Regional Integration Without Empire


Henry C.K. Liu


Presented at the 2015 Eurasian Workshop at IIASA, Luxemburg, Austria – Sept 15-16


Regional integration is a multi-national political process in which sovereign nation states within a region voluntarily agree to enhance cooperation in regional affairs through participation in supranational institutions governed by integrated regulatory regimes to facilitate the region’s common goals and objectives in socio-economic development, while retaining individual state sovereignty. It is important that regional integration does not degenerate into empire structure dominated by any one nation state, or one group of nation states.

As a political process, regional integration aims to achieve within a region economic, social, cultural and political integration. This goal is to be achieved through the promotion of international trade by reducing trade barriers within a region, such as reduction or removal of tariffs to create a single regional market, and to adopt unified rules on trade, standards on goods quality and service performance, legal framework and a common currency, or at least a free convertibility of currencies of member states.

The process also orchestrates multilateral governmental support from sovereign states in a region for tackling common regional problems that transcend national borders, such as protection of the environment, maintenance of public health, safeguard of cross-border water purity and supply, setting standards for food safety, policing of transnational crime, particularly illegal cross-border traffic of narcotic drugs and controlled substances, undocumented immigration, violation of financial regulations and fraudulent business practices,  and illicit money laundering.

Regional integration as it has developed nowadays focuses primarily on economic issues, particularly through market liberalization in international trade and finance and concerted efforts to create a region-wide single market, operating under the assumption that prosperity can best be achieved through trade and that prosperity is a sine qua non for achieving socio-cultural and political integration .

Yet many regional problems are not purely economic or financial, but are social-political problems with economic and financial dimensions. Such socio-economic-political problems cannot be understood, let alone solved, through doctrinaire market fundamentalism. This is because the market is only one narrow aspect of the economy and while the market can give a quick fix on economic conditions at a specific moment, it is not informative to view the market itself as the economy, particularly as an input in socio-political policy deliberation.

Historically, the most effective venue for regional integration has been the empire structure of the 19th century. As WWI brought about the end of Age of Empire, it also gave life to a new Age of Imperialism gamely practiced by democratic governments of new bourgeois sovereign republics that followed the demise of imperial monarchies.

WWII ended the Age of Colonialism but gave a second life to Neo-Colonialism as whitewashed by Winston Churchill’s fantasy propaganda of the victorious Allies as “The Democracies” and “Defenders of Freedom”, and because neocolonialism could be used as an effective program to stop the spread of global communism, it deserved the support of the US as the superpower of the capitalistic democratic camp.

It is particularly pathetic that Churchill himself was nor democratically elected Prime Minister, but appointed by the King as an emergency arrangement to form a war-time coalition government with the opposing Labor Party without an election being held.

Predictably, lingering colonialism drove many national liberation movements to turn toward communism in pursuit of self determination. Post-war France was consumed by civil war to suppress national liberation in Algeria and Vietnam seeking self determination.

Anti-communist fixation in the US forced the guarantor of self-determination to support residual French colonialism, dragging the country into a protracted Vietnam War that instead of bringing peaceful unification in the small distant Asian country, caused a deep split in US public opinion, radicalizing US politics and exposing US government to populist mass protests. The high cost of the no-win war in Vietnam torpedoed LBJ’s grand vision of Great Society as massive resources were siphoned off to fund foreign war to save French colonialism.

Real Politik

Han Morgenthau in his Politics among Nations: The Struggle for Power and Peace (New York: McGraw-Hill Education, 2005) sets forth six fundamental principles of real politik.  The first principle of political realism maintains that politics are grounded in observable laws of human nature any idealistic attempt to challenge these laws will only lead to failure. Therefore, the project of political realists is “the testing of this rational hypothesis against the actual acts and their consequences that gives theoretical meaning to the reality of international relations. He describes US post-war behavior as imperialistic.

Moegenthau’s second principle of political realism is the centrality of power. Political realists believe that power is the main articulation of political interest, a hypothesis that can be tested by the observable actions of statesmen throughout history. By focusing on the study of political power, realists create a continuity of analysis of policy: each state can then be analyzed in terms of power politics.

However, Morgenthau warns against two common misconceptions: the first, trying to understand the motives of statesmen, is faulty because motives do not always align to actual policy or outcomes of policy; and the second, the alignment of ideology with action, to which the realist responds that a policy may be articulated in terms of popular ideologies, but nevertheless remains a product of considerations of power. Only a rational foreign policy built off a reasoned analysis of international relations will be a successful foreign policy.

The third principle is that while power is a universally valid concept, realism does not endow that concept with a meaning that is fixed for once and all. While the focus of analysis remains power, the method and articulation of power throughout centuries has changed and will continue to change. It is possible for a shift in scalar units of analysis (away from then nation-state), since the contemporary connection between interest and the nation-state is a product of history and therefore bound to disappear in the course of history. However, realists still disagree with their idealist counterparts in believing that the transition away from the nation-state system will occur as a product of the laws of international relations not by the reasoned pleas of a utopian minority.

The fourth principle states: political realism is aware of the moral significance of political action. However, the moral principles relevant to a particular policy must be historicized and contextualized. Therefore, ethics is incorporated into political realism through the calculation of the political consequences of a particular policy or action.

The fifth principle holds that political realism refuses to identify the moral aspirations of a particular nation with the moral laws that govern the universe”. Since nations have and will continue to disguise their particular ambitions within the language of universal morality, the shrewd realist sees through their rhetorical maneuver.  Instead, power forms the basis for judging the actions of other countries and developing appropriate reactions to those actions.

Lastly, the sixth principle is the acknowledgment of the primacy of political analysis in the sphere of the political. Morgenthau warns that policy repeatedly guided by legal and moral guidelines instead of strictly political considerations endangers the power of a country and the welfare of its citizens. Instead, realism advocates that policy must arise out of purely political analysis: an analysis of power. In a world order of sovereign state interacting in free trade financial capitalism operating through markets with a price mechanism, policy must arise from an analysis of market power, which can be defined as a participant’s ability to effect price to his benefit in an open market without alienating other participants to the extent of causing market failures.

Virtual Synthetic Empires

Even today, the formation of regional integration frameworks is at constantly risk of dominant states exploiting the creation of ideologically preferred integration frameworks in which preeminent states can exercise exclusive imperialistic influence over other weaker member states in a virtual form of synthetic empire building. 

In this context, including and excluding of certain target countries in regional integration schemes are essentially stealth empire building measures by dominant states, as can be observed in the distinct feature of the US engineered Trans-Pacific Partnership (TPP) in its pointed exclusion of the People’s Republic of China (PRC).

Boycotts or nonparticipation in regional integration initiatives is a negative form of empire building as US position of the China-proposed Asian Infrastructure Investment Bank (AIIB), an international financial institution focused on supporting infrastructure construction in the Asia-Pacific region.

AIIB was proposed as an initiative by the government of China and was supported by 37 regional and 20 non-regional members as Prospective Founding Members (PFM), 51 of which have signed the Articles of Agreement that form the legal basis for the proposed bank. AIIB starts operation after the agreement enters into force, which requires 10 ratifications, holding a total number of 50% of the initial subscriptions of the Authorized Capital Stock. Countries with a large GDP that did not become PFMs are the US, Japan (which dominated the ADB) and Canada.  AIIB is regarded by some as a rival for the IMF, the World Bank and the Asian Development Bank (ADB), which are regarded as dominated by developed countries

AIIB is regarded by some as a rival for the IMF, the World Bank and the Asian Development Bank (ADB), which are regarded as dominated by developed countries like the United States. The United Nations has addressed the launch of AIIB as "scaling up financing for sustainable development" for the concern of Global Economic Governance.

AIIB was proposed by China in 2013 and the initiative was launched in Beijing in October 2014. The Articles of Agreement (AOA) were signed by 50 PFMs on 29 June 2015, which become a party to the agreement through ratification. As of July 2015, one member state (Myanmar) has ratified the agreement, formally becoming a founding member.

Rise of China Upsets US

Within US policy circles, the rapid rise of China as a major force in the global economy is proving a reconsideration of whether free trade is still in the US national interest. The prospect that China can be a major economic power is feeding wide-spread paranoia in the US The fear is that developing nations led by China and India may out-compete the advanced nations for high-tech jobs while keeping the low-skill, labor-intensive manufacturing jobs they already won.

China already is the world's biggest producer and exporter of consumer electronics and it is a matter of time before it becomes a major player in auto exports. Shipbuilding is now dominated by China and aircraft manufacturing will follow. The US Navy is now dependant on Asia, and eventually China, to build its new ships and eventually the economics of trade will force the US Air Force to procure planes assembled in China from parts made in Asia.

The fear of China by the US dates back to almost two centuries of institutional racial prejudice, ever since Western imperialism invaded Asia beginning in early 19th century.  Notwithstanding that it is natural, ceteris paribus, that the country with the world’s largest population, an ancient culture and long history would again be a big player in the world economy in modern times as it modernizes, the fear that China might soon gain advantages of labor, capital and even technology that would allow it to dominate the world economy and gain the strategic advantages that go along with such domination, is enough to push the world’s only superpower to openly contemplate preemptive strikes against it.

Furthermore, Chinese culture commands close affinity with the population in Asia, the main concentration of the world’s population and a revived focal point of global geopolitics. Suddenly, socio-economic Darwinism of survival of the fittest, celebrated in the US since its founding, is no longer welcome by US policymakers when the US is no longer the fittest and the survival of US hegemony is at stake.  To many in the US, particularly the militant neo-conservatives, international trends of socio-economic Darwinism now need to be stopped by war.

China has more than 1.3 billion people, a fifth of the world’s population, and a work force of 700 million as against a US work force of 147 million. This is a ratio of 5 to 1. To avoid being over taken by China in aggregate national income, US wages would have to maintain a gap of five times over Chinese wages. Historically-based technological and economic advantages currently give US workers a nominal wage gap of over 35 to 1 over Chinese workers, or 9 to 1 on purchasing power parity (PPP) basis. This comfortable gap is not based on current productive differentials but rather on unbalanced terms of trade and geopolitical incongruity left by history. Yet until wage parity is attained, free trade will continue to be driven by cross-border wage arbitrage in favor of China.  But with wage parity, the Chinese economy will be five times the size of the US economy, a prospect not particularly welcomed by the US geopolitical calculations. It was the superior US economy that enabled the US to emerge as victor in the two world wars and to prevail in the Cold War.

Free Trade leads to Unbalance Trade

The US is waking up from its self delusion about free trade to the reality that free trade never leads to balanced trade. Free trade always works against the weaker trading partner, notwithstanding Ricardian principle of comparative advantage. The British promoted free trade when it’s early industrial economy was the strongest in the world.  

Friedrich List, in his National System of Political Economy (1841), asserts that political economy theory as espoused in England, far from being a valid science universally, was merely British national opinion, suited only to British historical conditions.

 List’s school of institutional economics asserts that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and such free trade must be fought with protective tariffs and other protective measures of economic nationalism by trading countries with weaker economies. Henry Clay’s "American system" was a national system of political economy.

The US was happy to promote free trade when unbalanced trade was in favor of the stronger US economy. Balanced trade between unequal partners requires managed trade to reduce market power of the stronger partner, which is achieved by the weaker economy resorting to government interference on free trade for more favorable terms of trade.  Such government interference is driven by the politics of trade.  When managed trade is conducted against the weaker partner, it is economic imperialism.  When it is conducted against the stronger partner, it is known as leveling the playing field.  Yet some in the US are engaging in New Speak when they seek the perpetuation of economic imperialism by demanding a leveling of the playing field in trade with weak, less-developed economies with low wages.

Poor Economies Oppose US Farm Subsidies

As poor nations press the WTO to stop unfair US farm subsidy, US cotton growers try to defuse the mounting pressure by offering help to growers in poor nations. The US government spends $4.5 billion annually in subsidy on a cotton crop with a market price of $5.9 billion, which otherwise must be priced more than double in the world market. This subsidy enables US growers to profitably export three quarters of their output and control 40% of world trade in cotton. What the US lost in textile manufacturing, it gains back in subsidized cotton export, high returns on investment in overseas textile mills and low consumer prices in cotton goods. Thus the current tariff war against Chinese textile is merely the US wanting its cake and eating it too. While $4.5 billion is a merely pittance in the $2.4 trillion 2005 US fiscal budget, the subsidy has the effect of ruining the economies of the world’s poorest nations.

The National Cotton Council, a powerful trade group in US domestic politics, while basking in the happy situation of seeing US cotton export increase by 350% between 1999 and 2004, from 4 million bales of 480 pounds to 14 million bales, explains that the goal of helping African growers is “not to make Africa a big cotton producer, only to make the miserable lives of poor Africans a little better. It is a strategy of protecting managed trade with welfare trade.

On the other hand, simply doubling the market price of cotton will not help African growers, whose competitive disadvantages go beyond market price, and cannot be eliminated without fundamental changes in the terms of global agriculture trade.

While China’s economy has grown by over 9% annually for the last couple of decades and its GDP had soared from $147 billion in 1978 to $1.6 trillion in 2004, the US GDP, $11.75 trillion in 2004, was still far ahead by 7.4 times over that of China.  A 2% growth in the larger US GDP contributes to a widening GP gap over the 7% growth in China’s GDP.

Because of the difference in population size, US 2005 per capita GDP is $41,917 while that of China is only $1,411, a gap of almost 30 times. The US ranks 8th in the world in per capita GDP while China ranks 111th.  In 2004, US per capita income was $35,400 while that of China was $960, a 36.8 times gap.  The per capita income gap between the two economies, while growing at a dramatic rate in China, is in fact widening, not closing.

Despite such wide per capita income disparity, the US is apprehensive because it is this perpetual disparity that will continue to drain jobs from the US to China. While a narrowing of the wage disparity is needed to slow the job drain to China, the resultant rise in Chinese aggregate national wealth will threaten US economic dominance in the world. In a neo-liberal free trade global regime, the US has a choice of losing jobs or losing economic dominance and geopolitical power to China.  That is the key dilemma in US economic policy towards China.

There is an economic basis behind US antagonistic militancy towards China. The US won both previous world wars primarily by its war-time productive power.  This fact has not been forgotten by US policy-planners. While US manufacturing base has been seriously eroded by neo-liberal global trade in the last two decades, the prospect of a shooting war with China will relocate much of the lost manufacturing back to the US in short order.

Impressive US War Production Record  

In 1942, only weeks after Japanese attack on Pearl Harbor, President Roosevelt called for an annual production of 60,000 military planes, a near impossible demand considering that prewar annual production was only 6,000, and working males were being taken into the war-time military.

But in 1943, some 86,000 planes were produced by a work force that recruited women, exceeding the president’s call by a third. In World War II, the US produced 31,000 B17 and B24 long-range bombers to support strategic bombing, reaching a peak production rate of 50 per day.  In 1941, 55,000 individual work hours were needed to turn out a B-17, and by 1944, this had dropped to 19,000 hours. Strategic bombing crippled German war production from ball bearings production to oil refineries for critically needed gasoline. The shortage of gasoline stalled German resistance in both the Eastern and Western fronts and crippled the Luftwaffe. Also, the time it took for an aircraft carrier to be built in the US dropped from 36 months in 1941, to 15 months in 1945. In all, 300,000 military planes were produced in four years of war.

Because of the production prowess of the US, Germany and Japan simply could not produce enough weaponry fast enough to keep up with battle attrition the way the Allies could. It was only a matter of time before the Axis powers would be defeated.  A market economy is a feeble weakling compared to a war-command economy. That a war in Asia will relocate manufacturing jobs back to the US in large scale to get the US economy moving again must have occurred to the neo-con warriors who have been controlling US policy since 2000.  The hawks in this group are betting on the gamble that China’s nuclear deterrence against attacks from the US can be neutralized by US strategic defense initiative (SDI), and that the US mainland will continue to be safe from counter attack.

US Fear of Rising Chinese Economy

Notwithstanding irrational paranoia from US militarists, the fear of China by the US is not fundamentally based on military threat, albeit it has a military dimension. On June 13, 2005, a period of fatalist talk on the need for preemptive strike against China by some normally responsible politicians, Henry Kissinger, arguably the greatest living guru of contemporary geo-realpolitik, wrote in the Washington Post: “Military imperialism is not the Chinese style. Clausewitz, the leading Western strategic theoretician, addresses the preparation and conduct of a central battle. Sun Tzu, his Chinese counterpart, focuses on the psychological weakening of the adversary. China seeks its objectives by careful study, patience and the accumulation of nuances -- only rarely does China risk a winner-take-all showdown.”

US fear of China is a reaction to the destabilizing effect on existing, established geo-economics from the natural rise in economic power of a modernizing nation with a large population. It was this natural advantage of a large population that permitted the US and the USSR to exploit geopolitical opportunities to capitulate themselves into superpowers status after WWII.

The British Empire was first and foremost a quest for population, and the wealth associated with it, albeit without the benefit of equality, the lack of which became the central weakness that deprived the empire of longevity. The lack of equality within the USSR was the main cause of its dissolution, not perverted communist doctrine. The large aggregate population of the EU is now driving its new economic aspirations, but inequality will be the main stumbling block. Japan will never be a contender for superpower status because of its small population and its exclusionary national culture.

Immigration Good for Economies

Immigration is the fountainhead of economic development and sustained prosperity.  The developmental history of the US is a story of immigration. The US owed its economic rise to immigrants. Throughout Chinese history, immigration from distant lands and foreign cultures enriched Chinese civilization and contributed to long periods of prosperity. Germany benefited greatly from the immigration of Jews and lost much from Nazi prosecution of its Jewish citizens.  The current anti-immigration phobia in the US and in the EU will put self-inflicted roadblocks in the path of these economies toward a new age of prosperity.

Still the history of the US in its process in becoming an economic superpower is instructive.  As a prosperous, internationally-engaged US evolved into a huge open market for the world’s developing economies, so will a prosperous, internationally engaged China. China, similar to historical US experience, will go through several series of historic policy debates over the choice between isolationism and international engagement as its economy develops.

Isolation Bad for Economies

US trade embargo on Communist China after WWII caused the failure of the Pax Americana until the Nixon-Kissinger opening to China in 1973. The embargo effectively delayed development in China for half a century, and radicalized Chinese both domestic politics and foreign policy.

Developing countries should not misconstrue isolationism as an effective strategy of anti-imperialism. Quarantine is a strategy that deprives the subject of any chance of developing effective immunity against invading viruses that eventually exposes it to more serious vulnerability.   Yet US policy on China will continue to impact the outcome of China’s policy debates with serious consequences.  Hostility breeds counter hostility and protectionism breeds counter protectionism. Isolation between hostile nations leads inevitably to war.

Kissinger went on in the same article: “With respect to the overall balance, China’s large and educated population, its vast markets, its growing role in the world economy and global financial system foreshadow an increasing capacity to pose an array of incentives and risks, the currency of international influence. Short of seeking to destroy China as a functioning entity, however, this capacity is inherent in the global economic and financial processes that the United States has been preeminent in fostering.” Unfortunately, Kissinger’s influence on US foreign policy was cut short by the Watergate scandal.

A China forced defensively by hostile US policy into isolationism, a recurring tendency throughout its long history, ironically would lead to regional decline and instability that would quickly turn global in this interconnected world. The decline of China that began in early 19th century was traceable in part to Chinese self-imposed isolationism, in contrast to Japan’s forced opening to the then more technologically advanced West that led to the Meiji Reformation. The modern history of China might have been totally different if Chinese isolationism had not prevailed in Chinese politics in the early 1800s, and modernization had been allowed to proceed with needed stimulation from mutually beneficial contacts with the West before Western imperialism had a chance to take shape.

An internationally-engaged China will be a positive force for world peace and prosperity. As the enormous China market becomes reality from rising income, it will impact traditional international economic relations to restructure residual prejudicial racial enmity and Cold War geopolitical alliances and give rise to a new mode of world order free of residual racial phobia and obsolete ideological conflicts.

US hostility and pre-emptive strategy toward a peacefully-rising China may be forced to fall back on ineffective US unilateralism, devoid of willing partners even from among its residual Cold War allies.  Trade protectionism will lead to US isolationism, a movement with a significant past in US history. Yet, as a superpower, the US cannot isolate itself from the rest of the world without severe penalties. Or to put it another way, the cost of US isolationism is the forfeiture of US superpower status.

