest for it, to hold it idle without penalty. The positive effect would be that the value of money might not fall. Money would, in market parlance, be "well held". The holders would be under no pressure to employ all of it, waiting to employ part at a high rate. The negative effect is that money will be underemployed and cause to economy to stagnate. Thus the three conditions that compel money to be constantly fully employed are taxes, interest payments and mild inflation which forces holders of money to seek returns above inflation rate. Tax reduction, low interest rates and deflation are conditions that destabilized money markets by retarding money circulation.

The Economic function of Taxes, Fair Profit and Equitable Wages

Taxes are not levied to finance government expenditure, but to keep the population financially productive. Similarly, interest on money is not to reward the holders of money, but to keep the borrowers working for it. Prosperity is produced by work, not profits. Return on capital without work is mere speculative profit.

This is the key misunderstanding on the part of market capitalists who insist that profit is necessary for job creation and therefore government must adopt policies that induce maximum profit for the good of the economy. While this is true to a limited extent, excess profit that comes from depressed wages is economically counterproductive.  

Operationally, excess profit can only come from wage deficits. Excess profit leads to overcapacity as it drains off needed wages to sustain consumer demand to soak up the increased productivity created by investment attracted by high return on capital. Cyclical overinvestment produces overcapacity. It is the basic cause of the business cycle. 

The Need for Equitable Wages

To moderate the adverse effects of the business cycle, the curse of overcapacity must be curbed by limiting corporate profit by returning excess profit above the rate of inflation and reasonable return on capital to workers in the form of higher wages. Incentives must be structured to encourage management to raise wages to limit excess corporate profit or face punitive corporate income tax penalties.  This point is largely missed in the on-going debate on executive compensation and corporate income tax rate by market capitalists who misleadingly present high executive pay and low corporate income tax rate as indispensable to economic growth.
Making Money Work 

Money is economically productive only if it is not free. In the money market, money is held by those who must pay interest on it, such as money-market fund managers, and such entities must employ all the money in its care to avoid insolvency. Such entities do not so much care at what rate of interest they employ the money they manage: they can reduce the interest dividend they pay investors in proportion to that which they can make from lending, but they must pay something. They must also always avoid losing capital, known as breaking the buck, as each unit of investment is generally structured as $1.00.  

The fluctuations in the value of money are therefore more directly responsive to market conditions than fluctuations in the value of most other commodities. At times, there is a high demand to borrow money, and at times high pressure to lend money, and so the price of money is forced up and down every day.  

Role of the Fed 

The role of the Fed is to moderate such fluctuations by quantitative easing and tightening to keep the price of money in line with the need of the economy. Market considerations define the responsibility thrust on the Fed and other central banks. The Fed cannot control the long-term price of money, but it can fully control its spot price at any one time. It cannot change the average value of money over time, but it can determine the deviations from the average at any one time.  

If the Fed badly manages its responsibility as a market stabilizer, the rate of interest will at one time be excessively low, and at another time excessively high. The economy will experience pernicious booms and busts. This has been the case through most of the history of central bank performance since it establishment in 1913. But if the Fed manages well, the rate of interest will not deviate much from the average rate, at least in theory. As far as anything can remain steady, the value of money will then be steady, and in consequence, trade probably will be steady too, or at least a principal cause of periodic cyclical disturbance will have been withdrawn from it.

This is the view of Milton Friedman, who coined the slogans "money matters" and “inflation is everywhere and anywhere a monetary phenomenon.” Friedman advocated a fixed expansion of M1 at 3% long-term to moderate the runaway business cycle over-stimulated by Keynesian deficit-financing measures.

But economies can develop imbalances from monetary causes independent of inflation, as the US economy has from dollar hegemony. Greenspan’s solution was to keep a steady expansion of the money supply to neutralize the imbalances with painless debt, thus postponing the day of reckoning by accepting a bigger future crash that requires a bigger cleanup. That day of reckoning came in mid July 2007 in the form of a global melt down of an unsustainable two-decade long serial bubble released by Greenspan after he took over the Fed in 1987.

Prices and the State of Credit

The rise in prices, also known as inflation, is the quickest way to improve the general state of credit. The fall in prices, known as deflation, is the quickest way to cause a deterioration of the general state of credit. For this reason, central banks fear deflation more than they fear inflation. Prices in general are mostly determined by wholesale transactions, which are commonly not cash transactions, but bill transactions. Years of improving credit, if there be no disturbing causes, are years of rising prices, and years of decaying credit are years of falling prices. Deflation is the deadly enemy of outstanding debt. In the current debt-infested economy, deflation is a real killer.