Kissinger observed correctly in the same recent article that “in a US confrontation with China, the vast majority of nations will seek to avoid choosing sides.” Already, normally dependable US allies such as the UK, the EU (particularly France and Germany), Japan, Australia and even Israel, are experiencing rising conflicts with US policy on China.  These nations are beginning to see US demands for unquestioning support of its hostile policy on China as not being congruent with their separate national interests.

Everywhere else in the world, from Asia to Latin America, from the Middle East to Africa, sympathy for China’s effort to regain its natural prominence in the world and positive response to its effective development strategy are mounting while appreciation for unilateral US security and economic policies is falling.  While the US is still a juggernaut in its coercive ability to commandeer much of the world’s wealth, its ability to produce wealth appears to have visibly declined. It is becoming increasingly obvious to some in Washington that a military option is the answer to arresting US economic decline that threatens US superpower status.

Eleven of the 16 countries surveyed in June 2005 by the US-based Pew Research Center: Britain, France, Germany, Spain, the Netherlands, Russia, Turkey, Pakistan, Lebanon, Jordan and Indonesia, had a more favorable view of China than of the US. The survey on global attitude finds that while China is well-regarded in both Europe and Asia, its burgeoning economic power elicits mixed reactions. Majorities or pluralities in France and Spain believe that China's growing economy has a negative impact on their own economies. Respondents in the Netherlands and Great Britain, traditionally free trade nations, have much more positive reactions to China's economic growth. Public opinion in the US on this issue is divided; ­ 49% view China’s economic emergence as a good thing, while 40% say it has a negative impact on the US.

Whatever their views on China's increasing economic power, European publics are opposed to the idea of China becoming a military rival to the US, despite their deep reservations over US policies and hegemony. Solid majorities in every European nation ­except Turkey regard China’s emergence as a military superpower as undesirable. In Turkey and most other predominantly Muslim countries, where antagonism toward the US runs much deeper at this time in history, most people think a Chinese challenge to US military power would be a good thing.

Nonetheless, there is considerable support across every country surveyed, other than the US, for some other country or group of countries to rival the US militarily. In France, 85% of respondents believe it would be good if the EU or another country emerged as a military rival to the US. Most Western Europeans want their countries to take a more independent approach from the US on diplomatic and security affairs than it has in the past. The European desire for greater autonomy from the US is increasingly shared by the Canadian public; 57% of Canadians favor Canada taking a more independent approach from the US, up from 43% two years ago. The US public, by contrast, increasingly favors closer ties with US allies in Western Europe, a continuation of traditional US Eurocentric attitude, while the center of world affairs is shifting toward Asia.

China’s Dilemma: Growth and Equality

Chinese President Hu Jintao laid out China’s economic goals through 2020 in a May 16, 2005 address in Beijing. He vowed to quadruple to $4 trillion the nation’s 2000 GDP of $1 trillion.  This would still be only about one-third the size of the US economy in 2005, which itself will surely grow significantly by 2020.  Even if China’s economy quadruples, the average Chinese will remain poor. If China succeeds in her goal, per capita income would rise only to $3,000. In contrast, US per capita income was $40,100 in 2004. Thus all the talk of China overtaking the US in the near future is misleading.

Yet China is paying a heavy social price for fast GDP growth. A recent survey by China’s National Bureau of Statistics found that earners in the highest-income bracket in cities earned 11.8 times more than those at the low end of the scale in the first quarter of 2005.  The figures were 4.16 times in 1996 and 5.7 times in 2000. Statistics from the Ministry of Labor and Social Security also indicate that the richest 10% of households own 45% of private urban wealth. The poorest 10% of urban households have less than 1.4% of the private wealth in Chinese cities. Urban poverty has been increasing since the mid-1990s although the Chinese Government has been more successful in reducing rural poverty. Urban poverty is concentrated in three groups: the disabled and elderly without family, the unemployed and migrant workers. Given the absence of a sound social security system in the country’s move toward socialist market economy, the rich-poor gap among Chinese urbanites may become threatening to social stability. Popular resentment towards the rich is approaching seismic dimensions, unlike in the US where the rich enjoy the enviable status of adored celebrities. The business newspaper, China Daily, identified government policies as mainly to blame for their failure to ensure equal opportunity and fair wealth distribution and to give enough help on a timely basis to the urban needy.”

To the government;s credit, Premier Wen Jiabao in a press conference on March 14, 2005 referred to Nobel laureate economist Theodore Schultz (1979) who maintained that rural poverty in poor countries persists because government policy in those countries is biased in favor of urban residents at the expense of rural dwellers. Schultz visits to farms and interviews of farmers led to new ideas, such as human capital (Investment in Human Capital, American Economic Review 51 - March 1961). So if we knew the economics of the poor, we would know much of the economics that really matter. Most of the world's poor people earn their living from agriculture. So if we knew the economics of agriculture, we would know much of the economics of being poor,said the premier.  Yet free trade prevents government subsidy to agriculture. China Daily suggested that the government should also be concerned with the urban poor.  This disparity of wealth naturally accompanies market liberalization and deregulation in all economies. For the Chinese economy to remain a socialist market economy, income and wealth disparity is the biggest obstacle that must be tackled as a top priority.  Socialism does not reject wealth, only the mal-distribution of it.

US Rethinks China Trade Policy

For a decade now, debate in US policy circles has swirled over whether China - a “socialist market economy” according to its constitution - is a strategic partner, a strategic competitor or a rising military rival. What makes China unacceptable to the US is that it is still a communist country, albeit the neo-communism being put in place in China is increasingly free of authoritarian effects of a garrison mentality that has resulted from US hostility and containment during the Cold War.  Neo-communism in China is largely a strategic response to and the resultant consequence of expanding global neo-liberalism. Yet while the policy debate between orthodox communism and neo-communism has yet to be definitively settled in China, free trade and market fundamentalism are under reconsideration in US policy circles. If neo-liberalism should fail and the global trading system freezes, the future of Chinese neo-communism will also be put in jeopardy.  Thus US isolationism is the unwitting ally of Chinese orthodox communism.

Paul Samuelson, a Nobel laureate economist, famed author of the standard economics textbook and an ardent supporter of free trade, in an article in the Journal of Economic Perspectives (2004) suggested that China’s growing economic might calls into question whether free trade is a win-win game for the US.  Samuelson said open trade helped the US economy grow since World War II, but that competition from abroad drove down wages in lower-skill jobs. Over time, China and India could displace US high-tech jobs as well and more US wages could be forced further down to sustain competitiveness. Even though US consumers get cheaper Chinese-made goods, many US citizens could be net losers from such trade, Samuelson wrote. Consumer gains from lower prices are offset by worker income losses. If globalization causes enough US citizens to suffer lower wages, the US as a whole loses. “It is going to become so big a problem that some slowing down is going to be politically popular - and has some merits,” says Samuelson, who estimates that from World War II to the early 1980s, increased trade with a revived Europe and the Pacific Basin accounted for 30% of the rise in the standard of living in the US, as a result of the law of comparative advantage.

But Samuelson expects the US to gain less from trade, outsourcing, investment, and other aspects of globalization in the coming 30 years, possibly even lose out on a net basis. In such case, a minority of the US population would gain, but more would suffer lower living standards. “The general dogma that anything that expands globalization is good for everyone isn't right,” Samuelson says. And as all political scientists know, when the majority loses, the politics turns ugly in a democracy.  Even for free-trade guru Samuelson, free trade in a global market economy is only desirable if its serves US national interest. When it does not, free trade needs to be replaced by managed trade, directed by a domestic command economy.

One difference between free trade then, when it was good for the US, and now is that greater inequality has become institutionalized in the US, Samuelson argues. Neither the political establishment nor the electorate is any longer willing to spread around the benefits of freer trade to help those in the US hurt by globalization, as they did in the aftermath of the Great Depression after World War II, through a progressive tax structure, government social spending, and transfer payments. Those harmed are usually at the lower end of the income and wealth ladder. This is true of individuals within the US as well as those in other trading nations. Free trade has worsened the fair distribution of income for the working class and emasculated the ability trade unions to command pricing power for labor, while the more educated professional classes, particularly those in management and finance, have gotten most of the financial gain.  Warren Buffet, one of the most successful investing capitalists in the world, has also been saying that the current US tax regime favors the rich unfairly. Inequality of wealth and disparity of income during the 1920s, coupled with easy credit to fuel a speculative debt bubble, led to the 1929 stock market crash. But it was the resultant pain that disproportionately fell on the unemployed and the working poor that led to the politics of protectionism that prolonged the Great Depression. A repeat of similar economic-political dynamics seems to be evolving in the first decade of the 21st century in the US.

Political philosophers in the past worried that in a democracy, lower-income classes would elect politicians who would confiscate much of the riches of the wealthy. Proponents of democracy then guard against this tendency by promoting the concept of minority rights. The US version of representative democracy has turned that worry on its head. The cost of getting a representative elected in a US election has escalated so much that the rich minority has been excessively able to protect and enhance its interests through campaign contributions to sympathetic if not captured politicians.

Trade was kept from emerging as an important issue in the 2004 presidential campaign. The Bush administration had taken protective measures during its first term in areas where key political constituencies faced competitive pressures, such as steel, agriculture, and lumber, but the president remained solidly a free trader. The AFL-CIO has been pushing for trade with the poor nations to be “fair,” by forcing them to adopt international labor and environmental standards. Fair trade has become the slogan for both labor and conservatives, but the practical effect of fair trade as defined by US labor would be no trade, as the poor country are not allowed any pricing power, particularly in wages and environmental protection, by the unfair and unequal terms of trade set by their more powerful trading partners in the on-going trade regime.

US Labor Opposes Free Trade

The labor movement in the US has been the main victim of neo-liberal global trade.  Union membership has fallen from 31.8% of the workforce in 1948 to 12.5% in 2004.  Unions have been increasingly ineffective in protecting worker interests as US domestic politics turns conservative in favor of management.  Yet US labor had been in the forefront in the support for US global anti-communist policy and was among the most fervent supporters of every unpopular war, from Vietnam to Iraq, wars waged to lay the ground for a world of neo-liberalism that eventually came to undermine the economic interests of US labor.  Traditionally, union pay and benefits helped lift even non-union worker pay as employers had to match or better union pay scale to keep employees from joining unions. While union membership of government workers increased from 25% in 1975 to 36% in 2004, the total number of government workers has been declining as a direct result of anti-big-government trends since the Reagan era.

Membership in the private sector where most of the jobs are, union membership has dropped from 21.5% in 1975 to 8% in 2004. The industries that have the largest declines are: manufacturing (from 36% in 1975 to 13% in 2004); transportation (from 47% in 1975 to 27% in 2004); and construction (from 35% in 1975 to 16% in 2004).

Manufacturing workers unions suffer from both sector-wide aggregate job loss and a drastic drop in membership percentage of the remaining work force, as the first waves of outsourcing were concentrated in union plants where labor cost was highest. While wage arbitrage has been the driving force behind the decline of labor unions, the US bankruptcy regime had been the legal venue for the wholesale abrogation of labor contracts and employee pension obligations.

Disparity of Income

The growing disparity of income in the US translates into low pay for place-related service jobs that cannot be outsourced.  Yet the disproportionate concentration of women, minorities, new immigrants, both legal and illegal, in these jobs presents opportunities for union organization.  The emergence of large employers such as Wal-Mart, Home Depot, FedEx, major national cleaning and telecommunication companies, and labor-intensive food packaging companies such as Tyson, presents identifiable organizing targets.  There is a trend in union strategy to shift from improving the pricing power of labor in vibrant sectors of the economy, to resistance against inhumane oppression in a structurally unfair economy.

This trend will move the labor movement increasing out of progressive economics into radical political confrontation.  The first signs of such a shift came from the withdrawal from the AFL-CIO by the service workers union and the Teamsters on July 16, 2005 at the opening of its annual convention in Chicago, followed by the United Food and Commercial workers and United Here which represents hotel, restaurant and apparel workers. These dissident unions aim to cooperate with other unions of laborers, farm workers and carpenters to develop multi-union drives against Cintas, the big nation-wide laundry company, as well as Wal-Mart and FedEx.

In the 2004 presidential campaign, Democratic challenger John Kerry was careful not to disappoint US organized labor, traditionally a key political constituent. But labor is a captured constituent for the Democrats, with no alternative champions in US politics.  In a tight race, the strategy was to woe the undecided who otherwise would vote for the opponent. The opposing presidential candidates of both political parties proclaimed support for trade liberalization, while they make protectionist concessions separately to their traditional constituents for purely tactical reasons of election politics rather than as strategic reforms in national trade policy, with Bush favoring big business such as steel and Kerry opposing outsourcing. Samuelson of course warns that just because free trade sometimes hurts does not mean that trade barriers in the form of tariffs can help. Most efforts at protectionism are self-defeating, Samuelson says. Nonetheless, a slowdown in globalization might be “more comfortable,” allows the guru of free trade.

US Politicians Critical of Chinese Trade Posture

Many politicians whose own fates are dependent on voter sentiments, are less sanguine. Liberal Senator Charles Schumer (D - New York), and Conservative Senator Lindsey Graham (R - South Carolina), with broad-based bi-partisan support reflective of popular sentiment, introduced the China Currency Bill (S. 295) in April 2005, calling for 27.5% tariffs on all Chinese products sold in the US if China does not revalue its currency by 27.5% within 180 days of the passage of the bill.  The bill was “attached” as an amendment to the Foreign Affairs Authorization Act (S. 600) -- the umbrella legislative authority for the $34 billion foreign aid program.

The pro-free-trade Senate leadership attempted to have the amendment struck down, but was defeated by an overwhelming margin of 67-33. After that, Senator Schumer agreed to withdraw his amendment only with the quid pro quo compromise of being allowed to hold a full-blown Senate Finance Committee hearing on the Chinese currency issue and the guarantee of a vote on S. 295 before the end of this summer. Similar bi-partisan legislation was also introduced in the US House of Representatives by Reps. Duncan Hunter (R - CA) and Tim Ryan (D - OH).

Chinese Export Revenue Goes To Foreign Investors

In the past decade, Chinese exports have increased 6.5 times, from US$91.7 billion in 1993 to US$593.4 billion in 2004.  Yet 62% of that increase has been driven by foreign direct investment as offshore Chinese outposts of foreign companies and investors from the US, Europe, Japan and elsewhere in Asia. For every dollar China retains as a trade surplus, another $4 goes to returns on foreign investment.  And even that dollar goes to the Chinese central bank to buy US Treasuries to finance the US debt economy, and cannot be spent inside China. This is why economists say Chinese GDP growth is supporting the global economy, which is dominated by the dollar economy.

China is significant not only because it is the most populous nation with the fastest growing economy, but also because it is one of the poorest and thus has much prospect and room for basic growth with a huge appetite for imports. Blessed with a long history of a rich culture, the economic revival of China can proceed at lightning speed and bring with it a new world of plentitude. The whole world now wants to trade and interact with the Chinese economy because under the current trade regime, trade with China benefits the foreign trading partners more than its does China itself.

Exchange Rates

It does not matter what the exchange rate of the Chinese currency is; China is totally free to set the exchange rate as long as trade is ultimately denominated in Chinese currency and Chinese prices are competitively adjusted according to the exchange value of the Chinese currency, even if the dollar remains the world’s main reserve currency for global trade for a long time.

The question of the exchange value of the Chinese yuan in relation to the US dollar is a minor technical issue within the peculiar regime of dollar hegemony. It has no fundamental macroeconomic significance.  The day will come when this technical issue will become mute, when the Chinese yuan will naturally become a reserve currency for trade with China, reflecting the reality of changing global trade patterns.

As the attempt of a Chinese state-owned oil company to merge with US-based Unocal Corporation fanned protectionist passion in the US Congress, Federal Reserve Chairman Alan Greenspan warned senators in public testimony not to let their misguided frustrations with China’s economic policies breed reactions that would do the US economy more harm than good. What is not generally recognized is the fact that Chinese monetary and trade policies are defensively driven by US policy. Proposed tariffs against Chinese goods and other forms of protectionism would significantly lower US living standards and would not save jobs in the US, Greenspan told members of the Senate Finance Committee.

Greenspan testified that he was aware of no credible evidence that revaluing the Chinese currency would significantly increase manufacturing activity and jobs in the US.  Many of the goods sold in the U.S. with a “Made in China” label are merely assembled in China from parts made elsewhere in Asia. If the yuan, and therefore Chinese labor, were more expensive in dollar terms, those goods would be assembled elsewhere in Asia, at no net benefit to the US, Greenspan said.  He said that Senator Schumer’s proposed tariffs on Chinese goods “would significantly lower US imports from China but would comparably raise US imports from other low-cost sources of supply in Asia and perhaps Latin America as well. Few, if any, jobs in the US would be protected. In this respect, CAFTA (Central America Free Trade Agreement) is linked to the China trade issue.

Greenspan credited the relatively free flow of goods and services across national borders with enabling the global prosperity of the last six decades. “A return to protectionism would threaten the continuation of much of the extraordinary growth in living standards worldwide, but especially in the United States, that is due importantly to the post-World War II opening of global markets,” he said.  For lawmakers worried about US job losses, Greenspan recommended that they bolster job retraining programs and improve education in middle and high schools. Nevertheless, Congress introduced political obstacles that successfully blocked the proposed CNOOC/Unocal merger, forcing CNOOC to withdraw on August 4.

US False Hope on Yuan Revaluation

The People’s Bank of China announced on July 20 that effective immediately the Renminbi (RMB) exchange rate will go up by 2.1% to 8.11 yuan to the dollar and that China will drop the dollar peg to its currency. Instead, China will move to a managed float of the RMB, pegging the currency's exchange value to a basket of currencies. In an effort to limit the amount of volatility, China will not allow the currency to fluctuate by more than .3% in any one trading day. Linking the yuan to a basket of currencies means China’s currency is relatively free from market forces acting on the dollar, shifting to market forces acting on a basket of currencies of China’s key trading partners.  The basket will be composed of the euro, yen and other Asian currencies as well as the dollar. Though the precise composition of the basket is not disclosed, it can nevertheless be deduced by China’s trade volume with key trading partners and by mathematic calculation from the set-daily exchange rate. 

The valuation shift to a basket of currencies is only a superficial move because the exchange rate of the dollar in an efficient foreign exchange market already reflects the equilibrium of the exchange rates of major currencies around the dollar. This equilibrium is the function of the market by definition, sustained by the complex workings of hedging through derivative trading with the dollar as the base.  By a managed float for its currency, China will enjoy the flexibility of leading the market, but it cannot go against the market as soon as the yuan becomes freely convertible, which according to current policy intention, may not become reality for some years.

Even when the yuan is not freely convertible under China’s strict capital control regime, hedge funds and other speculators have been trading yuan for years in the derivative market and through the trading in the equities of companies with large operations in China, and through trading of Asian currencies with flexible but close links to the Chinese yuan.  Companies such as Wal-Mart and Motorola, which buy from China, and LVMH Moet Hennessy Louis Vitton, which sells to China, face opposite impacts from a stronger yuan, with Wal-Mart losing on higher import cost and LVMH gaining on more Chinese purchasing power for foreign goods.

Non-deliverable forwards (NDF) have been an instrument of choice for professional currency traders. The NDF market allows traders to speculate on the value of currencies whose fluctuation is restricted by government fiat. In recent years, the NFD market has grown from $3 to $5 billion a day. Despite the huge size of China’s $1.4 trillion-a-year economy, the volume of currency traded in Shanghai is tiny, averaging just under $1 billion per day.

By comparison, daily currency trading on the Chicago Mercantile Exchange averages about $43 billion and worldwide around $2 trillion, with most of it transacted in London. Following the news of the yuan revaluation, NDF traders were taking bets for further revaluation ranging from 2.5% to 6% for 12-month contracts. In Singapore, one day after the news, one-year RMB NDF rose to about 7.64 yuan per dollar, a level that predicts further revaluation of more than 6% by the middle of next year. Big international banks routinely act as counterparties between opposing bets to generate risk-free fees.  Merrill Lynch forecast that the renminbi would rise to 7.5 yuan to the dollar by the end of this year. Other analysts were more conservative. Bank of America saw the reminbi being held at 8.11 yuan to the dollar until the year-end, while BNP Paribas believed Beijing would allow the renminbi to firm to 7.9 yuan to the dollar by the year-end. When market participants disagree, the market becomes active.

Xia Bin, director general of the Financial Research Institute under the State Council, China’s cabinet, warned speculators against harboring “illusions” about further revaluation, saying Beijing was likely to move carefully and slowly. Xia said no “clear” appreciation was likely in the remainder of this year. China Daily warned that expectation of a revaluation bigger than the 2.1% announced on July 20 “was, and will be, unrealistic.” Yu Yongding, a member of the monetary policy committee of the People’s Bank of China, the central bank, and a long-standing supporter of revaluation, was reported to have said he did not think China would allow dramatic changes in the exchange rate. “The principle is stability as well as flexibility,” Prof Yu said. “We don't want to encourage speculative capital inflows.” Gradualism has always been the hallmark Chinese economic policy.  As this article is being written, the flood of hot money into China and Hong Kong, which had begun some two years earlier when the market was anticipating eventual adjustments, has continued to accelerate.

RMB Revaluation

China’s central bank repeatedly insisted with strongly phrased announcements that there would be no more government-led revaluation of the renminbi, saying that the currency’s exchange rate was already reflecting market forces. Zhou Xiaochuan, People’s Bank governor, unintentionally fuelled market expectations by describing the revaluation move as “an initial adjustment to the exchange rate level”. The central bank later clarified that the remark did not mean there might be more adjustments to come. “Some foreign people have tried to create misunderstanding by saying this adjustment is an initial move and there will be more to come,” the bank said, adding that such foreigners had come up with such explanation "to suit their own purposes". In fact, the bank said, the renminbi rate was being set “according to objective rules”. “These movements will be created by the floating mechanism and there will be no more official adjustments of the renminbi level,” it said, and that “in trading since revaluation, the renminbi had been reflecting market forces and movements in international currency exchange rates.”  Yet the more China stresses its determination to resist further evaluation, the more such announcements would induce stronger US pressure to push the yuan higher.

China is caught between market pressure and US political pressure in that moves to quell market pressure to push up the yuan will increase political pressure from the US to push up the yuan. China should stay quiet to avoid agitating more US political reaction and let actions deliver the message to the market.  The most effective way to manage the market is to make speculators lose money.

Despite its recent rhetoric, the Chinese central bank itself is widely seen in Beijing as favoring a more substantial revaluation than was announced, and is suspected of accepting the 2.1% move with open reluctance, only under pressure from other government departments.

Yuan credit and interest rates are mostly administered by Chinese government policy which is normal for a national banking regime. In such a regime, state-owned enterprises are not affected by the short-term market cost of loans. That means the People’s Bank of China (PBoC), the central bank, does not have as much leverage over the economy as the US Federal Reserve does. Also, the large foreign-exchange inflows into China affect the flexibility of PBoC to set interest rates to manage the credit needs of the domestic economy.

A stable currency has macroeconomic merits, but a currency kept below market expectations produces inflationary fallouts.  In a central banking regime, it is the central bank’s responsibility to fight inflation with interest rate policies. But China is still in a transition stage between national banking and central banking.

The PBoC is working feverishly on building the finance infrastructure of monetary policy needed for changing China’s previous national banking regime to a new central banking regime. Shifting the yuan’s peg to the dollar to crawling rates pegged to a basket of currencies will help facilitate structural reforms that will enable monetary policy to act as a key tool for managing China’s economy in a central banking regime.  

Whether a shift to a central banking regime in the context of global dollar hegemony is good for an economy that cannot print dollars at will is another question.  A central banking regime for China serves only the interest of foreign capital denominated in dollars.

In market economies operating under central banking, interest rate is the main means by which central bankers manage aggregate demand, fight inflation and reining in unruly financial markets when the economy overheats, and fighting deflation and stimulating economic activities when the economy slows. This approach remains controversial as it can lead to liquidity traps under certain conditions, as in Japan in the last decade, or debt bubbles as in the US in recent years. Yet most neo-liberal monetary economists continue to view interest rate policy as the best tool for managing aggregate demand in market economies.

In the late 1990s, China used fiscal policy to stimulate the stalled economy and to fight deflation. Treasury-bond issuance rose, and in 2001 the central bank encouraged Chinese banks to lend more, leading to huge credit expansion and an investment boom that the government now is trying to slow down. Fiscal stimulant worked in China and not in Japan because the Chinese economy had not yet been saturated with built infrastructure, as was the case in Japan where new unneeded expressways were built that led to points of no economic significance. Fiscal spending in China, even if indiscriminately applied, while suffering from less than optimum effectiveness, still produced positive impacts on the vastly underdeveloped Chinese economy.

Year-on-year annual M2 growth in China hit 21.6% in August 2003, overall bank credit grew at 23.9%, and annual fixed-asset investment was booming at 30% to 40%. By 2004, the government was compelled to curb over-investment and speculation, particularly in the real-estate sector. Over-investment was creating overcapacity, causing a new wave of nonperforming loans for the banks. As monetary policy had repeatedly proved ineffective in directing market trends, raising rates was decidedly not a policy option, as such broad-brush measures would hurt the healthy sectors along with the speculative sectors. Instead, the government administratively managed its fiscal stimulus and imposed planned-economy measures.

In April 2004, a “macro-economic adjustment” program was launched targeting over-investment in key heavy industries, including steel, cement and coal. National Development Reform Commission (NDRC) approval was required for all new investment, with some on-going projects suspended in midstream. Control over land development rights was tightened, and banks were instructed to curb their lending selectively, instead of responding to market demand by lending only to borrowers who were prepared to pay high interests. Instead of raising interest rates which would put all projects in distress, the government chose to selectively turn off the funding source for undesirable projects. By June 2004, M2 growth was back below 16% year on year, domestic credit growth had fallen back, and consumer price inflation was heading downward. The PBoC was allowed to raise bank rates just once, in October 2004, by 27 basis points, perhaps just enough to signal rates could rise. Apart from that, it has played a subsidiary role in macro-policy over the past 18 months.

National Baning vs Central Banking

With that experience, one would think that Chinese policymakers would learn the lesson of the ineffectiveness of central banking with its fixation on keeping banks profitable at the expense of the economy, and revert back to a national banking regime to support industrial policy for effective development of the Chinese economy.  Yet the central banking movement in China, urged on by neo-liberal economists both inside and outside of China, is adopting a “damn the torpedoes, full steam ahead” mentality.

Ongoing structural changes towards a central banking regime are leading China’s economy towards being increasingly more sensitive to interest rates. State-owned enterprises will be forced to manage their operations with an eye on quarterly earnings for repayment of short-term loans, preventing them from making long-range plans for growth. They are subjected to the unpredictable short-term fluctuation of the market cost of funds, while they are still at a stage of undercapitalization which puts them at structural disadvantage in the global arena of market capitalism.

As more state-owned enterprises are privatized and sold off at fire sale prices to foreign competitors, political pressure to keep rates low for the remaining state-owned enterprises wanes, making them more vulnerable to foreign takeovers. More private companies are accessing credit in the open market and be rate sensitive in the business decisions. Chinese banks now lend 11% of their outstanding loans to consumers who are sensitive to rate changes. Recent upstream imported raw materials inflation is pushing interest rates up and slowing economic expansion generally, rather just in overheated sectors.  In a global regime of financial liberalization based on dollar hegemony, it is not wise for a nation such as China, which lacks capital denominated in dollars, to expose its economy to market capitalism, a game in which those with less capital always loses.

As the yuan is not a freely convertible currency, there is no market basis to judge if the yuan is undervalued or overvalued. The trade imbalance, as many economists has pointed out, is a complex phenomenon of which exchange rate is only a last resort compensating factor.  Besides, the US-China trade imbalance is only nominally in favor of China, with China earning a foreign fiat currency that can only be spent in the dollar economy and not the yuan economy.  Even then, Chinese held dollars are not fungible as they can only be spent under political constraints imposed by the issuer of the dollar, as the failed CNOOC/Unocal merger has shown.

And for a currency that is not freely convertible, fixed exchange rate has no basic effect on trade balance except as a positive stabilizing force against price volatility. Usually, undervalued currencies, even if nor freely convertible, cause domestic inflation, thus making export prices higher even if the exchange rate remains unchanged. This is because a cheap currency means more exports than imports, and the resulting current account surplus causes net inflows of money from overseas. These inflows add to the monetary base, allowing banks to lend the added money out to new customers. Prices will rise as a result of more money chasing goods and services which expand at a slower rate than money supply expansion. Domestic inflation translates into higher export prices. But for China, the bulk of the profit from higher export prices goes to pay unlimited returns on foreign capital, not to higher domestic wages.

The Poor Financing the Rich

Even then, there are domestic economic benefits from this inflow of funds if it goes to facilitating domestic economic expansion beyond the export sector. But with dollar hegemony, these economic benefits of China’s trade surplus are blocked from domestic economic expansion, with all the dollars from the Chinese trade surplus going back into US Treasuries to finance the US debt bubble with which to incur more US trade deficits.  It is a classic example of the poor lending their meager wages received from the rich back to the rich to enable the rich to make the next pay day, with the rich demanding that the money they pay the poor should buy less in the neighborhood where the poor live. The US is confusing the spread of freedom with an expanding collection of freebies.

Dollar inflows into China were $206 billion in 2004. This came on an accelerated basis, meaning the rate of inflow increased toward the end of the year. Some $101 billion flowed into China in the first half of 2005, a 50% year-on-year growth rate for first halves. The PBoC uses open market operations, mainly selling PBoC bills, to deal with these inflows. These bills allow the PBoC to take high-power money from the commercial banks in exchange for bills that the banks cannot re-lend to customers, thus stopping the creation of new money by banks issuing loans on partial reserve requirements. Net bill issuance accelerated in late 2004 to cope with dollar inflows of up to $30 billion a month, and remained at high levels. During 2004, the PBoC withdrew a total of 616 billion yuan ($74.5 billion) from the monetary base through bill issuance in the interbank market. This was the equivalent of 36.1% of forex inflows for the year.

In addition, the PBoC issued 196.6 billion yuan ($23.8 billion) in PBoC bills in May 2004 to the four major state-owned banks. In total, the PBoC sterilized 812.6 billion yuan ($98.3 billion) during the year, equivalent to 47.5% of forex inflows during 2004. In the first half of 2005, there was an estimated increase in outstanding PBoC bills of 645 billion to 672 billion yuan, soaking up the equivalent of $78 billion to $81 billion worth of the forex inflows. In other words, the PBoC sterilized 68% to 71% of the inflows.  Still, some 30% of the forex inflows went into the expansion of the yuan money supply.

China Raises Banks Reserve Ratio

Another tactic the PBoC used to control forex reserve inflows was higher required reserve ratios, (RRR) which banks are required to place with the central bank in proportion to their deposits. On September 21, 2003, RRR was raised to 7% from 6%, and to 7.5% on April 25, 2004. These moves had the effect of withdrawing 203 billion yuan ($24.5 billion) and 111.2 billion yuan ($13.4 billion) from the banking system.

The PBoC also issues guidance to banks on which sectors and regions to lend and which to restrict credit, less to cement plants and real estate, and more to agriculture and small- and medium-sized enterprises and less to the coastal regions and more to the interior west.

China’s commercial banks are trying to meet the new capital-adequacy ratios of 8% by January 2007 that bank regulators have imposed. Investments in PBoC paper and most other forms of debt, which carry no capital requirement, are now preferable to loans to corporate borrowers. This is causing banks to draw back lending.  China had to pay a price to defend the yuan’s peg to the dollar. Faced with massive forex inflows, fast-growing bank deposits and limited profitable investment options, commercial banks are eager buyers of PBoC paper. The ample liquidity in China’s money markets drove yields low. The overnight borrowing rate in the market is now hovering around 1.2%, and one-year PBoC bills sold for 2% in late May, down from an average in 2004 of 3.2%.  
For a more in-depth analysis of the exchange rate issue, see: China steady on the peg.

The revaluation move by China is basically a political gesture to appease US pressure on an allegedly over-valued Chinese currency against the dollar. The market was expecting a lot more from China. Key Asian currencies will now float with the RMB yuan. As global trading began after the initial news of the yuan revaluation, the dollar was falling against other major currencies. The dollar dropped to 110.97 yen from 113.06 in New York at the end of the day of the news, while the 12-nation euro jumped to US$1.2196 from US$1.2108. Minutes after China announced its decision on the evening news, Malaysia said it was also un-pegging its currency, the ringgit, from the dollar, replacing it with a managed float in a move similar to that of China. That left Hong Kong as the only major economy in Asia that pegs its currency to the U.S. dollar. As long as the yuan is still not freely convertible, Hong Kong can keep its currency peg to the dollar, albeit at a high cost.  Eventually, as the yuan fluctuates against the dollar, the HK peg to the dollar will create transactional inefficiencies and instabilities and possibly new manipulative attacks from hedge funds. In South Korea, the news was received in stride, and government officials said they didn't expect it to have a big impact on the nation's economy, the third largest in Asia following Japan and China. Philippine central bank Governor Amando Tetangco said the move was expected to strengthen all regional currencies, including the Philippine peso.

The yuan will now be allowed to trade in a tight 0.3 percent band against an undisclosed basket of foreign currencies. Under the new system, the yuan immediately jumps to 8.11 to the dollar. But once off this starting block, it could, in theory anyway, rise (or fall) as much as 0.03 percent a day, since each day’s closing price against a basket of currencies becomes the center of the next day's trading band. Each step is tiny, but over time they add up.  Yet gradualism is a key to stability.

China Revalue RMB to Appease US Pressure

The yuan revaluation move is a response to the Schumer-Graham China Currency Bill (S. 295), calling for 27.5% tariffs on all Chinese products sold in the US if China does not revalue its currency by 27.5% within 180 days of the passage of the bill, which had been slated to pass before the end of the summer. A deal was worked out months ago to postpone a vote in exchange for a Senate hearing to be followed by a token gesture by China, so everyone could claim they won something without any real changes.  The desire to ease tension in preparation for President Hu Jintao’s planned visit to the Washington in September 2005 and the pending US Treasury ruling, also due in the Fall, on whether China is a “currency manipulator” also played a role in the timing of the move. The 2.1% upward revaluation of the yuan against the dollar was immediately neutralized by readjustments by other Asian currencies.<>

Managed Float

China has now officially adopted the Singapore manage float model rather than the HK currency-board model. This is a significant move. It shows that the HK tycoons are losing their myopic influence on Chinese economic/monetary policy.  The smug Hong Kong Monetary Authority has been emanating false pride of superior monetary wisdom by stubbornly hanging on to its currency board arrangement pegged to a volatile dollar mistaken as a stable currency. The blind error left by the parting British colonial rulers launched Hong Kong into a bubble economy when the dollar was undervalued throughout much of the 1990s that burst with unprecedented disaster in 1997 as part of the Asian financial crisis a day after the British left Hong Kong.  The same currency board regime kept the Hong Kong economy from recovering for more than seven years after 1997 when Hong Kong was returned to China, until the dollar began to fall in 2004.  During that painful period, , the Hong Kong equity market was exposed to manipulative attacks by hedge funds in 1998 that required massive government incursion in the market to foil.

By contrast, Singapore has used what is known as the “basket, band and crawl”, or BBC, system since the early 1980s. The Singapore dollar is managed against an undisclosed basket of currencies of its main trading partners and competitors. It allowed Singapore to devalue its currency immediately after the Asian financial crisis to moderate unnecessary pain on its economy.  John Williamson, the neo-liberal economist who coined the term Washington Consensus, is credited with developing the BBC model in the 1970s. The Monetary Authority of Singapore asserts that the BBC policy has given it flexibility in responding to changes in local, regional and global conditions to maintain export competitiveness and control inflation. The composition of the currency basket is revised periodically to take into account changes in trade patterns. The secret policy band is also regularly reviewed to ensure it remains consistent with economic changes, with adjustments every six months if needed.  Singapore, whose currency was first pegged to the US dollar and then floated in the 1970s, chose the BBC regime because of a close link between exchange rates and interest rates in a small and open economy. Whether the BBC system will work for a gigantic, relative closed economy like China remains an open question.

The city-state of Singapore has since guided monetary policy through exchange rates instead of directly adjusting interest rates. This in theory has the advantage of insulating borrowers from interest rate risks. But for an international finance center, exchange rate risks are equally problematic.  In recent years, derivatives have been the instruments of choice in hedging both interest rate and foreign exchange rates.  Inflation has been relatively low at 2% a year since the early 1980s. Under the BBC managed float, the Singapore dollar has appreciated by about 20% against the US dollar as the dollar fell against other key currencies, although its strong currency policy has eased since the Asian financial crisis in 1997. In contrast, the currency has fallen 40% against the levitating Japanese yen.

Both China’s and Malaysia’s managed float exchange rate systems appear broadly similar to that of Singapore, although details remain sketchy on their operations. But there are several obvious differences. The most significant is that the yuan is not freely convertible. The currency trading bands in China and Malaysia are narrower than in Singapore, which means smaller currency movements. China’s trading band is also adjusted on a daily basis.  The fundamental difference for China lies in the option of administrative measures to manage both interest rates and exchange rates, with consistency between the two less critical because the yuan remains not freely convertible.

The International Monetary Fund has listed about 40 countries that use some type of managed float system. But Singapore officials say their system is in some ways unique since it is used also to control monetary policy, while policy statements provide a clear indication to the markets of where the currency is headed. Some neo-liberal economists have argued that a BBC regime could provide the basis for the eventual adoption of a common Asian currency. Others suggest the system is not widely applicable in spite of Singapore’s success.  Supporters of floating exchange rates argue that Singapore has strengths, such as a well regulated banking and financial system and large fiscal reserves that many other countries do not have to support a BBC system. A managed float system for a freely convertible currency largely rests on gaining the confidence of the markets. Only if other macroeconomic policies are consistent with a managed float will it be a success.  Many economists and market participants believe China faces a potential challenge in introducing a managed float since a small revaluation would continue to attract speculative foreign capital in anticipation of further currency appreciation. As a result, China may have to widen its currency trading band eventually to gain market acceptance.  This problem will be magnified if  and when the yuan becomes freely convertible, which is not likely to happen until China’s banking system is brought up to BIS standards, in which case, the problem shifts from exchange rates to interest rates.

A Strong Yuan Not Good for US Economy 

The US has been saying that the Chinese yuan is between 20-40% undervalued against the dollar and this undervaluation is a key factor in recurring US-China trade imbalance. Reality shows a very different picture.

Let us examine the economic impacts on the US economy of a yuan suddenly trading at 20% higher against the dollar. The first impact will be that prices of US imports from China will rise some 20%, significantly pushing up US inflation rate and dollar interest rates. High dollar interest rates will lift the exchange value of the dollar, pushing to problem back to square one. Since the bulk of US consumer goods are imported from China, a sudden and drastic rise in import prices of 20% will dampen US consumption of Chinese imports at a time when consumer spending is holding up the US economy.

There is a possibility that US consumer spending will hold in dollar terms, but the actually amount of goods sold will be reduced, lowering US living standards while not reducing the US trade deficit. The dollar value of US-China trade may remain the same, with more Chinese goods available for export to other countries or staying in the Chinese domestic market, raising Chinese living standards, and shrinking the relative size of the US economy.  And if the US Federal Reserve further accommodates consumer credit to absorb the rise in import prices to prevent a real reduction in consumer product sales, the US trade deficit may actual increase while US standard of living remains unchanged. Even if US trade deficit with China should moderate, it would only lead to a corresponding reduction in US capital account surplus with China.  With a slower growth of Chinese holdings of dollars, China will buy less US sovereign debt, pushing US interest rates higher, possibly bursting the already precarious US debt bubble.

With a yuan pegged to a basket of currencies of which the dollar is only one among several, China will have less of a need to hold dollars.  With a drop in Chinese export to the US, China may see its ability to buy US sovereign debt reduced. And with the uncertainty of the exchange values of the dollar against the other volatile currencies in the Chinese basket, the market price of the yuan may at times fall as well as rise against the dollar.  If market forces should act against the yuan and push the dollar higher against the yuan, US political pressure on letting the market determine the value of the yuan would have proved to be counterproductive toward its goal of a stronger yuan against the dollar.  And the adverse consequences the misguided cure can be significantly worse than the current malady. For one thing, with a stronger dollar, US assets not directly related to import prices, such as real estate, will suffer a price collapse, adding a last straw effect to the already precarious housing bubble.  A strong yuan may not be a blessing for the US economy.