In the United States, when house prices had generally tripled in less than a decade up to 2007, it is evidence that the value of the dollar has declined by a factor of three in the same time period. But official inflation had not gone up 300%. US average annual inflation rate between 1997 and 2007 had been between a low of 1.59% (2002) and a high of 3.39% (2005). The average inflation for the decade was less than 3.5% per year, yielding a price increase of less than 35%. Some 265% of housing price rise was the effect of the debt bubble.

Consumer prices had not increased by the same amount as housing prices because of outsourcing of manufacturing to low-wage economies overseas, which also acted as a depressant on domestic wages. Real estate prices affect prices of all other assets types, including equity assets. The stock market generally rises with inflation but shoots ahead of it. Thus a housing bubble quickly expands to include a stock market bubble.
Imbalances in the economy can appear if wages and earnings do not rise proportionately to prices. A homeowner whose house increased 300% in market price while his income rose only 30% had not become richer. He had become a victim of uneven inflation. He might enjoy a one-time joyride with cash-out financing with a new home equity mortgage, but his income could not sustain the new mortgage payments if interest rates rose, or if house prices fall, and he would lose his home. And interest rates will rise if his income increases, because that is how the Fed defines inflation. Thus when his income rises, the interest payment on his mortgage will rise and the market price of his home will fall, giving him an incentive to walk away from a big mortgage in which he has little equity tie-up. This can become a systemic problem for the mortgage-backed security sector. And it did in mid 2007.
Primary Dealers

In every financial market, there will always be banks or securities dealers who, by attending to one class of securities or a segment of the credit market, come to be particularly well acquainted with that class. The Fed recognizes them as primary dealers who may trade directly with it. Such firms are required to make bids or offers when the Fed conducts open market operations, provide market information to the Fed’s open market trading desk, and participate actively in US Treasury security auctions. They consult with both the Treasury and the Fed about funding the government budget and trade deficits and implementing monetary policy. Because of their special knowledge of government debt markets, many former employees of primary dealers work at the Treasury as well as former Treasury officials work for primary dealers. The Fed has a policy to avoid similar revolving door relationship. Still, an incest culture unavoidably develops among members of this exclusive fraternity of financial high priesthood. 

The list of primary dealers is composed of US (7), British (3), Japanese (3), Swiss (2), French (1), Canadian (1) and German (1) banks and firms. Primary dealers as a group purchase the vast majority of the US Treasury securities sold at auction, and resell them to the public around the world. Their activities extend well beyond the Treasury market to the foreign exchange market, accounting for 73% of foreign exchange trading volume, making them as a group the most influential and powerful non-governmental institutions in world financial markets.  

China, now the biggest purchaser of US Treasury security, has no primary dealer recognized by the Fed even though as of 2009 China has the three largest banks in the world, measured by market capitalization, and four of the top ten. 

Fed Bailouts of Primary Dealers 

The primary dealers form a worldwide network that distributes new U.S. government debt. In response to the subprime mortgage crisis and to the collapse of Bear Stearns, the Fed on March 19, 2008 set up the Primary Dealers Credit Facility (PDCF) to allow primary dealers to borrow at the Fed’s discount window collateralized by toxic assets. It was deemed imperative that the primary dealer network must not be allowed to collapse.  

PDCF is an overnight loan facility that will provide funding to primary dealers in exchange for any tri-party-eligible collateral and is intended to foster the functioning of financial markets more generally. Eligible participants include primary dealers participating through their clearing banks.

PDCF loans will settle on the same business day and will mature the following business day. The rate paid on the loan will be the same as the primary credit rate at the New York Fed. In addition, primary dealers will be subject to a frequency-based fee after they exceed 45 days of use. The frequency-based fee will be based on an escalating scale and communicated to the primary dealers in advance.

The rate of the loan is the primary credit rate at the New York Fed which was 0.50% on August 15, 2009 when the Fed Funds target was 0 to 0.25%. Eligible collateral will include all collateral eligible in tri-party repurchase arrangements with the major clearing banks as of September 12, 2008. A primary dealer will be allowed to borrow up to the margin-adjusted collateral they can deliver to the Federal Reserve’s account at the clearing banks. All loans are made for the duration of one day. New loans can be taken out each day. Loans to primary dealers made under the PDCF are made with recourse beyond the collateral to the primary dealer entity itself.