On the Chinese side, a stronger yuan will have to be compensated with lower Chinese wages, or a slowdown of rising wages, in order that Chinese exports remain price competitive and profitable. Lower Chinese wages will slow the development of a vibrant Chinese domestic market for US exports to China.  The better option would be to let the peg stand, and push China to raise wages.

In a global market dominated by dollar hegemony, it is idiotic to expect that the complex problems of the US economy can be solved by the exchange value of one single foreign currency.  Dollar hegemony by definition eliminates the impact of the exchange value of the dollar on the dollar economy.

Hostile, ill-considered US political pressure on China’s economic/monetary policies has opened a can of currency worms with highly unpredictable and possibly negative consequences for the US and the whole world.  Just as the 1985 Plaza Accord on the Japanese yen destroyed the Japanese export economy and brought stagflation to the US that led to the 1987 crash, forcing the yuan off its decade-old dollar peg now may well be the spark that will ignite a raging forest fire in the US debt-infested economy in the coming years.

The Danger of Trade Wars

US geopolitical hostility toward China will manifest itself first in trade friction, which will lead to a mutually recriminatory trade war between the two major economies that will attract opportunistic trade realignments among the traditional allies of the US.  US multinational corporations, unable to steer US domestic politics, will increasingly trade with China through their foreign subsidiaries, leaving the US economy with even less jobs, and a condition that will further exacerbate anti-China popular sentiments that translate into more anti-free-trade policies generally and anti-China policies specifically.

The resultant global economic depression from a trade war between the world’s two largest economies will in turn heighten further mutual recriminations. An external curb from the US of  Chinese export trade will accelerate a redirection of Chinese growth momentum inwards, increasing Chinese power, including military power, while further encouraging anti-US sentiment in Chinese policy circles.  This in turn will validate US apprehension of a China threat, increasing the prospect for inevitable armed conflict.

Problem of Overcapacity

A war between the US and China can have no winners, particularly on the political front. Even if the US were to prevail militarily through its technological superiority, the political cost of military victory will be so severe that the US as it currently exists will not be recognizable after the conflict and the original geopolitical aim behind the conflict would remain elusive, as the Vietnam War and the Iraq War have demonstrated.  By comparison, the Vietnam and Iraq conflicts, destructive as they have been on US social fabric, are mere minor scrimmages compared to a war with China.

US policymakers have an option to make China a friend and partner in a peaceful world for the benefit of all nations. To do so, they must first recognize that the world can operate on the principle of plentitude and that prosperity is not something to be fought over by killing consumers in a world plagued with overcapacity. 

Virtual Synthetic Empires

Even today, the formation of regional integration frameworks is at constantly risk of dominant states exploiting the creation of ideologically preferred regional frameworks in which preeminent powers can exercise exclusive imperialistic influence over other weaker member states in a virtual form of synthetic empire building.

In this context, including and excluding of certain target countries in regional integration schemes are essentially stealth empire building measures by dominant powers, as can be observed in the distinct feature of the US engineered Trans-Pacific Partnership (TPP) in its pointed exclusion of the People’s Republic of China (PRC).

Exclusion of a particular country does not mean that the excluded country will perpetually remain outside the framework. In fact, TPP holds the door ajar for positive engagement with China, shifting from the current balancing strategy to purposeful engagement, holding better behavior as admission requirement.

The beginning step of such imperialistic policy is the establishment of a neoliberal regional framework from which a target country is conditionally engaged and proactively encouraged to reform in the direction preferred by the hegemonic power. Regional integration can be a trap for creeping ideological empire building by dominant member states.

Trade War Fought With Dollar Hegemony 

Through international trade denominated in dollars, the US has been waging an imperialistic trade war on its trading partners, using dollar hegemony as weapon. The productivity boom in the US in the past three decades was as much a mirage as the money that drove the apparent boom. There was no productivity boom in the US in the final two decades of the 20th century; only an import boom. What's more, this boom was driven not by the spectacular growth in productive activities in the American economy; it was driven by debt borrowed from the low-wage countries producing wealth for export to US markets, paid for with unlimited supply of fiat dollars that the US can print at will with no adverse consequence because these fiat dollars has no place to go except return to the US to buy US sovereign debt instruments, i.e. Treasury bonds. Thus the US current account deficit caused by imports is extinguished by capital account surplus bulging with returned trade deficit dollars.

Empire in the Age of Free Trade

This economic boom made possible US currency hegemony, fueled by payments of tribute from vassal states kept perpetually at the level of subsistence poverty by their own addiction to exports for paper money. It is the economics of empire in the Age of Free Trade.  

For the exporting nations, globalized “Free Trade” has installed export as the only path to national development in a trade regime of market fundamentalism, which is the belief that the only route to prosperity is through free trading markets, and the optimum societal interest can only be served through free market equilibrium reached through interactions of countless individual decisions made independently by self-centered market participants, each freely seeking to maximize his/her/its own private gain. Such market equilibrium, if distorted by regulatory regimes in the name of the common good of society, will in fact be harmful to economy, causing it to fail in its function of allocation resources efficiently. This fanatic view is summed up by Margaret Thatcher's infamous declaration that there is no such thing as society in a market economy.

Exclusion of a particular country does not mean that the excluded country will perpetually remain outside the framework. In fact, TPP holds the door ajar for positive engagement with China, shifting from the current balancing strategy to purposeful engagement, holding better behavior as admission requirement.

The beginning step of such imperialistic policy is the establishment of a neoliberal regional framework from which a target country is conditionally engaged and proactively encouraged to reform in the direction preferred by the hegemonic power. Regional integration can be a trap for creeping ideological empire building by dominant member states.

Import Boom mistaken as Productivity Boom

Through international trade denominated in dollars, the US has been waging an imperialistic trade war on its trading partners, using dollar hegemony as weapon. The productivity boom in the US in the past three decades was as much a mirage as the money that drove the apparent boom.

There was no productivity boom in the US in the final two decades of the 20th century; only an import boom. What's more, this boom was driven not by the spectacular growth in productive activities in the American economy; it was driven by debt borrowed from the low-wage countries producing wealth for export to US markets, paid for with unlimited supply of fiat dollars that the US can print at will with no adverse consequence because these fiat dollars has no place to go except return to the US to buy US sovereign debt instruments, i.e. Treasury bonds. Thus the US current account deficit caused by imports is extinguished by capital account surplus bulging with returned trade deficit dollars.

This economic boom made possible US currency hegemony, fueled by payments of tribute from vassal states kept perpetually at the level of subsistence poverty by their own addiction to exports for paper money. It is the economics of empire in the Age of Free Trade.  

For the exporting nations, globalized “Free Trade” has installed export as the only path to national development in a trade regime of market fundamentalism, which is the belief that the only route to prosperity is through free trading markets, and the optimum societal interest can only be served through free market equilibrium reached through interactions of countless individual decisions made independently by self-centered market participants, each freely seeking to maximize his/her/its own private gain. Such market equilibrium, if distorted by regulatory regimes in the name of the common good of society, will in fact be harmful to economy, causing it to fail in its function of allocation resources efficiently. This fanatic view is summed up by Margaret Thatcher's infamous declaration that there is no such thing as society in a market economy. 

National Sovereignty in the Pease of Westphalia

The fact is that in a Westphalian World Order of sovereign states that has been functioning since its creation in 1648, all sovereign nations have managed to retain their sovereign prerogative of command on their own economies until economic globalization through international trade driven by the integration of markets that all nations must develop trading economies to remain prosperous and strong. The United States, the Mecca of market fundamentalism, commands its alleged free market economy in the name of national security.

As a process, regional integration aims to reduce barriers of international trade within a region, such as removal or reduction of tariffs and adoption of a common currency for trade. The process also orchestrates multilateral governmental support from all sovereign states in a region for joint tackling of common regional problems that transcend national borders, such as protection of the environment, maintenance of public health, safeguard of cross-border water purity and supply, setting standards for food safety, policing of transnational crime, particularly illegal cross-border traffic of narcotic drugs, undocumented immigration, financial fraud and illicit money laundering.

Free Trade as Diplomatic Weapon

While the US tirelessly advocates free trade, denial of trade to another country is a declared instrument of war in US foreign policy. President George W Bush declares that "open trade is a moral imperative" to spread democracy around the world. Administratively, the White House Council of Economic Advisers is organizationally subservient to the National Security Council. National-security concerns dictate trade policies the US adopts for its economic relations with different foreign countries. The exchange rate policy of the dollar is set by the US Treasury, not the Federal Reserve, the central bank, and certainly not set by the market beyond a safe range.

Phyllis Schlafly, syndicated conservative columnist, responded to the President three weeks later in an WSJ op-ed article: Free Trade is an Economic Issue, Not a Moral One.  In it, she notes while conservatives should be happy to finally have a president who adds a moral dimension to his actions, “the Bible does not instruct us on free trade and it’s not one of the Ten Commandments. Jesus did not tell us to follow Him along the road to free trade. … Nor is there anything in the U.S. Constitution that requires us to support free trade and to abhor protectionism. In fact, protectionism was the economic system believed in and practiced by the framers of our Constitution. Protective tariffs were the principal source of revenue for our federal government from its beginning in 1789 until the passage of the 16th Amendment, which created the federal income tax, in 1913. Were all those public officials during those hundred-plus years remiss in not adhering to a “moral obligation” of free trade?”  Hardly, argues Schlafly whose views are noteworthy because US politics is currently enmeshed in a struggle between strict-constructionist paleo-conservatives and moral-imperialist neo-conservatives.  Despite the ascendance of neo-imperialism in US foreign policy, protectionism remains strong in US political culture, particularly among conservatives and in the labor movement.

World trade today is free only to the extent of being free to support US unilateralism. For the US imperia, the line between foreign policy and domestic policy is merged to make room for new global policy. The sole superpower views the world as its oyster, and global trade is to replace foreign trade in a global economy the rules for which are set by a World Trade Organization dominated in the hegemonic dollar as reserve currency freely printed at will by the sole superpower. 

FreeTrade under Market Fundamentalism

Market fundamentalism as the term is generally used in macroeconomics as a key component of neoliberal globalization of trade, in the same sense that the British, through Adam Smith, promoted British opinion of "free trade" as universal truth in the 18th -19th  centuries.

The difference between Smithian free trade doctrine and 21st century neoliberal market fundamentalism is that British free trade was limited to the sphere of political influence within the British Empire, whereas neoliberal market fundamentalism aims to be universally global in a new form of economic empire building.

Market fundamentalism helps no economy. It helps only gangs of select elites in economies that subscribe to it.  Since the segment most favored by market economy is in control of the US polity, market fundamentalism is officially billed as being the appropriate doctrine for the US and the world order it dominates.

Washington Consensus

Washington Consensus is a “conditionality” for inclusion into global market fundamentalism through supranational intervention on national sovereignty prerogative over monetary and fiscal policies.  It is another tool for building a new form of empire.

Washington Consensus is a term coined in 1990 by John Williamson of the Institute for International Economics to summarize the synchronized ideology of Washington-based establishment neoliberal economists, reverberated around the world for a quarter of a century as the true gospel of reform indispensable for achieving growth in a globalized market economy. Economic neoliberalism has turned most trade-dependent nations into failed states. (Please see my AToL article: World Order, Failed States and Terrorism - PART 1: The failed-state cancer)

Initially applied to Latin America and eventually to all developing economies, the term neoliberal has come to be synonymous with globalized universal policy prescriptions based on capitalistic free-market principles and a hegemonic monetarist regime within narrow ideological limits. It promotes macroeconomic control, trade openness, pro-market microeconomic measures, privatization and deregulation in support of a dogmatic ideological faith in the market's ability to solve all socio-economic problems more efficiently, and to assert a blanket denial of an obvious contradiction between market efficiency and poverty eradication.

Under monetarism, financial capital growth is to be achieved at the expense of human capital growth. Sound money, undiluted by inflation, imposed on all by US monetarists who ironically are the most flagrant violators of the sound money principle, is to be maintained by keeping wages low through structural unemployment and cross-border wage arbitrage. Pockets of poverty in the periphery are the necessary price for prosperous centers in the global economy. All economic activities are to be governed by profit incentive. Such dogmas grant unemployment and poverty, conditions of economic failure, undeserved conceptual respectability. Structural unemployment then becomes the vaccine against inflation that would lead to massive unemployment. Pockets of poverty become the venue to contain the systemic spread of poverty in the whole economy. State intervention has come to focus mainly on reducing the market power of labor in favor of market power of capital in a blatantly predatory market mechanism.

The set of policy reforms prescribed by the Washington Consensus is composed of 10 propositions:

1) fiscal discipline;

2) redirection of public-expenditure priorities toward fields offering high financial returns;

3) tax reform to lower marginal rates and broaden the tax base;

4) interest-rate liberalization;

5) competitive exchange rates;

6) trade liberalization;

7) liberalization of foreign direct investment (FDI) inflows;

8) privatization;

9) deregulation and

10) secure private-property rights.

These propositions landed the world economy in recurring economic and financial crises every decade, each crisis bigger than the previous one, until the current crisis that began in mid 2007 which is now being described as the crisis of a century. 

Creation of WTO

The creation of the World Trade Organization (WTO) on January 1, 1995 was a crucial reform landmark in international trade since the end of Second World War. It also reversed the failed attempt in 1948 to create an International Trade Organization (ITO).

In December 1945, representatives of 15 sovereign nations held talks to reduce and set customs tariffs in the post-war era. With the Second World War only recently ended, these sovereign nations wanted to give a timely boost to liberalization of international trade, and to erase the lingering legacy of counter-productive protectionist measures of the early 1930 which remained in place at the end of the war.


This first round of negotiations resulted in a package of trade rules and 45,000 tariff concessions affecting $10 billion of trade, about one fifth of the world’s total at the time. The group had expanded to 23 sovereign states by the time the deal was signed on October 30, 1947. The tariff concessions came into effect by June 30, 1948 through a “Protocol of Provisional Application”, creating the new General Agreement on Tariffs and Trade (GATT), with the 23 founding members, officially known as “contracting parties”.

The 23, part of the larger group negotiating the ITO Charter, accepted some of the trade rules of the draft Protocol of Provisional Application in order to safeguard the result of the tariff concessions they had negotiated. They spelled out how they envisaged the relationship between the new GATT and the ITO Charter, but they also allowed for the possibility that the ITO might not be created, which turned out to be the case.

The Havana conference began on November 21, 1947, less than a month after GATT came into existence. The ITO Charter was finally agreed to in Havana in March 1948, but ratification in many of the 23 national legislatures proved impossible. The fatal blow came from most serious opposition in the US Congress, even though the Truman Administration had been one of the driving forces behind the effort to form ITO.

In 1950, the US government announced that it would not continue to seek Congressional ratification of the Havana Charter, rendering the ITO was effectively dead. GATT then was left to be the only multilateral; instrument governing international trade from 1948 until the WTO was established in 1995.

The WTO governs global rules of trade between nations. Its main function is supposed to ensure that trade flows as smoothly, predictably and freely as possible. In fact, the effect of WTO rules can be manipulated by the dominant member to misuse as empire building algorithms.

Negotiation sessions were held in Geneva in 1947, Havana (Cuba 1948), Annecy (France 1949), Torquay (UK 1951), Geneva (1956),  the Dillion Round (1960-61), the Kennedy round (1964-67), Tokyo (Japan 1973-79), Punta del Este (Uruguay 1986-94), Montreal (Canada), Brussels (Belgium) and finally to Marrakesh (Morocco) in 1994.

During that period of 47 years, the world trading system operated under GATT, salvaged from the aborted attempt to create the ITO.

GATT facilitated the establishment of  a strong and prosperous multilateral trading system that became increasingly liberal through several rounds of trade negotiations.

From 1948 to 1994, the General Agreement on Tariffs and Trade (GATT), a provisional agreement and organization, provided rules for world trade and presided over periods of high growth rates in international commerce.

The original intention was to create a third institution to handle the trade side of international economic cooperation, joining the two “Bretton Woods” created institutions: the World Bank and the International Monetary Fund.


The mandate of the IMF is to promote international monetary cooperation and provides policy advice and technical assistance to help countries build and maintain strong economies through a sound monetary regime. It also makes loans and helps countries design policy programs to solve balance of payments problems when sufficient financing on affordable terms cannot be obtained in credit markets to meet net international payments. IMF loans are short and medium term and funded mainly by the pool of quota contributions that its members provide. IMF staff are primarily economists with wide experience in macroeconomic and financial policies.

World Bank

The mandate of the World Bank is to promote long-term economic development and poverty reduction by providing technical and financial support to help countries reform particular sectors or implement specific projects, such as building schools and health clinics, providing clean water and electricity, fighting disease, and protecting the environment. World Bank assistance is generally long term and is funded both by member country contributions and through development bond issuance in the credit market. World Bank staff are generally specialists in particular issues, sectors, or techniques in development. The staffs of the two institutions also cooperate on the conditionality involved in their respective lending programs.

The IMF and World Bank also work together to reduce the external debt burdens of the most heavily indebted poor countries under the Heavily Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI). The objective is to help low-income countries achieve their development goals without creating future debt problems. IMF and Bank staff jointly prepare country debt sustainability analyses under the Debt Sustainability Framework (DSF) developed by the two institutions.

In 1999, the IMF and the World Bank launched the Poverty Reduction Strategy Paper (PRSP) approach as a key component in the process leading to debt relief under the HIPC Initiative and an important anchor in concessional lending by the Fund and the Bank.

While PRSPs continue to underpin the HIPC Initiative, the World Bank adopted in July 2014 a new approach to country engagement that no longer requires PRSPs while focusing on the elimination of extreme poverty and promotion of shared prosperity. The Fund continues to rely on the PRSP to provide the link between a Fund-supported program and the poverty reduction and growth objectives of a member country.

Monitoring progress on the MDGs 

Since 2004, the Fund and the Bank have worked together on the Global Monitoring Report (GMR), which assesses progress towards the 2015 UN Millennium Development Goals (MDGs).

According to the final MDG report launched on July 6, 2015 by United Nations Secretary-General Ban Ki-moon, the MDGs have produced the most successful anti-poverty movement in history and will serve as the jumping-off point for the new sustainable development agenda to be adopted this year. The Millennium Development Goals Report 2015 found that the 15-year effort to achieve the eight aspirational goals set out in the Millennium Declaration in 2000 was largely successful across the globe, while acknowledging shortfalls that remain. The data and analysis presented in the report show that with targeted interventions, sound strategies, adequate resources and political will, even the poorest can make progress.

“Following profound and consistent gains, we now know that extreme poverty can be eradicated within one more generation”, said Ban Ki-moon. “The MDGs have greatly contributed to this progress and have taught us how governments, business and civil society can work together to achieve transformational breakthroughs”.

Goals and targets work

The MDG report confirms that goal-setting can lift millions of people out of poverty, empower women and girls, improve health and well-being, and provide vast new opportunities for better lives. Only two short decades ago, nearly half of the developing world lived in extreme poverty. The number of people now living in extreme poverty has declined by more than half, falling from 1.9 billion in 1990 to 836 million in 2015. The world has also witnessed dramatic improvement in gender equality in schooling since the MDGs, and gender parity in primary school has been achieved in the majority of countries. More girls are now in school, and women have gained ground in parliamentary representation over the past 20 years in nearly 90 per cent of the 174 countries with data. The average proportion of women in parliament has nearly doubled during the same period. The rate of children dying before their fifth birthday has declined by more than half, dropping from 90 to 43 deaths per 1,000 live births since 1990. The maternal mortality ratio shows a decline of 45 per cent worldwide, with most of the reduction occurring since 2000.

Targeted investments in fighting diseases, such as HIV/AIDS and malaria, have brought unprecedented results. Over 6.2 million malaria deaths were averted between 2000 and 2015, while tuberculosis prevention, diagnosis and treatment interventions saved an estimated 37 million lives between 2000 and 2013. Worldwide, 2.1 billion have gained access to improved sanitation and the proportion of people practicing open defecation has fallen almost by half since 1990.

Official development assistance from developed countries saw an increase of 66 per cent in real terms from 2000 and 2014, reaching $135.2 billion.

Inequalities persist The report highlighted that significant gains have been made for many of the MDG targets worldwide, but progress has been uneven across regions and countries, leaving significant gaps. Conflicts remain the biggest threat to human development, with fragile and conflict-affected countries typically experiencing the highest poverty rates.

New Sustainable Development Goals (SDGs) will replace the MDGs in 2015 as the basis for the post-2015 development agenda. The Fund and the Bank will support the implementation of the new SDGs and contribute to monitoring progress toward their achievement.

The IMF and the World Bank are also working together to make financial sectors in member sovereign states resilient and well regulated. The Financial Sector Assessment Program (FSAP) was introduced in 1999 to identify the strengths and vulnerabilities of a country's financial system and recommend appropriate policy responses.

Free market reform policies promoted by the World Bank are often harmful to economic development, particularly if implemented badly, by "shock therapy"), in the wrong sequence or in weak, uncompetitive economies.

Failed ITO

Over 50 countries participated in the failed negotiations to create an International Trade Organization (ITO) as a specialized agency of the United Nations. The draft ITO Charter was ambitious. It extended beyond world trade disciplines, to include rules on employment, commodity agreements, restrictive business practices, international investment, and services. The aim was to create the ITO at a UN Conference on Trade and Employment in Havana, Cuba in 1947.

But by the 1980s the GATT system needed a thorough overhaul. This led to the Uruguay Round (1986-94), and ultimately to the WTO.

The Final Act of the Uruguay Round was signed by participants in Marrakesh, Morocco, on April 15, 1994, marking the formal end of the most far-reaching liberalization in world trade history. It lasted 2,643 days, cutting tariffs, opening markets and bringing new areas of cross-border economic activity under international rules for the first time.

For almost half a century, the GATT’s basic legal principles remained much as they were in 1948. There were additions in the form of a section on development added in the 1960s and “plurilateral” agreements (i.e. with voluntary membership) in the 1970s, and efforts to reduce tariffs further continued. Much of this was achieved through a series of multilateral negotiations known as “trade rounds” — the biggest leaps forward in international trade liberalization have come through these rounds which were held under GATT  auspices.

In the early years, the GATT trade rounds concentrated on further reducing tariffs. Then, the Kennedy Round in the mid-sixties brought about a GATT Anti-Dumping Agreement and a section on development. The Tokyo Round during the seventies was the first major attempt to tackle trade barriers that do not take the form of tariffs, and to improve the system. The eighth, the Uruguay Round of 1986-94, was the last and most extensive of all. It led to the WTO and a new set of agreements.

The Tokyo Round: a first try to reform the system

The Tokyo Round lasted from 1973 to 1979, with 102 countries participating. It continued GATT’s efforts to progressively reduce tariffs. The results included an average one-third cut in customs duties in the world’s nine major industrial markets, bringing the average tariff on industrial products down to 4.7%. The tariff reductions, phased in over a period of eight years, involved an element of “harmonization” — the higher the tariff, the larger the cut, proportionally.

In other issues, the Tokyo Round had mixed results. It failed to come to grips with the fundamental problems affecting agriculture trade and also stopped short of providing a modified agreement on “safeguards” (emergency import measures). Nevertheless, a series of agreements on non-tariff barriers did emerge from the negotiations, in some cases interpreting existing GATT rules, in others breaking entirely new ground. In most cases, only a relatively small number of (mainly industrialized) GATT members subscribed to these agreements and arrangements. Because they were not accepted by the full GATT membership, they were often informally called “codes”.

Codes were not multilateral, but they were a beginning. Several codes were eventually amended in the Uruguay Round and turned into multilateral commitments accepted by all WTO member states. Only four remained “plurilateral” — those on government procurement, bovine meat, civil aircraft and dairy products. In 1997, WTO members agreed to terminate the bovine meat and dairy agreements, leaving only two.

GATT was provisional with a limited field of action, but its success over 47 years in promoting and securing the liberalization of much of world trade is incontestable. Continual reductions in tariffs alone helped spur very high rates of world trade growth during the 1950s and 1960s — around 8% a year on average. And the momentum of trade liberalization helped ensure that trade growth consistently out-paced production growth throughout the GATT era, a measure of countries’ increasing ability to trade with each other and to reap the benefits of trade. The rush of new members during the Uruguay Round demonstrated that the multilateral trading system was recognized as an anchor for development and an instrument of economic and trade reform.

But all was not well. As time passed new problems arose. The Tokyo Round in the 1970s was an attempt to tackle some of these new problems, but achievements were limited. This was a sign of difficult times to come in the global trade system.

GATT’s success in reducing tariffs to a low level, combined with a series of economic recessions in the 1970s and early 1980s, drove governments to devise other forms of protection for domestic sectors facing increasingly inasive foreign competition. High rates of unemployment and constant factory closures led governments in Western Europe and North America to seek bilateral market-sharing arrangements with competitors and to embark on a subsidies race to maintain their holds on agricultural trade. Both these changes undermined GATT’s credibility and effectiveness and in the case of strong nations, they were stealth empire-building measures..

The problem was not just a deteriorating trade policy environment. By the early 1980s the General Agreement was clearly no longer as relevant to the realities of world trade as it had been in the 1940s. For a start, world trade had become far more complex and important than four decades before. The globalization of the world economy was underway, trade in services, not covered by GATT rules, was of major concern to increasing more countries, and international investment had expanded. The expansion of services trade was also closely tied to further increases in world merchandise trade.

GATT was ill equipped to handle trade in agriculture Loopholes in the multilateral system were heavily exploited, and efforts at liberalizing agricultural trade were unsuccessful. In the textiles and clothing sector, an exception to GATT’s normal disciplines was negotiated in the 1960s and early 1970s, leading to the Multifibre Arrangement. Even GATT’s institutional structure and its dispute settlement system were causing concern.

An example of transnational convention in regional development is the Agreement on the Application of Sanitary and Phyto-sanitary Measures (SPS Agreement). The SPS Agreement is an international treaties of the World Trade Organization (WTO) regarding the application of standard food safety and regulation on  animal and plant health regulation. It was negotiated during the Uruguay Round of GATT, and entered into force with the establishment of the WTO on January 1, 1995.

GATT originated with a meeting of 22 nations meeting in 1947 in Geneva, Switzerland. By 2000, there were 142 member nations, with another 30 countries seeking admission. The detailed commitments by each country to limit tariffs on particular items by the amount negotiated and specified in its tariff schedule is the central core of the GATT system of international obligation.

The obligations relating to the tariff schedules are contained in Article II of GATT. For each commodity listed on the schedule of a country, that country agrees to charge a tariff that will not exceed an amount specified in the schedule. It can, if it wishes, charge a lower tariff.

The WTO heavily influences the workings of the GATT treaties through the efforts of various committees. Representatives of member countries of the WTO comprise the Council for the Trade in Goods (Goods Council), which oversees the work of 11 committees responsible for overseeing the various sectors of GATT. The committees focus on such issues as agriculture, sanitary measures, subsidies, customs valuation, and rules of origin.

SPS measures aim at the protection of human, animal and plant life and health from preventable risks. The WTO sets constraints on policies of member-states relating to food safety (bacterial contaminants, pesticides, inspection and labeling of products ) as well as animal and plant health (phyto-sanitation) with respect to of pests and contagious diseases.

Three organizations set standards that WTO members states are obliged to adopt for SPS methodologies. As provided for in Article 3, the three are:

the Codex Alimentarius Commission (Codex),

World Organization for Animal Health (OIE) and

Secretariat of the International Plant Protection Convention (IPPC). SPS standards target ‘scientifically unfounded’ barriers to trade disguised as health and safety regulations.

The Agreement on Technical Barriers to Trade (TBT), signed in the same year as the SPS, with similar goals. The TBT emerged from the Tokyo Round and was negotiated with the aim of ensuring non-discrimination in the adoption and implementation of technical regulations and standards.

The TBT exists to ensure that technical regulations, standards, testing, and certification procedures do not create unnecessary obstacles to trade. The agreement prohibits technical requirements created in order to limit trade, as opposed to technical requirements created for legitimate purposes such as consumer or environmental protection. 

In fact, its purpose is to avoid unnecessary obstacles to international trade and to give recognition to all WTO members to protect legitimate interests according to own regulatory autonomy, although promoting the use of international standards. The list of legitimate interests that can justify a restriction in trade is not exhaustive and it includes protection of environment, human and animal health and safety.

The General Agreement on Trade in Services (GATS) is a treaty of the  WTO that entered into force in January 1995 as a result of the Uruguay Round negotiations. The treaty was created to extend the multilateral trading system to service sector, in the same way GATT provides such a system for merchandise trade. All members of the WTO are signatories to the GATS. The basic WTO principle of most favoured nation (MFN) applies to GATS as well. However, upon accession, Members may introduce temporary exemptions to this rule.

While the overall goal of GATS is to remove barriers to trade, members are free to choose which sectors are to be progressively "liberalised", i.e. marketised and privatised, which mode of supply would apply to a particular sector, and to what extent liberalisation will occur over a given period of time. Members' commitments are governed by a "ratchet effect", meaning that commitments are one-way and are not to be wound back once entered into. The reason for this rule is to create a stable trading climate. However, Article XXI does allow Members to withdraw commitments, and so far two members have exercised this option (USA and EU). In November 2008, Bolivia gave a notification that it will withdraw its health services commitments.

Some activist groups consider that GATS risks undermining the ability and authority of governments to regulate commercial activities within their own boundaries, with the effect of ceding power to business interests ahead of the interests of citizens. In 2003 the GATSwatch network published a critical statement which was supported by over 500 organisations in 60 countries.[1] At the same time, countries are not under any obligation to enter international agreements such as GATS. For countries that like to attract trade and investment, GATS adds a measure of transparency and legal predictability. Legal obstacles to services trade can have legitimate policy reasons, but can also be an effective tool for large scale corruption

The GATS agreement has been criticized for tending to substitute the authority of national legislation and judiciary with that of a GATS Disputes Panel conducting closed hearings. WTO member-government spokespersons are obliged to dismiss such criticism because of prior commitment to perceived benefits of prevailing commercial principles of competition and 'liberalization'.

While national governments have the option to exclude any specific service from liberalization under GATS, they are also under pressure from international business interests to refrain from excluding any service "provided on a commercial basis". Important public utilities such as water and electricity most commonly involve purchase by consumers and are thus demonstrably "provided on a commercial basis". The same may be said of many health and education services which are sought to be 'exported' by some countries as profitable industries.

This definition defines virtually any public service as being "provided on a commercial basis" and is already extending into such areas as police, the military, prisons, the justice system, public administration, and government. Over a fairly short time perspective, this could open up for the privatization or marketization of large parts, and possibly all, of what today are considered public services currently available for the whole population of a country as a social entitlement, to be restructured, marketized, contracted out to for-profit providers, and eventually fully privatized and available only to those who can pay for them. This process is currently far advanced in most countries, usually (and intentionally) without properly informing or consulting the public as to whether or not this is what they desire.

When a WTO member enters into a regional integration arrangement through which it grants more favorable conditions to its trade with other parties to that arrangement than to other WTO members’ trade, it departs from the guiding principle of non-discrimination defined in Article I of GATT, Article II of GATS, and elsewhere.

WTO Members are however permitted to enter into such arrangements under specific conditions which are spelled out in three sets of rules:

Paragraphs 4 to 10 of Article XXIV of GATT(as clarified in the Understanding on the Interpretation of Article XXIV of the GATT 1994) provide for the formation and operation of customs unions and free-trade areas covering trade in goods; the so-called Enabling Clause (i.e., the 1979 Decision on Differential and More Favorable Treatment, Reciprocity and Fuller Participation of Developing Countries) refers to preferential trade arrangements in trade in goods between developing country Members; and Article V of GATS governs the conclusion of RTAs in the area of trade in services, for both developed and developing countries.

Other non-generalized preferential schemes, for example non-reciprocal preferential agreements involving developing and developed countries, require Members to seek a waiver from WTO rules. Such waivers require the approval of three quarters of WTO Members. Examples of such agreements which are currently in force include the US — Caribbean Basin Economic Recovery Act (CBERA), the CARIBCAN agreement whereby Canada offers duty-free non-reciprocal access to most Caribbean countries, Turkey-Preferential treatment for Bosnia-Herzegovina and the EC-ACP Partnership Agreement.

Financial Markets Globalization

Inequality of income has been widening with the top 1% gaining spectacularly against workers’ wages. This is attributable to the financialization of the economy, a term the describes not just expanding monetary value of the financial sector relative to the rest of the economy, but also the increasing central role of finance in economic activities, particularly the use of high leverage to create high returns on equity and the securitization of debt, turning liability into tradable asset as collateralized debt obligations (CDO) with steady flow of debt service payments legitimized by deregulation. This has led to under-pricing of risk in the financial system.

The success or failure of the financial sector has a disproportionate impact on the rest of the economy, especially when the combination of too much speculation and too little regulation starts inflating and bursting bubbles. And its returns flow almost exclusively to high earners. Please see my June 24, 2009 article: Mark-to-Market vs Mark-to-Model.

US Plunge Protection Team saving Free Market

Plunge Protection Team (PPT), the moniker given in 1997 to the then just-established President’s Working Group on Financial Markets (PWG) by The Washington Post, was created by Executive order 12631, signed on March 18, 1988 by President Ronald Reagan in response to the 1987 market crash to give recommendations for legislative and private sector solutions for “enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence.” Many perceive it as having been created solely to shore up crashing markets or even to manipulate the market to reverse free-falling stock indices.

PPT, officially created to make urgent financial and economic recommendations to various sectors of the economy in times of extreme market turbulence, consists a team of top policymakers and market regulators that include the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve, the Chairman of the SEC and the Chairman of the Commodity Futures Trading Commission.

In April 1999, the PWG issued a report on the lessons of the pending collapse of Long-Term Capital Management (LTCM)  in May 1998 and six months after the subsequent bailout of LTCM by creditors arranged by the New York Fed on September 23, 1998.

The PWG Report raised alarm over excessive leverage and the opaque risks of the Over the Counter (OTC) derivatives market that trade outside of exchanges, but called for only one legislative change -- a recommendation that unregulated affiliates of brokerages be required to assess and report their financial risk to government regulators.  Fed Chairman Greenspan dissented even on that vague recommendation on the ground that self regulation was preferred in financial markets.

Traces of  PPT market intervention are discernable regularly since its creation. Forbes Magazine in its August 24, 2015 issue headlined an article: U.S. Plunge Protection Team Out In Force This Morning, by Jay Somanev: "It sure looks like the U.S. plunge protection team is out in full force this morning. Our indices are off the lows made from the open and a lot of stocks that were   down to absolutely ridiculous levels have also bounced back and some are even trying to go green amidst the carnage. One of the most important things in this sort of market environment is capital preservation. So, if you are buying or adding do it in small increments and save your firepower for the days and weeks ahead where you might see better prices than what we are seeing right now. I don’t think we will see the prices that we saw at the open again but I am fairly confident that better prices than what we see right now will be available in the upcoming days. There is no way we don’t have an off-the-cuff comment from a Fed head soon.More importantly, China is not just going to reverse and bounce back from here on out.I have covered a lot of my hedges and have added in smallish increments, leaving plenty of cash should we get better  prices in the coming days/weeks."

Four persons as appointed members of PPT can control all US financial markets through the use of dangerous and explosive derivatives. They are empowered to risk the assets and retirement funds of all US citizens. Because of their manipulations, especially since 2001, US financial markets are now based on speculative whims of a special fraternity of Federal Government derivatives dealers.

PPT works closely with all US exchanges and Wall Street banks, including large derivative risk players such as Citibank and JP Morgan Chase.

Few are aware of Executive Order 12631 signed by Ronald Reagan on March 18, 1988 which delegates "authority" to four individuals to trade derivatives since 2001.

Executive Order 12631 - Working Group on Financial Markets - Mar. 18, 1988; 53 FR 9421, 3 CFR, 1988 Comp., p. 559: "By virtue of the authority vested in me as President by the Constitution and laws of the United States of America, and in order to establish a Working Group on Financial Markets, it is hereby ordered as follows:

Section 1. Establishment. (a) There is hereby established a Working Group on Financial Markets (Working Group). The Working Group shall be composed of:

(1) the Secretary of the Treasury, or his designee;

(2) the Chairman of the Board of Governors of the Federal Reserve System, or his designee;

(3) the Chairman of the Securities and Exchange Commission, or his designee; and

(4) the Chairman of the Commodity Futures Trading Commission, or her designee.

Section 2. Purposes and Functions. (a) Recognizing the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets and maintaining investor confidence, the Working Group shall identify and consider: the actions, including governmental actions under existing laws and regulations (such as policy coordination and contingency planning), that are appropriate to carry out these recommendations. The Working Group shall consult, as appropriate, with representatives of the various exchanges, clearinghouses, self-regulatory bodies, and with major market participants to determine private sector solutions wherever possible.

Section 3. Administration. (c) To the extent permitted by law and subject to the availability of funds therefore, the Department of the Treasury shall provide the Working Group with such administrative and support services as may be necessary for the performance of its functions.

US financial markets showed an astounding - yet confounding and puzzling - rise for the 4 months proceeding the 911 terrorist attack. US media dubbed it a "patriotic rally". The European Press called it a "PPT rally".

Obviously, US markets were manipulated and rigged to an inflated value in advance of the 911 disaster, after which there were at least three major long-term stock market rallies. In all 3 instances, when the markets opened, all the indices began to quickly plunge. In each incidence, by early afternoon the markets were brought back from the brink of collapse to the surprise of everyone, including historical analysts.

On September 16, 2001, The Guardian reported "that a secretive committee... dubbed 'the plunge protection team'... is ready to coordinate intervention by the Federal Reserve on an unprecedented scale. The Fed, supported by the banks it regulates, will buy equities from mutual funds and other institutional sellers..."

At the Fed Open Market Committee (FOMC) meeting on Jan 29-30, 2002, Fed Chairman  Alan Greenspan openly discussed the use of "unconventional methods" to stimulate the economy. The Financial Times of London quoted an anonymous US Fed official who stated that one of the extraordinary measures "considered" in January 2004 was "buying US equities".

On Feb 21, 2002, the Financial Times featured an article about Japan's Stock Buying Body. The article stated that "...government backed equity markets, as Japan has recently become aware, do not work... Plunge protecting the world's markets may be a hazardous pursuit."

Another event that should have sent markets spiraling downward was the Enron corporate accounting scandals. Here is the timeline on Eron collapse:

December 2000 - Enron announces that Skilling, then president and chief operating officer, will succeed Kenneth Lay as CEO in February 2001. Lay will remain as chairman. Stock hits 52-week high of $84.87.


Aug. 14 - Skilling resigns; Lay named CEO again.

Aug. 22 - Finance executive Sherron Watkins meets privately with Lay to discuss concerns of murky finance and accounting that could ruin the company.

Oct. 16 - Enron announces $638 million in third-quarter losses and a $1.2 billion reduction in shareholder equity stemming from writeoffs related to failed broadband and water trading ventures as well as unwinding of so-called Raptors, or fragile entities backed by falling Enron stock created to hedge inflated asset values and keep hundreds of millions of dollars in debt off the energy company's books.

Oct. 19 - Securities and Exchange Commission launches inquiry into Enron finances.

Oct. 22 - Enron acknowledges SEC inquiry into a possible conflict of interest related to the company's dealings with Fastow's partnerships. Lay says, "We will cooperate fully with the SEC and look forward to the opportunity to put any concern about these transactions to rest."

Oct. 23 - Lay professes confidence in Fastow to analysts.

Oct. 24 - Fastow ousted.

Nov. 5 - Enron treasurer Ben Glisan Jr. and in-house attorney Kristina Mordaunt fired for investing in Fastow-run partnership.

Each invested $5,800 in 2001 and received a $1 million return a few weeks later.

Nov. 8 - Enron files documents with SEC revising its financial statements for previous five years to account for $586 million in losses.

Nov. 9 - Dynegy Inc. announces an agreement to buy Enron for more than $8 billion in stock.

Nov. 19 - Enron restates its third-quarter earnings and discloses a $690 million debt is due Nov. 27.

Nov. 28 - Enron stock plunges below $1 as Dynegy Inc. aborts its plan to buy its former rival.

Dec. 2 - Enron goes bankrupt, thousands of workers laid off.


Jan. 9 - Justice Department confirms it has begun a criminal investigation of Enron.

Jan. 10 - The White House discloses Lay sought help from two Cabinet members shortly before the company collapsed, but neither offered aid. The company's auditor, Arthur Andersen LLP, says it has destroyed tons of Enron documents.

Jan. 23 - Lay resigns as chairman and CEO.