The earlier Term Auction Facility program (TAF), instituted on December 11, 2007 offers term funding to depository institutions via a bi-weekly auction, for fixed amounts of credit. The Term Securities Lending Facility (TSLF), instituted on March 11, 2008, as liquidity in the global markets came to a halt, expanded the types of acceptable collateral: student loans, car loans, home equity loans and credit card debt, as long as it was highly rated. TSLF is an auction for a fixed amount of lending of Treasury general collateral in exchange for Open Market Operation (OMO)-eligible and investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.

PDCF loans made to primary dealers increase the total supply of reserves in the banking system, in much the same way that Discount Window loans do. To offset this increase, the Desk will utilize a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements, redemptions of Treasury securities and changes in the sizes of conventional RP transactions.

This differs from discount window lending to depository institutions in a number of ways. Currently, the primary credit facility offers overnight as well as term funding for up to 90 calendar days at the primary credit rate secured by discount window collateral to eligible depository institutions. The PDCF, by contrast, is an overnight facility that will be available to primary dealers (rather than depository institutions). 

Similar to loans made to depository institutions via the Discount Window, information on PDCF borrowing will be made available each Thursday, generally at 4:30 p.m., on Federal Reserve Statistical Release H.4.1 - Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks. The H.4.1 release will contain the total amount of PDCF credit outstanding as of the close of business on the prior business day and the average daily amounts for each week. The August 13, 2009 release shows an average daily total factors supplying reserve funds to be $2.05 trillion.

PDCF loans are made under Section 13(3) of the Federal Reserve Act. The PDCF will remain available to primary dealers until February 1, 2010, or longer if conditions warrant. 

As primary dealers can for the most part lend much more than their own capital, they will always be ready to borrow largely from banks and other creditors and in the repo market, and to deposit the top-rated securities as collateral. They act thus as intermediaries between the borrowing public and the less qualified lenders of money in the market. Knowing better than the non-specialist lenders which loans are better and which are worse, specialist dealers borrow from them, and gain a profit by charging the public more than they pay to the lenders.

Many primary dealers and other stockbrokers transact such business on an enormous scale. They lend large sums on domestic and foreign bonds or infrastructure shares or other such securities, and borrow those sums from bankers, depositing the securities with the bankers, and generally, though not always, giving their guarantee. But with the development of deregulated capital and debt markets, banks are increasingly reduced to the role of market participants rather than intermediaries, by proprietary trading. By far the greatest of these new intermediate dealers are the bill-brokers. Mercantile bills are a kind of security that only professionals transact. In the US, they are called commercial papers, short-term obligations with maturity ranging from two to 270 days issued by banks, corporations and other institutional borrowers to investors with temporary idle cash. Such instruments are unsecured and usually discounted, though some are interest-bearing. (Please see my November 28, 2997 article: The Commercial Paper Market and Special Investment Vehicles)

Money Markets

In the US, the money market is a subsection of the fixed-income market. A bond is one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money-market investments are also called cash investments because of their short maturities. Money-market securities are in essence IOUs issued by governments, financial institutions and large corporations of top credit ratings. These instruments are very liquid and considered extraordinarily safe. Because they are extremely secured, money-market securities offer significantly lower return than most other securities that are more risky.

One other main difference between the money market and the stock market is that most money-market securities trade in very high denominations. This limits the access of the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this with the stock market, where a broker receives a commission to act as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. Individuals gain access to the money market through money-market mutual funds, or sometimes through money-market bank accounts. These accounts and funds pool together the assets of hundreds of thousands of investors to buy the money-market securities on their behalf. However, some money-market instruments, such as Treasury bills, may be purchased directly from the Treasury in denominations of $10,000 or larger. Alternatively, they can be acquired through other large financial institutions with direct access to these markets.

There are different instruments in the money market, offering different returns and different risks. The desire of major corporations to avoid costly banks borrowing as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivables and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of one to two months being the average.

Commercial Paper Market

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and creditworthiness issue commercial paper. Over the past four decades, there have only been a handful of cases where corporations have defaulted on their commercial-paper repayment. Commercial paper is usually issued with denominations of $100,000 or multiples thereof. Therefore, small investors can only invest in commercial paper indirectly through money market funds.