Jan. 25 - Cliff Baxter, former head of Enron's trading unit and later vice president before his resignation in May 2001, found dead of a self-inflicted gunshot wound.

Feb. 4 - Lay resigns from the board.

Feb. 7 - Skilling, Fastow, Michael Kopper appear at Congress with McMahon and in-house Enron lawyer Jordan Mintz. Skilling testifies; Fastow and Kopper invoke Fifth Amendment rights.

Feb. 12 - Lay invokes Fifth Amendment at a Senate hearing after expressing "profound sadness" at Enron's collapse.

March 14 - Former Enron auditor Arthur Andersen LLP indicted for destroying Enron-related documents to thwart investigators.

April 9 - David Duncan, Andersen's former top Enron auditor, pleads guilty to obstruction for instructing his staff to destroy documents as per company policy.

June 15 - Andersen convicted.

Aug. 21 - Former top Fastow aide Michael Kopper pleads guilty to money laundering and conspiracy, the first ex-Enron executive to strike a deal with prosecutors. He identifies a string of partnerships designed to falsely portray Enron as financially healthy while enriching him, Fastow and others.

Sept. 12 - Three former National Westminster Bank bankers indicted for wire fraud for siphoning off millions of dollars in income intended for their employer through investments in a Fastow partnership. They are fighting extradition.

Oct. 16 - Andersen sentenced to probation and fined $500,000; firm was already banned from auditing public companies and had only a few hundred employees left after its conviction.

Oct. 17 - Former top Enron trader Timothy Belden pleads guilty to wire fraud for participating in schemes to game California's power markets during the state's energy crisis in 2000 and 2001.

Oct. 31 - Fastow indicted on 78 charges of conspiracy, fraud, money laundering and other counts.

Yet an unprecedented across-the-board markets rally began on July 24, 2002. Once again, the European Press called it a "PPT rally".

In each of these events, a large "no-name" buyer in the futures market secretly plunged in and bought up massive quantities of derivatives through big banking groups such as JP Morgan. These were trades that were prepared to suffer losses not sustainable by the average market participant, neutralizing Keynes famous warning that market can stay irrational longer than investors can stay solvent. As unlimited funds were buying to support S&P's rise, in each instance, the market's free-fall was quickly reversed.

PPT successfully brought the markets back each time from sharp correction despite the inflated financial realities that existed. Each time, the large purchase of derivatives at a huge loss transformed developing market crises into a irrational rallies. Each time, such manipulation of the derivative market further inflated highly overvalued market indices to set up the next more severe crisis .

Supranational Institutions in Regional Integration 

The EU is the most prominent operating supranational union in which negotiated power is delegated to a super authority by the national governments of all its member sovereign states. It is the only entity which provides for international popular elections, going beyond the level of political integration generally afforded by international treaty.

The hierarchical term "supranational" is sometimes used in a loosely defined sense in different contexts, as a substitute for non-hierarchical “international”, or for transgressing “transnational” or for geographical “global”.

Intergovernmentalism refers to a theory of regional integration originally formulated by Stanley Hoffmann of Harvard in his influential book: The New European Community: Decisionmaking and Institutional Change, co-edited with Robert O. Keohane, (Westview Press, 1991).

As a broad political concept, Intergovernmentalism sees semi-autonomous state governments and their national governments in particular, as the primary actors in the integration process of a region.

Intergovernmentalists explain periods of radical transformation in the EU as being driven by converging governmental preferences, and periods of inertia as being outcome of diverging national interests.

Intergovernmentalism is distinguishable from  realism and neorealiam neorealism because of its recognition of both the significance of institutionalization in international politics and the impact of domestic politics upon governmental preferences.

European Integration

The best-known, most far-reaching and most studied operating example of regional integration is the European Union (EU), an economic and political intergovernmental organization of 28 member sovereign states, all in Europe.

The EU operates through a system of supranational independent institutions and intergovernmental negotiated decisions by the member sovereign states. Supranational institutions of the EU include the European Commission, the Council of the European Union, the European Council, the Court of Justice of the European Union, the European Central Bank, the Court of Auditors, and the European Parliament. The European Parliament is elected every five years by EU citizens.

EU's de facto capital is Brussels. The EU has developed a single market through a standardized system of laws that apply in all member states. Within the Schengen Area  (which includes 22 EU and 4 non-EU European states) passport controls have been abolished. EU policies favor the free movement of people, goods, services, and capital within its multination boundaries, enact legislation in justice and home affairs, and maintain common policies on trade, agriculture, fisheries and regional development.

A monetary union, the eurozone, was established in 1999 and is composed of 17 member states. Through the Common Foreign and Security Policy the EU has developed a role in external relations and defense. Permanent diplomatic missions have been established around the world. The EU is represented at the United Nations, the World Trade Organization, the G8 and the G-20.

Intergovernmentalism represents a way for limiting the conferral of powers upon supranational institutions, halting the emergence of common policies. in the current institutional system of the EU, the European Council and the Council play the role of the institutions which have the last word about decisions and policies of the EU, institutionalizing a de facto intergovernmental control over the EU as a whole, with the possibility to give more power to a small group of states. This extreme consequence can create the condition of supremacy of someone over someone else violating the principle of a “Union of Equals”.

A common method of decision-making in international organizations is intergovernnmentalism, in which sovereign state governments play a more prominent role.

Council of Europe

The Council of Europe has created a system based on human rights and rule of law in its founding Statute and its Convention of Human Rights and Fundamental Freedoms. Robert Schuman, French Foreign minister, initiated the debate on supranational democracy in his speeches at the United Nations, at the signing of the Council's Statutes and at a series of other speeches across Europe and North America.[3]

The term "supranational" occurs in an international treaty for the first time (twice) in the Treaty of Paris, 18 April 1951. This new legal term defined the Community method in creating the European Coal and Steel Community and the beginning of the democratic re-organization of Europe. It defines the relationship between the High Authority or European Commission and the other four institutions. In the treaty, it relates to a new democratic and legal concept.

The Founding Fathers of the European Community and the present European Union said that supranationalism was the cornerstone of the governmental system. This is enshrined in the Europe Declaration made on 18 April 1951, the same day as the European Founding Fathers signed the Treaty of Paris.

"By the signature of this Treaty, the participating Parties give proof of their determination to create the first supranational institution and that thus they are laying the true foundation of an organised Europe. This Europe remains open to all nations. We profoundly hope that other nations will join us in our common endeavour."

This declaration of principles that included their judgment for the necessary future developments was signed by Konrad Adenauer (West Germany), Paul van Zeeland and Joseph Meurice (Belgium), Robert Schuman (France), Count Sforza (Italy), Joseph Bech (Luxembourg), and Dirk Stikker and Jan van den Brink (The Netherlands). It was made to recall future generations to their historic duty of uniting Europe based on liberty and democracy under the rule of law. Thus, they viewed the creation of a wider and deeper Europe as intimately bound to the healthy development of the supranational or Community system.

This Europe was open to all nations who were free to decide – a reference, or rather an invitation and encouragement of liberty to the Iron Curtain countries. The term supranational does not occur in succeeding treaties such as the Treaties of Rome, officially the Treaty establishing the European Economic Community (TEEC), is an international agreement that led to the founding of the European Economic Community (EEC) on 1 January 1958. It was signed on 25 March 1957 by Belgium, France, Italy, Luxembourg, the Netherlands and West Germany; the Maastricht Treaty, (formally, the Treaty on European Union or TEU) undertaken to integrate Europe was signed on 7 February 1992 by the members of the European Community in Maastricht, Netherlands.

On December 9-10, 1991, the same city hosted the European Council which drafted the treaty; the Treaty of Nice, signed by European leaders on February 26, 2001 and came into force on February 1, 2003. It amended the Maastricht Treaty (or the Treaty on European Union) and the Treaty of Rome (or the Treaty establishing the European Community which, before the Maastricht Treaty, was the Treaty establishing the European Economic Community); or the Constitutional Treaty, an unratified international treaty intended to create a consolidated constitution for the European Union (EU). It would have replaced the existing European Union treaties with a single text, given legal force to the Charter of Fundamental Rights, and expanded Qualified Majority Voting into policy areas which had previously been decided by unanimity among member states. The Treaty was signed on 29 October 2004 by representatives of the then 25 member states of the European Union. It was later ratified by 18 member states, which included referendums endorsing it in Spain and Luxembourg. However the rejection of the document by French and Dutch voters in May and June 2005 brought the ratification process to an end.

Following a period of reflection, the Treaty of Lisbon was created to replace the Constitutional Treaty. This contained many of the changes that were originally placed in the Constitutional Treaty but was formulated as amendments to the existing treaties. Signed on 13 December 2007, the Lisbon Treaty entered into force on 1 December 2009.

A supranational union is a supranational polity which lies somewhere between a confederation that is an association of states, and a federation that is a state. 

The European Economic Community was described by its founder Robert Schuman as midway between confederalism which recognizes the complete independence of States in an association and federalism which seeks to fuse them in a super-state. The EU has supranational competences, but it possesses these competences only to the extent that they are conferred on it by its member states (Kompetenz-Kompetenz). Within the scope of these competences, the union exercises its powers in a sovereign manner, having its own legislative, executive, and judicial authorities. The supranational Community also has a chamber for organized civil society including economic and social associations and regional bodies.

Unlike states in a federal super-state, member states in a supranational Community retain ultimate sovereignty, although some sovereignty is shared with, or ceded to, the supranational body. Supranational agreements encourage stability and trust, because governments cannot break international accords at a whim. The supranational action may be time-limited. This was the case with the European Coal and Steel Community, which was agreed for 50 years with the possibility of renewal. Supranational accords may be permanent, such as an agreement to outlaw war between the partners. Full sovereignty can be reclaimed by withdrawing from the supranational arrangements but the member state would also lose the great advantages offered by mutualities, economies of scale, common external tariffs and other commonly agreed standards such as improved international trust and democracy and the increased weight of common external positions.

A supranational union, because it is an agreement between sovereign states, is based on international treaties. The European treaties in general are different from classical treaties as they are constitutionalizing treaties, that is, they provide the basis for a European level of democracy and European rule of law. They have something in the nature of a constitution and like the British constitution, not necessarily a single document. They are based on treaties between its member governments but have normally to undergo a closer democratic scrutiny than other treaties because they are more far-ranging, affecting many areas of citizens' lives and livelihoods. This is why citizens often demand referendums.

Decision-making is partly intergovernmental and partly supranational within the Community areas. The latter provides a higher degree of institutional scrutiny both via the Parliament and through the Consultative Committees. Intergovernmentalism provides for less democratic oversight, especially where the institution such as the Council of Ministers or the European Council takes place behind closed doors, rather than in a parliamentary chamber.

A supranational authority can have some independence from member state governments in specific areas, although not as much independence as with a federal government. Supranational institutions, like federal governments, imply the possibility of pursuing agendas in ways that the delegating states did not initially envision. Democratic supranational Communities, however, are defined by treaty and by law. Their activity is controlled by a Court, democratic institutions and the rule of law.

The union has legal supremacy over its member states (only) to the extent that its member state governments have conferred competences on the union. It is up to the individual governments to assure that they have full democratic backing in each of the member states. The citizens of the member states, though retaining their nationality and national citizenship, additionally become citizens of the union.

The European Union

The European Union, the only clear example of a supranational union, has a parliament with legislative oversight, elected by its citizens. To this extent, a supranational union like the European Union has characteristics that are not entirely dissimilar to the characteristics of a federal state like the United States of America. However, the differences in scale become apparent if one compares the United States federal budget with the budget of the European Union (which amounts only to about one percent of combined GDP) or the size of the federal civil service of the United States with the Civil Service of the European Union.

Because decisions in some EU structures are taken by majority votes, it is possible for a member state to be obliged by the other members to implement a decision. The states retain the competence for adding this additional supranational competence.

European Integration originates from Trade Integration. Historically the concept was introduced and made a concrete reality by Robert Schuman when the French Government agreed to the principle in the Schuman Declaration and accepted the Schuman Plan confined to specific sectors of vital interest of peace and war. Thus commenced the European Community system beginning with the European Coal and Steel Community. The six founder States, (France, Italy, Germany, The Netherlands, Belgium, Luxembourg) agreed on the goal: making 'war not only unthinkable but materially impossible'. They agreed about the means: putting the vital interests, namely coal and steel production, under a common High Authority, subject to common democratic and legal institutions. They agreed on the European rule of law and a new democratic procedure.

The five institutions (besides the High Authority) were a Consultative Committee (a chamber representing civil society interests of enterprises, workers and consumers), a parliament, and a Council of government ministers. A Court of Justice would decide disputes coming from governments, public or private enterprises, consumer groups, any other group interests or even an individual. A complaint could be lodged in a local tribunal or national courts, where appropriate. Member states have yet to fulfil and develop the articles in the Paris and Rome treaties for full democracy in the European Parliament and other institutions such as the Economic and Social Committee and the Committee of Regions.

Schuman described supranational unions as a new stage in human development. It contrasted with destructive nationalisms of the nineteenth and twentieth centuries that began in a glorious patriotism and ended in wars. He traced the beginning concept of supranationality back to the nineteenth century, such as the Postal Union, and the term supranational is used around the time of the First World War. Democracy, which he defined as 'in the service of the people and acting in agreement with it,' was a fundamental part of a supranational community. However, governments only began to hold direct elections to the European Parliament in 1979, and then not according to the treaties. A single electoral statute was specified in the treaty for Europe's first community of coal and steel in 1951. Civil society (largely non-political) was to have its own elected chamber in the Consultative Committees specific to each Community as democratically agreed, but the process was frozen (as were Europe's parliamentary elections) by Charles de Gaulle and other politicians who opposed the Community method.

Trade Origin of the EU

Today supranationalism only exists in the two European Communities inside the EU: the Economic Community (often called the European Community although it does not legally cover all State activities) and Euratom (the European Atomic Energy Community, a non-proliferation community, in which certain potentialities have been frozen or blocked.) Supranational Communities provide powerful but generally unexploited and innovatory means for democratic foreign policy, by mobilizing civil society to the democratically agreed goals of the Community.

The first Community of Coal and Steel was agreed only for fifty years. Opposition, mainly by enterprises which had to pay a small European tax of less than one percent and government ministers in the Council, led to its democratic mandate not being renewed. Its jurisprudence and heritage remains part of the European Community system.

De Gaulle attempted to turn the European Commission into a political secretariat under his control in the Fouchet Plan but this move was thwarted by such democrats in the Benelux countries as Paul-Henri Spaak, Joseph Luns and Joseph Bech as well as a large wave of other pro-Europeans in all the Community countries.

The supranational Community method came under attack, not only from de Gaulle but also from other nationalists and Communists. In the post-de Gaulle period, rather than holding pan-European elections under a single statute as specified in all the treaties, governments held and continue to hold separate national elections for the European Parliament. These often favour the major parties and discriminate against smaller, regional parties. Rather than granting elections to organised civil society in the consultative committees, governments created a three-pillar system under the Amsterdam Treaty and Maastricht Treaty, mixing intergovernmental and supranational systems. Two pillars governing External policy and Justice and Home affairs are not subject to the same democratic controls as the Community system.

In the Lisbon Treaty and the earlier nearly identical Constitutional Treaty, the democratic independence of the five key institutions is further blurred. This moves the project from full democratic supranationalism in the direction of not just intergovernmentalism but the politicization of the institutions, and control by two or three major party political organizations. The Commission defines key legal aspects of the supranational system because its members must be independent of commercial, labor, consumer, political or lobby interests (Article 9 of the Paris Treaty). The Commission was to be composed of a small number of experienced personalities, whose impartiality was beyond question. As such, the early presidents of the Commission and the High Authority were strong defenders of European democracy against national, autocratic practice or the rule of the strong over the weak.

The idea in the Constitutional and Lisbon Treaties is to run the European Commission as a political office. Governments would prefer to have a national member in the Commission, although this is against the principle of supranational democracy. (The original concept was that the Commission should act as a single impartial college of independent, experienced personalities having public confidence. One of the Communities was defined in the treaty with a Commission with fewer members than the number of its member states.) Thus, the members of the Commission are becoming predominantly party-political, and composed of sometimes rejected, disgraced or unwanted national politicians.

The first president of the High Authority was Jean Monnet who never joined a political party, as was the case with most of the other members of the Commissions. They came from diverse liberal professions, having made recognized European contributions.

Governments also wish to retain the secrecy of their deliberations in the Council of Ministers or the European Council, which discusses matters of the most vital interest to European citizens. While some institutions such as the European Parliament have their debates open to the public, others such as the Council of Ministers and numerous committees are not. Schuman wrote in his book, 'Pour l'Europe' (For Europe) that in a democratic supranational Community the Councils, committees and other organs should be placed under the control of public opinion that was effectual without paralyzing their activity nor useful initiatives.

The European Union, the North American Free Trade Agreement, the Association of Southeast Asian Nations, the South Asian Association for Regional Cooperation, the Common Market of the South (MERCOSUR), the Australia-New Zealand Closer Economic Relations Agreement, and so on.

By July 2005, Mongolia was the only WTO member state not party to a regional trade agreement. The surge in these agreements has continued unabated since the early 1990s. By July 2005, a total of 330 had been notified to the WTO and its predecessor, GATT. Of these: 206 were notified after the WTO was created in January 1995; 180 are currently in force; several others are believed to be operational although not yet notified.

One of the most frequently asked questions is whether these regional groups help or hinder the WTO’s multilateral trading system. A committee is keeping an eye on developments.

Regional Trading Arrangements

They seem to be contradictory, but regional trade agreements can actually support the WTO’s multilateral trading system. Regional agreements have allowed groups of countries to negotiate rules and commitments that go beyond what was possible at the time multilaterally. In turn, some of these rules have paved the way for agreement in the WTO. Services, intellectual property, environmental standards, investment and competition policies are all issues that were raised in regional negotiations and later developed into agreements or topics of discussion in the WTO.

The groupings that are important for the WTO are those that abolish or reduce barriers on trade within the group. The WTO agreements recognize that regional arrangements and closer economic integration can benefit countries. It also recognizes that under some circumstances regional trading arrangements could hurt the trade interests of other countries. Normally, setting up a customs union or free trade area would violate the WTO’s principle of equal treatment for all trading partners (“most-favoured-nation”). But GATT’s Article 24 allows regional trading arrangements to be set up as a special exception, provided certain strict criteria are met.

In particular, the arrangements should help trade flow more freely among the countries in the group without barriers being raised on trade with the outside world. In other words, regional integration should complement the multilateral trading system and not threaten it.

Article 24 says if a free trade area or customs union is created, duties and other trade barriers should be reduced or removed on substantially all sectors of trade in the group. Non-members should not find trade with the group any more restrictive than before the group was set up.

Similarly, Article 5 of the General Agreement on Trade in Services provides for economic integration agreements in services. Other provisions in the WTO agreements allow developing countries to enter into regional or global agreements that include the reduction or elimination of tariffs and non-tariff barriers on trade among themselves.

On February 6, 1996, the WTO General Council created the Regional Trade Agreements Committee. Its purpose is to examine regional groups and to assess whether they are consistent with WTO rules. The committee is also examining how regional arrangements might affect the multilateral trading system, and what the relationship between regional and multilateral arrangements might be.

Eurozone Sovereign Debt Crisis

The Eurozone sovereign debt crisis is rooted in the dysfunction of a monetary union without political union. The fundamental cause for the crisis lies in the arrangement under which the euro is legal tender for all member states in the eurozone, yet monetary policy for the eurozone is the exclusive responsibility of the European Central Bank, for which common representation of all member states, governance and fiscal policy union in support of currency union does not formally exist. This essentially makes sovereign debt of eurozone member states denominated in euro foreign currency debts. Since individual eurozone member states do not have sovereign authority over their common currency, they are deprived of the option of solving their sovereign debt problem with monetary measures, such as devaluing their common currency or lowering interest rates.

The eurozone, also known as euro area (EA17), is an economic and monetary union (EMU) of 17 out of the 27 member states of European Union (EU27) that have adopted the euro (€) as their common currency and sole legal tender that is freely convertible at market exchange rates. The euro is also legal tender in a five other non-EMU European political entities (Montenegro, Andorra, Monaco, San Marino and Vatican City) and the disputed territory of Kosovo.

The euro is the common currency used daily by some 332 million Europeans and their separate governments. Additionally, over 175 million people worldwide use currencies which are pegged to the euro, including more than 150 million people in Africa.

A Political Crisis with Financial Dimensions

The European sovereign debt crisis is at its base a intergovernmental political crisis in the eurozone-17 with financial and economic dimensions that reaches beyond the eurozone to all its trading partner regions as well as financial and trading markets in the entire world. The crisis is centered around the difficulty in achieving policy consensus among all eurozone member states and the inability of any eurozone member state under financial distress from sovereign debt difficulties to employ monetary measures individually, such a currency devaluation or interest rate measures, to solve its euro denominated sovereign debt problems, since no member state has individual authority to set or revise monetary policy or exchange rate value for the euro to address its public finance problems. Furthermore, the economic and public finance problems of eurozone member states are not congruent, thus giving rise to varying and often contradicting political incentives in different member states, pitting the political dynamics of richer economies against those of poorer economies.

Debt Crisis of a Rich Economy

On many levels, the eurozone (EA17) is a very rich economy. It has a population of 320 million with a 2010 GDP of €9.2 trillion ($12.2 trillion), albeit with an wide range of per capita GDP, ranging from €30,600 in Austria to €19,700 in Romania. Little Luxembourg's per capita GDP was €70,000 in 2010. Despite of the fact that eurozone membership involves only 17 of the 27 member state of the EU27, the eurozone is essentially the economic and financial core of the EU, which has the highest GDP ($16.2 trillion in 2010) in the world, larger that the US GDP ($14.7 trillion). A sovereign default in any eurozone member state will put in doubt the continuance of the euro as a common currency in the eurozone and as prime reserve currency for international trade.

Collapse of Aggregate Demand

The reason why a rich economy like that of the eurozone suffers such a sudden collapses in aggregate demand caused by a banking sector and sovereign debt crisis around a common currency lies squarely on a breakdown of political consensus among eurozone member state governments. The sovereign debt crisis in the eurozone began with the global economic recession that began in mid 2007 in New York, caused by a massive meltdown in electronically linked credit markets in all major open economies due to excessive private and public debts to compensated for decades of low wages.

This global recession  has thus far stubbornly resisted all coordinated efforts by governments and central banks of trading economies around the world to stimulate a quick economic recovery through the injection of liquidity via aggressive central bank interest rate policy and massive quantitative easing. The penalty for direct government bailout of too-big-to-fail financial entities to defuse a market meltdown will be a decade of slow growth for the world economy, because the debt crisis that had been caused by low wages is being solved with government austerity measures that will push wages further down. Slow economic growth is highly problematic for countries with high levels of sovereign debt. And for any country whose sovereign debt is denominated in currency not subject to the monetary authority of  its central bank, the problem can be fatal.

Anemic Recovery

The reason for the long and weak recovery in global economy is that the excessive debt in the global economy has not been extinguished by government bailouts. The debt has only been shifted from the private sector to the public sector, from the balance sheets of distressed commercial and investment banks to the balance sheets of central banks. The penalty for this liquidity play on the part of central banks to save insolvent financial institutions from collapse will be an extended anemic global economy in which banks, companies and households are all trying to deleverage from undistinguished debt with the new liquidity of no economic substance released by central bank quantitative easing. Also, government austerity programs needed to secure more debt will further reduce wage income and exacerbate further fall in aggregate demand in a downward vicious cycle.

The Coming Trade War and Global Depression

Many economic historians have suggested that the 1929 stock market crash was not the cause of the Great Depression. If anything, the 1929 crash was the technical reflection of the inevitable fate of an overblown bubble economy. Yet, stock market crashes can recover within a relatively short time with the help of effective government monetary measures, as demonstrated by the crashes of 1987 (23% drop, recovered in 9 months), 1998 (36% drop, recovered in 3 months) and 2000-2 (37% drop, recovered in 2 months).

Structurally, the real cause of the Great Depression, which lasted more than a decade, from 1929 till the beginning of the Second World War in 1941, was the 1930 Smoot-Hawley tariffs that put world trade into a tailspin from which it did not recover until World War II began.

While the US economy finally recovered from war mobilization after the Japanese attack on Pearl Harbor on December 7, 1940, most of the world’s market economies sunk deeper into war-torn distress and never fully recovered until the Korea War boom in 1951.

Barely five years into the 21st century, with a globalized neo-liberal trade regime firmly in place in a world where market economy has become the norm, trade protectionism appears to be fast re-emerging and developing into a new global trade war of complex dimensions.

The irony is that this new trade war is being launched not by the poor economies that have been receiving the short end of the trade stick, but by the US which has been winning more than it has been losing on all counts from globalized neo-liberal trade, with the EU following suit in locked steps. Japan of course has never let up on protectionism and never taken competition policy seriously.  The rich nations needs to recognize that in their effort to squeeze every last drop of advantage out of already unfair trade will only plunge the world into deep depression. History has shown that while the poor suffer more in economic depressions, the rich, even as they are fianancially cushioned by their wealth, are hurt by political repercussions in the form of either war or revolution or both.

Post Cold War Global Trade

During the Cold War, there was no international free trade. The economies of the two contending ideology blocks were completely disconnected.  Within each block, economies interact through foreign aid and memorandum trade from their respective superpowers.  The competition was not for profit but for the hearts and minds of the people in the two opposing blocks as well as those in the non-aligned nations in the Third World. The competition between the two superpowers was to give rather than to take from their separate fraternal economies.

The population of the superpowers worked hard to help the poorer people within their separate blocks and convergence toward equality was the policy aim even if not always the practice.

The Cold War era of foreign aid and memorandum trade had a better record of poverty reduction in either camps than post-Cold War globalized neo-liberal trade dominated by one single superpower.

The aim was not only to raise income and increase wealth, but also to close income and wealth disparity between and within economies.  Today, income and wealth disparity is rationalized as a necessity for capital formation. The New York Time reports that from 1980 to 2002, the total income earned by the top 0.1% of earners in the US more than doubled, while the share earned by everyone else in the top 10% rose far less and the share of the bottom 90% declined.

For all its ill effects, the Cold War achieved two formidable ends: it prevented nuclear war and it introduced development as a moral imperative into superpower geo-political competition with rising economic equality within each block.  In the years since the end of the Cold War, nuclear terrorism has emerged as a serious threat and domestic development is pre-empted by global trade even in the rich economies while income and wealth disparity has widened everywhere.

Since the end of the Cold War some three decacds ago, world economic growth has shifted to rely exclusively on globalized neo-liberal trade engineered and led by the US as the sole remaining superpower, financed with the US dollar as the main reserve currency for trade and anchored by the huge US consumer market made possible by the high wages of US workers.  This growth has been sustained by knocking down national tariffs everywhere around the world through supranational institutions such as the World Trade Organization (WTO), and financed by a deregulated foreign exchange market working in concert with a global central banking regime independent of local political pressure, lorded over by the supranational Bank of International Settlement (BIS) and the International Monetary Fund (IMF).

The Washington Consensus is a “conditionality” for inclusion into global market fundamentalism through supranational intervention on national sovereignty prerogative over monetary and fiscal policies.  It is another tool for building a new form of Empire.

US-China Trade

Bush said China, which had reached a trade agreement with the US at the close of the Clinton administration, and had became a member of the WTO in late 2001, would benefit from political changes as a result of liberalized trade policies.  This pronouncement gives clear evidence to those in China who see foreign trade as part of an anti-China “peaceful evolution” strategy first envisioned by John Forster Dulles, US Secretary of State under President Eisenhower in the 1950s. It is a strategy of inducing through peaceful trade the Communist Party of China (CPC) to reform itself out of power and to eliminate the dictatorship of the proletariat in favor of bourgeois liberalization. 

Almost four decades later, Deng Xiaoping criticized CPC Chairman Hu Yaobang and Premier Zhao Ziyang for having failed to contain bourgeois liberalization in their implementation of China’s modernization policy. Deng warned in November 1989, five months after the Tiananmen incident: “The Western imperialist countries are staging a third world war without guns. They want to bring about the peaceful evolution of socialist countries towards capitalism.”  Deng’s handling of the Tiananmen incident prevented China from going the catastrophic route of the USSR which dissolved two years later in 1991.

Yet it is clear that political freedom is often the first casualty of a garrison state mentality and such mentality inevitably results from hostile US economic and security policy toward any country the US deems as not free.  Whenever the US pronounces a nation to be not free, that nation will become less free as a result of US policy. This has been repeatedly evident in China and elsewhere in the Third World.  Whenever US policy toward China turns hostile, as it currently appears to be heading, political and press freedom inevitably face stricter curbs in China.

Reforming the Terms of Trade

For trade to mutually and truly benefit the trading economies, three conditions are necessary:

1) the de-linking of trade from ideological/political objectives,

2) equality must be maintained in the terms of trade and

3) recognition that global full employment at rising, living wages is the prerequisite for true comparative advantage in global trade.

The developing rupture between the sole superpower and its habitually deferential Cold War allies lies in mounting trade conflicts. The US has benefited from a post-Bretton Woods international financial architecture that gives the US economy a structural monetary advantage over those of the EU and Japan, not to mention the rest of the world.  This advantage is derived from dollar hegemony.

Dollar hegemony is detrimental even to the US domestic economy, as it is only good for the global dollar economy of which the US economy is but one component, albeit a key major one. Through globalization and the growth of euro-dollars (the name given to all offshore dollars and has no direct relation to the euro or the EU), the global dollar economy is increasingly detached from the US domestic economy. What is good for the global dollar economy is not necessarily good for the US domestic economy. Economic nationalists in the US are beginning to understand the threat of internationalist dollar hegemony to the US economy itself.

Trade issues range from government subsidies disputes between Airbus and Boeing, on banana, sugar, beef, oranges, steel, as well as disputes over fair competition associated with mergers and acquisition and financial services. If either government is found to be in breach of WTO rules when these disputes wind through long processes of judgment, the other will be authorized to retaliate.

The US could put tariffs on other European goods if the WTO rules against Airbus and vice versa. So if both governments are found in breach, both could retaliate, leading to a cycle of offensive protectionism. When the US was ruled to have unfairly supported its steel industry, tariffs were slapped by the EU on Florida oranges to make a political point in a politically important state in US politics.

Trade competition between the EU and the US is spilling over into national security areas, allowing economic interests to conflict with ideological sympathy.  Both of these highly proficient national production engines, saddled with serious overcapacity, are desperately seeking new markets, which inevitably leads them to Asia in general and China in particular, with its phenomenal growth rate and its 1.2 billion eager consumers bulging with rapidly rising disposable income.

The growth of the Chinese economy will lift all other economies in Asia, including Australia which has only recently begun to understand that its future cannot be separated from its geographic location and that its prosperity is interdependent with those of other Asian economies.

Australian iron ores, beef and dairy products are destined for China, not the British Isles. The EU is eager to lift its 15-year-old arms embargo on China, much to the displeasure of the US. Israel faces similar dilemma, with its close relations with the US, on military sales to China. Isreal must export arms to help reduce high arms production cost to its small economy. Even the US defense establishment has largely come around to the view that US arms industry must export, even to China, to remain on top form with technical innovation that needs huge revenue.

The Bangkok Post reported that Secretary Rumsfeld tried to sell to Thailand F-16 warplanes capable of firing advanced medium-range air-to-air missiles (AMRAAMs) two days after he lashed out in Singapore at China for upgrading its own military when no neighboring nations are threatening it. The sales pitch was in competition with Russian-made Sukhoi SU-30s and Swedish JAS-39s.

The open competition in arms export had been spelled out for Congress years earlier by Donald Hicks, a leading Pentagon technologist in the Reagan administration. “Globalization is not a policy option, but a fact to which policymakers must adapt,” Hick said. “The emerging reality is that all nations’ militaries are sharing essentially the same global commercial-defense industrial base.”  The boots and uniforms worn by US soldiers in Afghanistan and Iraq were made in China.

The WTO is the only global international organization dealing with the rules of trade between its 148 member nations. At its heart are the WTO agreements, known as the multilateral trading system, negotiated and signed by the majority of the world’s trading nations and ratified in their parliaments. The stated goal is to help producers of goods and services, exporters, and importers conduct their business, with the dubious assumption that trade automatically brings equal benefits to all participants.  The welfare of the people is viewed only as a collateral aim based on the doctrinal fantasy that “balanced” trade inevitably brings prosperity equally to all, a claim that has been contradicted by facts produced by the very terms of trade promoted by the WTO itself.

Trade and Inequality in Wealth Distribution

Two decades of neo-liberal globalized trade have widened income and wealth disparity within and between nations. Free trade has turned out not to be the win-win game promised by neo-liberals.  It is very much a win-lose game, with heads, the rich economies win, and tails, the poor economies lose.

Domestic development has been marginalized as a hapless victim of foreign trade, dependent on trade surplus for capital.  Foreign trade and foreign direct investment have become the prerequisite engines for domestic development. This trade model condemns those economies with trade deficits to perpetual underdevelopment.  Because of dollar hegemony, all foreign investment goes only to the export sector where dollars can be earned.  Even the economies with trade surpluses cannot use their dollar trade earnings for domestic development, as they are forced to hold huge dollar reserves to support the exchange rate of their currencies.

In the fifth WTO Ministerial Conference held in Cancun in September 2003, the richer countries rejected the demands of poorer nations for radical reform of agricultural subsidies that have decimated Third World agriculture. Failure to get the Doha round back on track after the collapse of Cancun runs the danger of a global resurgence of protectionism, with the US leading the way. 

Larry Elliott reported on October 13, 2003 in The Guardian on the failed 2003 Cancun Ministerial meeting: “The language of globalization is all about democracy, free trade and sharing the benefits of technological advance. The reality is about rule by elites, mercantilism and selfishness.” Elliot noted that the process is full of paradoxes: why is it that in a world where human capital is supposed to be the new wealth of nations, labor is treated with such contempt?

Sam Mpasu, Malawi’s commerce and industry minister, asked at Cancun for his comments about the benefits of trade liberalization, replied dryly: “We have opened our economy. That’s why we are flat on our back.” Mpasu’s comments summarize the wide chasm that divides the perspectives of those who write the rules of globalization and those who are powerless to resist them.

Exports of manufactures by low-wage developing countries have increased rapidly over the last 3 decades due in part to falling tariffs and declining transport costs that enable outsourcing based on wage arbitrage. It grew from 25% in 1965 to nearly 75% over three decades, while agriculture’s share of developing country exports has fallen from 50% to under 10%. 

Many developing countries have gained relatively little from increased manufactures trade, with most of the profit going to foreign capital. Market access for their most competitive manufactured export, such as textile and apparel, remains highly restricted and recent trade disputes threaten further restrictions. Still, the key cause of unemployment in all developing economies is the trade-related collapse of agriculture, exacerbated by the massive government subsidies provided to farmers in rich economies.  Many poor economies are predominantly agriculturally based and a collapse of agriculture means a general collapse of the whole economy.

The Doha Development Agenda (DDA) negotiations, sponsored by the WTO, collapsed in Cancun, Mexico over the question of government support for agriculture in rich economies and its potential impacts on causing more poverty in developing countries. The Doha negotiations since Cancun are focused on the need to better understand the linkages between trade policies, particularly those of the rich economies, and poverty in the developing world. 

While poverty reduction is now more widely accepted by establishment economists as a necessary central focus for development efforts and has become the main mission of the World Bank and other supranational development institutions, very little effective measures have been forthcoming.

The UN Millennium Development Goals (UNMDG) of 1990 commits the international community to halve world poverty by 2015, a quarter of a century hence. With then  current trends, that goal is likely to be achievable only through death of half of the poor by starvation, disease and local conflicts. The UN Development Program warns that 3 million children will die in sub-Saharan Africa alone by 2015 if the world continues on its then current path of failing to meet the UNMDG agreed to in 2000. Several key venues to this goal are located in international trade where the record of poverty reduction has been exceedingly poor, if not outright negative. 

The fundamental question whether trade can replace or even augment socio-economic development remains unasked, let alone answered.  Until such issues are earnestly addressed, protectionism will re-emerge in the poor countries.  Under such conditions, if democracy expresses the will of the people, democracy will demand protectionism more than government by elite. It is not surprising why WTO meetings are target of popular protects.

Exchange Rate as Virtual Countervailing tariff

While tariffs in the past decade have been coming down like leaves in autumn, flexible exchange rates have become a form of virtual countervailing tariff.  In the current globalized neo-liberal trade regime operating in a deregulated global foreign exchange market, the exchanged value of a currency is regularly used to balance trade through government intervention in currency market fluctuations against the world’s main reserve currency – the dollar, as the head of the international monetary snake.

Purchasing power parity (PPP) measures the disconnection between exchange rates and local prices. PPP contrasts with the interest rate parity (IRP) theory which assumes that the actions of investors, whose transactions are recorded on the capital account, induces changes in the exchange rate. For a dollar investor to earn the same interest rate in a foreign economy with a PPP of four times, such as the purchasing power parity between the US dollar and the Chinese yuan, local wages would have to be at least 4 time lower than US wages.  

PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy.  The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets.  But the law of one price does not apply to the price of labor. Price arbitrage is the opposite of wage arbitrage in that producers seek to make their goods in the lowest wage locations and to sell their goods in the highest price markets.  This is the incentive for outsourcing which never seeks to sell products locally at prices that reflect PPP differentials.

What is not generally noticed is that price deflation in an economy increases its PPP, in that the same local currency buys more. But the cross-border one price phenomenon applies only to certain products, such as oil, thus for a PPP of 4 times, a rise in oil prices will cost the Chinese economy 4 times the equivalent in other goods, or wages than in the US.  The larger the purchasing power parity between a local currency and the dollar, the more severe is the tyranny of dollar hegemony on forcing down wage differentials.

Ever since 1971, when US president Richard Nixon, under pressure from persistent fiscal and trade deficits that drained US gold reserves, took the dollar off the gold standard (at $35 per ounce), the dollar has been a fiat currency of a country of little fiscal or monetary discipline. The Bretton Woods Conference at the end of World War II established the dollar, a solid currency backed by gold, as a benchmark currency for financing international trade, with all other currencies pegged to it at fixed rates that changed only infrequently.  The fixed exchange rate regime was designed to keep trading nations honest and prevent them from running perpetual trade deficits. It was not expected to dictate the living standards of trading economies, which were measured by many other factors besides exchange rates.

Bretton Woods was conceived when conventional wisdom in international economics did not consider cross-border flow of funds necessary or desirable for financing world trade precise for this reason. Since 1971, the dollar has changed from a gold-back currency to a global reserve monetary instrument that the US, and only the US, can produce by fiat.  At the same time, the US continued to incur both current account and fiscal deficits. That was the beginning of dollar hegemony.

With deregulation of foreign exchange and financial markets, many currencies began to free float against the dollar not in response to market forces but to maintain export competitiveness.  Government interventions in foreign exchange markets became a regular last resort option for many trading economies for their preserving export competitiveness and for resisting the effect of dollar hegemony on domestic living standards.

World Trade and Dollar Hegemony

World trade under dollar hegemony is a game in which the US produces paper dollars and the rest of the world produce real things that paper dollars can buy. The world’s interlinked economies no longer trade to capture comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies in foreign exchange markets. To prevent speculative and manipulative attacks on their currencies in deregulated markets, the world’s central banks must acquire and hold dollar reserves in corresponding amounts to market pressure on their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creates a built-in support for a strong dollar that in turn forces all central banks to acquire and hold more dollar reserves, making it stronger. This anomalous phenomenon is known as dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The denomination of oil in dollars and the recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973.

By definition, dollar reserves must be invested in dollar-denominated assets, creating a capital-accounts surplus for the US economy. A strong-dollar policy is in the US national interest because it keeps US inflation low through low-cost imports and it makes US assets denominated in dollars expensive for foreign investors. This arrangement, which Federal Reserve Board chairman Alan Greenspan proudly calls US financial hegemony in congressional testimony, has kept the US economy booming in the face of recurrent financial crises in the rest of the world. It has distorted globalization into a “race to the bottom” process of exploiting the lowest labor costs and the highest environmental abuse worldwide to produce items and produce for export to US markets in a quest for the almighty dollar, which has not been backed by gold since 1971, nor by economic fundamentals for more than a decade. The adverse effects of this type of globalization on the developing economies are obvious. It robs them of the meager fruits of their exports and keeps their domestic economies starved for capital, as all surplus dollars must be reinvested in US treasuries to prevent the collapse of their own domestic currencies.