On December 23, 2005, commercial paper placed directly by GE Capital Corp (GECC) was 4.26% on 30-44 days and 4.56% on 266-270 days, while the Fed Funds rate target was 4.25% and the discount rate was 5.25%, both effective since December 13. On August 14, 2009, commercial paper was 0.21% on 30-44 days and 0.27% on 90 to 119 days, while the effective Fed Funds Rate was 0.16%. Shares of GE reached a high of $42.12 on October 12, 2007, three months after the credit crisis broke out, and fell to a low of $6.69 on March 4, 2009.  It was $13.92 on August 14, 2009, still less than a third of its peak. GE market capitalization fell from $447.63 billion at its high in 2007 to $71.09 billion at it low in 2009 and bounced back to $147.93 billion on August 14, 2009.  Before the collapse of the commercial-paper market, GE had become the world’s biggest non-bank finance company until the financial crisis of 2007. GE commercial paper is no longer listed in the financial press as a bench mark rate. 

Rates on AA ranked financial commercial paper due in 90 days fell to a record low of 0.28% on Jan. 8, 2008, or 21 basis points more than the US borrowing rate,

The market for commercial paper backed by assets such as auto loans and credit cards was the first to seize up. It fell 37% over five months to $772.8 billion, from its peak in August 2007 of $1.22 trillion, as defaults on subprime home loans began to soar.

After Lehman Brothers Holdings Inc. filed for bankruptcy on September 15, 2008, the broader commercial paper market froze. The next day, the flagship $62.6 billion money-market fund of Reserve Management Co. became the second of its kind to “break the buck” in market history, or fell below the $1-a-share price paid by investors, triggering a run that helped freeze global credit markets and drove up borrowing costs. Returns on money-market funds have dropped 62% since then.  

Meanwhile, the commercial paper market slumped 20% over six weeks as money-market investors fled for safer assets such as Treasuries. Prime money-market funds’ holdings of first-tier paper, rated at least P-1 by Moody’s Investors Service and A-1 by Standard & Poor’s, fell by 33% from September 9 to October 7, 2008. 

On October 27, 2008, the Fed set up the Commercial Paper Funding Facility (CPFF), complementing a separate program for providing liquidity to the asset-backed debt market that had begun in September. These programs were intended to ensure companies would have access to short-term credit and to ease redemption concerns at money-market funds. The amount outstanding under the asset-backed program peaked at $152.1 billion on October 1, 2008 before plunging to a low of $14.8 billion as redemption concerns subsided.  

On October 21, 2008, the Fed set up another program, the Money Market Investor Funding Facility (MMIFF), to provide liquidity to money-market investors. The facility buys commercial paper due in 90 days or less. The short-term debt markets had been under considerable strain in recent weeks as money market mutual funds and other investors had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs.  By facilitating the sales of money market instruments in the secondary market, the MMIFF is designed to improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments.  Improved money market conditions enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households. 

About $220 billion to $230 billion of 90-day commercial paper was sold to the Fed above market rates in October 2008 through the CPFF matures in the first week of operation. That was as much as 66% of the $350 billion in debt that the CPFF owns. The Fed has purchased about one-fifth of the commercial paper market through the CPFF.  

Currency Hegemony 

Currency hegemony, which in the current global trade regime is essentially dollar hegemony, allows the monetary hegemon to dictate predatory terms of trade on the entire globalized market economy in the name of free trade, at the expense of national economies in both the commodities and financial markets. Economic nationalism in the context of a world order of independent sovereign states is challenged by global free traders by labeling it as counterproductive protectionism. National industrial policies and monetary sovereignty are dismissed as unenlightened opposition to Ricardian principle of comparative advantage in free trade. (Please see my February 16, 2008 AToL article: The global money and currency markets) 

The Comparative Advantage Trap 

Comparative advantage in trade economics refers to the economic optimization of the ability of a country to produce a particular good at lower marginal and opportunity costs than its trading partner can. Comparative advantage differs from absolute advantage which refers to the ability of a country to produce a particular good at a lower absolute cost than other countries. Comparative advantage allows trade to increase economic value for trading parties, known as gains from trade, even when one party can produce all goods at lower cost than its trading partner.  

In 1815, during the Corn Laws debate in England, Robert Torrens advanced the concept of comparative advantage in an article: Essay on the External Corn Trade by concluding that both England and Poland would benefit from trade by importing corn from Poland to England even though corn could be produced cheaper in England, if by doing so England were to be able to concentrate on manufacturing for export to Poland. Torrens did not deal with the problem of the developmental penalty for Poland to forego manufacturing in order to produce more corn for export to England. Thus trade under comparative advantage would support industrialization in England to produce higher value-added products at the expense of industrialization in Poland, making England into an industrial power by the middle of the 19th century to build the British Empire, while assigning Poland the fate of an underdeveloped agricultural weakling dependent on British markets for its low value-added farm produce. Empire building then was attributed to British cultural fitness to greatness rather than British structural advantage through trade. 

David Ricardo formalized the term “comparative advantage” his 1817 book: On the Principles of Political Economy and Taxation by the example of trade in wine and cloth between England and Portugal. Even when Portugal was able to produce both wine and cloth at lower cost than in England, because the relative costs of producing the two goods were different in the two countries, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England would benefit from this trade because its cost for producing cloth remained unchanged but it can now import wine at a lower price. The conclusion drawn is that each country can gain by specializing in the good that it has comparative advantage in and trading that good for the other.  

The negative effect of comparative advantage from trade that Ricardo did not elaborate is that a country that exploits comparative advantage in trade to focus on advanced technological gains will achieve absolute advantage in the long term. Cloth production was beginning to be mechanized in England in the 1800s and investment in cloth production eventually led to the industrial revolution in England and allowed England to develop a societal culture of the industrial age.
Thus national industrial policy is necessary to protect countries from falling into the developmental trap of comparative advantage in trade, trading long-term economic development for short-term trade benefits. Comparative advantage in free trade favors the more advanced economy to widen the gap in development. In early 19th century, England was emerging as the most technological economy in the world, and British national opinion adopted free trade to perpetuate its advanced status. Comparative advantage was a short-term accounting trick to lure the less advanced economies into free trade with England.
Friedrich List (1789-1846), as expounded in his Das Nationale System der Politischen Oekonomie (1841), translated as The National System of Political Economy, that once a nation (or a bloc of nations) falls behind developmentally in the trade arena, it cannot catch up through free trade alone without government intervention.

List’s German Historical School is distinctly different in outlook from the British classical economics of David Ricardo and James Mill. List argues that economic behavior that gives credence to laws of economics is contingent with its historical, social and institutional context. When a nation is forced to adopt the national opinion of another nation with different historical conditions as natural laws of international economics, it will always be the victim of such alien, unnatural laws.

Such views have been validated by the experience of the trade relation between Britain and her colonies within the British Empire. The American Revolution was fought over economic dominance by Britain, the freedom and democracy issues were merely rhetorical dressing. The founding father of the United States had first in mind forming a constitutional republic with a king rather than a president. The issues were again visible in post-WWII Japan and Germany, which had to pay the price of being client states of the US in exchange for trickled-down prosperity through free trade.

For the socialist camp, trading with the capitalist camp during the Cold War was the strategic error that caused it to expose itself unprotected to a predatory capitalist game it could not win and that it would lose from the outset and never catch up. The dissolution of socialist USSR was rooted in Soviet decision to engage in trade with the capitalist West to earn dollars to finance the Soviet arms race with the US.

In that sense, neo-liberals are on target in claiming that free trade promotes capitalistic democracy, but they are dishonest in claiming that free trade is a win-win game for all participants or that capitalist democracy is suitable or workable for all nations. Even Wal-mart is dropping its commercial DSMS (data based management system) of one-size-fits-all, to accommodate local differences in cultural and social idiosyncrasies in consumer choices. Is the choice of produce is acknowledged to be governed by local preferences in order to optimize profit, can the choice of political system be expected to governed by one-size-fits-all model to produce world peace? Superpower cultural imperialism is the key defect in US foreign policy.  

International free trade is only good for the financial hegemon, as domestic free trade is good for the monopolist. Socialism works only if development is not preempted by external trade. The World Trade Organization and the IMF are regimes designed to favor the capitalist hegemon by keeping the weaker economies at a structural disadvantage with rules that would make it impossible for them to overcome their weaknesses. The current anti-WTO and anti-IMF movements around the world are early signs of a grassroots awakening to this truism.    
The myth of comparative advantage aside, international trade is necessary because most nations do not produce all basic commodities that every economy needs. This is because the location of basic commodities has been fixed by nature prior to the emergence of the nation state. After the age of imperialism, when quest for basic commodities can no longer be accomplished through military conquest at low cost, international trade is then driven by the need of all modern economies for basic commodities. Thus international trade is not driven by comparative advantage. It is driven by competition for basic commodities. Modern geopolitics is shaped by the uneven location of basic commodities left by nature around the globe. Neo-imperialism then replaces old fashion imperialism by substituting military conquest with predatory trade to exploit the less advanced economies.

August 17, 2009

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