Dollar hegemony is detrimental even to the US domestic economy, as it is only good for the global dollar economy of which the US economy is but one component, albeit a key major one. Through globalization and the growth of euro-dollars (the name given to all offshore dollars and has no direct relation to the euro or the EU), the global dollar economy is increasingly detached from the US domestic economy. What is good for the global dollar economy is not necessarily good for the US domestic economy. Economic nationalists in the US are beginning to understand the threat of internationalist dollar hegemony to the US economy itself.

The adverse effect of this type of globalization on the US economy is also becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a debt bubble that thrives on conspicuous consumption and fraudulent accounting. The unsustainable and irrational rise of US equity and real estate prices, unsupported by revenue or profit, had merely been a de facto devaluation of the dollar. Ironically, the recent fall in US equity prices from its 2004 peak and the anticipated fall in real estate prices reflect a trend to an even stronger dollar, as it can buy more deflated shares and properties for the same amount of dollars. The rise in the purchasing power of the dollar inside the US impacts its purchasing power disparity with other currencies unevenly, causing sharp price instability in the economies with freely exchangeable currencies and fixed exchange rates, such as Hong Kong and until recently Argentina.  For the US, falling exchange rate of the dollar actually causes asset prices to rise. Thus with a debt bubble in the US economy, a strong dollar is not in the US national interest.  Debt has turned US policy on the dollar on its head.

The setting of exchange values of currencies is practiced not only by sovereign governments on their own currencies as a sovereign right.  The US, exploiting dollar hegemony, usurps the privilege of dictating the exchange value of all foreign currencies to support its own economic nationalism in the name of global free trade. And US position on exchange rates has not been consistent. When the dollar was rising, as it did in the 1980s, the US, to protect its export trade, hailed the stabilizing wisdom of fixed exchange rates.  When the dollar falls as it has been in recent years, the US, to deflect the blame of its trade deficit, attacks fixed exchange rates as currency manipulation, as it targets China’s currency now which has been pegged to the dollar for over a decade, since the dollar was lower. How can a nation manipulate the exchange value of its currency when it is pegged to the dollar at the same rate over long periods?  Any manipulation came from the dollar, not the yuan.

The rise of the euro against the dollar, the first appreciation wave since its introduction on January 1, 2002, was the result of an EU version of the 1985 Plaza Accord on the Japanese yen, albeit without a formal accord.  The strategic purpose was more than merely moderating the US trade deficit.  The record shows that even with the 30% drop of the dollar against the euro, the US trade deficit has continued to climb. The strategic purpose of driving up the euro is to reduce the euro to the status of the yen, as a subordinated currency to dollar hegemony. The real effect of the Plaza Accord was to shift the cost of support for the dollar-denominated US trade deficit, and the socio-economic pain associated with that support, from the US to Japan.

What is happening to the euro now is far from being the beginning of the demise of the dollar.  Rather, it is the beginning of the reduction of the euro into a subservient currency to the dollar to support the US debt bubble. Six and a half years since the launch of European Monetary Union, the eurozone is trapped in an environment in which monetary policy of sound money has in effect become destructive and supply-side fiscal policy unsustainable. National economies are beginning to refuse to bear the pain needed for adjustment to globalization or the EU’s ambitious enlargement.  The European nations are beginning to resist the US strategy to make the euro economy a captive supporter of a rising or falling dollar as such movements fit the shifting needs of US economic nationalism.

By allowing a trade surplus denominated in dollars to be accumulated by non-dollar economies, such as yen, euro, or now the Chinese yuan, the cost of supporting the appropriate value of the dollar to sustain perpetual economic growth in the dollar economy is then shifted to these non-dollar economies, which manifests themselves in perpetual relative low wages and weak domestic consumption.  For already high-wage EU and Japan, the penalty is the reduction of social welfare benefits and job security traditional to these economies. For China, now the world’s second largest creditor nation, it is reduced to having to ask the US, the world’s largest debtor nation, for capital denominated in dollars the US can print at will to finance its export trade to a US running recurring trade deficits denominated in dollars.

The IMF, which has been ferocious in imposing draconian fiscal and monetary “conditionalities” on all debtor nations everywhere in the decade after the Cold War, is nowhere to be seen on the scene in the world’s most fragrantly irresponsible debtor nation.  This is because the US can print dollars at will and with immunity.  The dollar is a fiat currency not backed by gold, not backed by US productivity, not back by US export prowess, but by US military power.  The US military budget request for Fiscal Year 2005 was $420.7 billion. For Fiscal Year 2004, it was $399.1 billion; for 2003, $396.1 billion; for 2002, $343.2 billion and for 2001, $310 billion.  In the first term of the Bush presidency, the US spent $1.5 trillion on its military.  That is bigger than the entire GDP of China in 2004. The US trade deficit is around 6% of its GDP while it military budget is around 4%.  In other words, the trading partners of the US are paying for one and a half times of the cost of a military that can someday be used against any one of them for any number of reasons, including trade disputes.  The anti-dollar crowd has nothing to celebrate about the recurring US trade deficit.

Normally, according to free trade theory, trade can only stay unbalanced temporarily before equilibrium is re-established or free trade would simply stop. When bilateral trade is temporarily unbalanced, it is generally because one trade partner has become temporarily uncompetitive, inefficient or unproductive. The partner with the trade deficit receives more goods and services from the partner with the trade surplus than it can offer in return and thus pays the difference with its currency that someday can buy goods produced by the deficit trade partner to re-established balance of payments.  This temporary trade imbalance is due to a number of socio-economic factors, such as terms of trade, wage levels, return on investment, regulatory regimes, shortages in labor or material or energy, trade-supporting infrastructure adequacy, purchasing power disparity, etc.  A trading partner that runs a recurring trade deficit earns the reputation of being what banks call a habitual borrower, i.e. a bad credit risk, one who habitually lives beyond his/her means. If the trade deficit is paid with its currency, a downward pressure results in the exchange rate. A flexible exchange rate seeks to remove or moderate a temporary trade imbalance while the productivity disparities between trading partners are being addressed fundamentally.

Dollar hegemony prevents US trade imbalance from returning to equilibrium through market forces. It allows a US trade deficit to persist based on monetary prowess. This translates over time into a falling exchange rate for the dollar even as dollar hegemony keeps the fall at a slow pace. But a below-par exchange rate over a long period can run the risk of turning the temporary imbalance in productivity into a permanent one.  A continuously weakening currency condemns the issuing economy into a downward economic spiral. This has happened to the US in the last decade. To make matters worse, with globalization of deregulated markets, the recurring US trade deficit is accompanied by an escalating loss of jobs in sectors sensitive to cross-border wage arbitrage, with the job-loss escalation climbing up the skill ladder.  Discriminatory US immigration policies also prevent the retention of low-paying jobs within the US and exacerbate the illegal immigration problem.

Regional wage arbitrage within the US in past decades kept the US economy lean and productive internationally.  Labor-intensive US industries relocated to the low-wage South through regional wage arbitrage and despite temporary adjustment pains from the loss of textile mills, the Northern economies managed to upgrade their productivity, technology level, financial sophistication and output quality. The Southern economies in the US also managed to upgrade these factors of production and in time managed to narrow the wage disparity within the national economy. This happened because the jobs stay within the nation.

With globalization, it is another story.  Jobs are leaving the nation mercilessly. According to free trade theory, the US trade deficit is supposed to cause the dollar to fall temporarily against the currencies of its trading partners, causing export competitiveness to rebalance to remove or reduce the US trade deficit or face the collapse of its currency.  Either case, jobs that have been lost temporarily are then supposed to return to the US.

But the persistent US trade deficit defies trade theory because of dollar hegemony. The current international finance architecture is based on dollar hegemony which is the peculiar arrangement in which the US dollar, a fiat currency, remains as the dominant reserve currency for international trade. The broad trade-weighted dollar index stays in an upward trend, despite selective appreciation of some strong currencies, as highly-indebted emerging market economies attempt to extricate themselves from dollar-denominated debt through the devaluation of their currencies. While the aim is to subsidize exports, it ironically makes dollar debts more expensive in local currency terms. The moderating impact on US price inflation also amplifies the upward trend of the trade-weighted dollar index despite persistent US expansion of monetary aggregates, also known as monetary easing or money printing. 

Adjusting for this debt-driven increase in the exchange value of dollars, the import volume into the US can be estimated in relationship to expanding monetary aggregates. The annual growth of the volume of goods shipped to the US has remained around 15% for most of the 1990s, more than 5 times the average annual GDP growth. The US enjoyed a booming economy when the dollar was gaining ground, and this occurred at a time when interest rates in the US were higher than those in its creditor nations. This led to the odd effect that raising US interest rates actually prolonged the boom in the US rather than threatened it, because it caused massive inflows of liquidity into the US financial system, lowered import price inflation, increased apparent productivity and prompted further spending by US consumers enriched by the wealth effect despite a slowing of wage increases.  Returns on dollar assets stayed high in foreign currency terms.

This was precisely what Federal Reserve Board chairman Alan Greenspan did in the 1990s in the name of pre-emptive measures against inflation. Dollar hegemony enabled the US to print money to fight inflation, causing a debt bubble of asset appreciation. This data substantiated the view of the US as Rome in a New Roman Empire with an unending stream of imports as the free tribune from conquered lands. This was what Greenspan meant by US “financial hegemony.”

The Fed Funds rate (ffr) target has been lifted eight times in steps of 25 basis points from 1% in mid 2004 to 3% on May 3, 2005.  If the same pattern of “measured pace” continues, the ffr target would be at 4.25% by the end of 2005. Despite Fed rhetoric, the lifting of dollar interest rate has more to do with preventing foreign central banks from selling dollar-denominated assets, such as US Treasuries, than with fighting inflation.  In a debt-driven economy, high interest rates are themselves inflationary.  Rising interest rate to fight inflation could become the monetary dog chasing its own interest rate tail, with rising rate adding to rising inflation which then requires more interest rate hikes. Still, interest rate policy is a double edged sword: it keeps funds from leaving the debt bubble, but it can also puncture the debt bubble by making the servicing of debt prohibitively expensive.

To prevent this last adverse effect, the Fed adds to the money supply, creating an unnatural condition of abundant liquidity with rising short-term interest rate, resulting in a narrowing of interest spread between short-term and long-term debts, a leading indication for inevitable recession down the road.  The problem of adding to the money supply is what Keynes called the liquidity trap, that is, an absolute preference for liquidity even at near zero interest-rate levels. Keynes argued that either a liquidity trap or interest-insensitive investment draught could render monetary expansion ineffective in a recession. It is what is popularly called pushing on a credit string, where ample money cannot find credit-worthy willing borrowers.  Much of the new low cost money tends to go to refinancing of existing debt take out at previously higher interest rates. Rising short-term interest rates, particularly at a measured pace, would not remove the liquidity trap when long term rates stay flat because of excess liquidity.

The debt bubble in the US is clearly having problems, as evident in the bond market. With just 14 deals worth $2.9 billion, May 2005 was the slowest month for high-yield bond issuance since October 2002. The late-April downgrades of the debt of General Motors and Ford Motor to junk status roiled the bond markets. The number of high-yield, or junk bond deals fell 55% in the March-to-May 2005 period, compared with the same three months in 2004. They were also down 45% from the December-through-February period. In dollar value, junk bond deals totaled $17.6 billion in the March-to-May 2005 period, compared with $39.5 billion during the same three months in 2004 and $36 billion from December through February 2005.  There were 407 deals of investment-grade bond underwriting during the March-to-May 2005 period, compared with 522 in the same period 2004 - a decline of 22%. In dollar volume, some $153.9 billion of high-grade bonds were underwritten from March to May 2005, compared with $165.5 billion in the same period in 2004 - a 7% decline. Oil at $50, along with astronomical asset price appreciation, particularly in real estate, is giving the debt bubble additional borrowed time. But this game cannot go on forever and the end will likely be triggered by a new trade war’s effect on reduced trade volume.  The price of a reduced US trade deficit is the bursting of the US debt bubble which can plunge the world economy into a new depression.  Given such options, the US has no choice except to ride the trade deficit train for as long as the traffic will bear, which may not be too long, particularly if protectionism begins to gather force.

The transition to offshore outsourced production has been the source of the productivity boom of the “New Economy” in the US in the last decade. The productivity increase not attributable to the importing of other nations’ productivity is much less impressive. While published government figures of the productivity index show a rise of nearly 70% since 1974, the actual rise is between zero and 10% in many sectors if the effect of imports is removed from the equation. The lower productivity values are consistent with the real-life experience of members of the blue-collar working class and the white collar middle class who have been spending the equity cash-outs from the appreciated market value of their homes. World trade has become a network of cross-border arbitrage on differentials in labor availability, wages, interest rates, exchange rates, prices, saving rates, productive capacities, liquidity conditions and debt levels. In some of these areas, the US is becoming an underdeveloped economy.

The Bush Administration repeatedly assured the public that the state of the economy was sound while in reality the US had been losing entire sectors of its economy, such as manufacturing and information technology, to foreign producers, while at the same time selling off the part of the nation to finance its rising and unending trade deficit. Usually, when unjustified confidence crosses over to fantasized hubris on the part of policymakers, disaster is not far ahead.

To be fair, the problems of the US economy started before the second Bush Administration. The Clinton Administration’s annual economic report for 2000 claimed that the longest economic expansion in US history could continue “indefinitely” as long as “we stick to sound policy”, according to Chairman Martin Baily of the Council of Economic Advisors (CEA) as reported in the Wall Street Journal.  The New York Times report differed somewhat by quoting Baily as saying: “stick to fiscal policy.”  Putting the two newspaper reports together, one got the sense that the Clinton Administration thought that its fiscal policy was the sound policy needed to put an end to the business cycle. Economics high priests in government, unlike the rest of us mortals who are unfortunate enough to have to float in the daily turbulence of the market, can afford to aloofly focus on long-term trends and their structural congruence to macro-economic theories. Yet, outside of macro-economics, long-term is increasingly being re-defined in the real world.  In the technology and communication sectors, long-term evokes periods lasting less than 5 years.  For hedge funds and quant shops, long-term can mean a matter of weeks.

Two factors were identified by the Clinton CEA Year 2000 economic report as contributing to the “good” news:  technology-driven productivity and neo-liberal trade globalization. Even with somewhat slower productivity and spending growth, the CEA believed the economy could continue to expand perpetually. As for the huge and growing trade deficit, the CEA expected global recovery to boost demand for US exports, not withstanding the fact that most US exports are increasingly composed of imported parts. Yet the US has long officially pursued a strong dollar policy which weakens world demand for US exports.

Schumpeter’s creative destruction theory, while revitalizing the macro-economy with technological obsolescence in the long run, leaves real corporate bodies in its path, not just obsolete theoretical concepts.  Financial intermediaries and stock exchanges face challenges from Electronic Communication Networks (ECNs) which may well turn the likes of NYSE into sunset industries.  ECNs are electronic marketplaces which bring buy/sell orders together and match them in virtual space. Today, ECNs handle roughly 25% of the volume in NASDAQ stocks.  The NYSE and the Archipelago Exchange (ArcaEx) announced on April 20, 2005 that they have entered a definitive merger agreement that will lead to a combined entity, NYSE Group, Inc., becoming a publicly-held company.  If approved by regulators, NYSE members and Archipelago shareholders, the merger will represent the largest-ever among securities exchanges and combine the world’s leading equities market with the most successful totally open, fully electronic exchange. Through Archipelago, the NYSE will compete for the first time in the trading of NASDAQ-listed stocks; it will be able to indirectly capture listings business that otherwise would not qualify to list on the NYSE. Archipelago lists stocks of companies that do not meet the NYSE’s listing standards.

On fiscal policy, US government spending, including social programs and defense, declined as a share of the economy during the eight years of the Clinton watch.  This in no small way contributed to a polarization of both income and wealth, with visible distortions in both the demand and supply sides of the economy.  This was the opposite of the FDR record of increasing income and wealth equality by policy. The wealth effect tied to bloated equity and real estate markets could reverse suddenly and did in 2000, bailed out only by the Bush tax cut and the deficit spending on the War on Terrorism after 2001.  Private debt kept making all time highs throughout the 1990s and was celebrated by neo-liberal economists as a positive factor.  Household spending was heavily based on expected rising future earnings or paper profits, both of which might and did vanished on short notice.  By election time in November 1999, the Clinton economic miracle was fizzling.  The business cycle had not ended after all, and certainly not by self-aggrandizing government policies.  It merely got postponed for a more severe crash later.  The idea of ending the business cycle in a market economy was as much a fantasy as Vice President Cheney’s assertion in a speech before the Veterans of Foreign Wars in August 26, 2002 that “the Middle East expert Professor Fouad Ajami predicts that after liberation, the streets in Basra and Baghdad are sure to erupt in joy ….”

Clinton-Gore Defaulted on Campaign Promises to Equalilize wealth Distribution

In their 1991 populist campaign for the White House, Bill Clinton and Al Gore repeatedly pointed out the obscenity of the top 1% of Americans owning 40% of the country’s wealth. They also said that if you eliminated home ownership and only counted businesses, factories and offices, then the top 1% owned 90% of all commercial wealth. And the top 10%, they said, owned 99%. It was a situation they pledged to change if elected. But once in office, Clinton and Gore did nothing to redistribute wealth more equally - despite the fact that their two terms in office spanned the economic joyride of the 1990s that would eventually hurt the poor much more severely than the rich. On the contrary, economic inequality only continued to grow under the Democrats.  Reagan spread the national debt equally among the people while Clinton gave all the wealth to the rich.

Geopolitically, trade globalization was beginning to face complex resistance worldwide by the second term of the Clinton presidency.  The momentum of resistance after Clinton would either slow further globalization or force the terms of trade to be revised. The Asian financial crises of 1997 revived economic nationalism around the world against US-led neo-liberal globalization, while the North Atlantic Treaty Organization (NATO) attack on Yugoslavia in 1999 revived militarism in the EU. Market fundamentalism as espoused by the US, far from being a valid science universally, was increasingly viewed by the rest of the world as merely US national ideology, unsupported even by US historical conditions. Just as anti-Napoleonic internationalism was essentially anti-French, anti-globalization and anti-moral-imperialism are essentially anti-US. US unilateralism and exceptionism became the midwife for a new revival of political and economic nationalism everywhere. The Bush Doctrine of monopolistic nuclear posture, pre-emptive wars, “either with us or against us” extremism, and no compromise with states that allegedly support terrorism, pours gasoline on the smoldering fire of defensive nationalism everywhere.

Greenspan celebrates global financial crisis as having salutary effect” on the US

Alan Greenspan in his October 29, 1997 Congressional testimony on Turbulence in World Financial Markets before the Joint Economic Committee said that “it is quite conceivable that a few years hence we will look back at this episode [Asian financial crisis of 1997]…. as a salutary event in terms of its implications for the macro-economy.”  When one is focused only on the big picture, details do not make much of a difference: the earth always appears more or less round from space, despite that some people on it spend their whole lives starving and cities get destroyed by war or natural disasters. That is the problem with macroeconomics.  As Greenspan spoke, many around the world were waking up to the realization that the turbulence in their own financial markets was viewed by the US central banker as having a “salutary effect” on the US macro-economy.  Greenspan gave anti-US sentiments and monetary trade protectionism held by participants in these financial markets a solid basis and they were no longer accused of being mere paranoia.

Ironically, after the end of the Cold War, market capitalism has emerged as the most fervent force for revolutionary change.  Finance capitalism became inherently democratic once the bulk of capital began to come from the pension assets of workers, despite widening income and wealth disparity. The monetary value of US pension funds is over $15 trillion, the bulk of which belong to average workers. A new form of social capitalism has emerged which would gladly eliminate the worker’s job in order to give him/her a higher return on his/her pension account. The capitalist in the individual is exploiting the worker in same individual. A conflict of interest arises between a worker’s savings and his/her earnings. As Pogo used to say: “The enemy: they are us.”  This social capitalism, by favoring return on capital over compensation for labor, produces overinvestment, resulting in overcapacity. But the problem of overcapacity can only be solved by high income consumers. Unemployment and underemployment in an economy of overcapacity decrease demand, leading to financial collapse. The world economy needs low wages the way the cattle business need foot and mouth disease.

The nomenclature of neo-classical economics reflects, and in turn dictates, the warped logic of the economic system it produces. Terms such as money, capital, labor, debt, interest, profits, employment, market, etc, have been conceptualized to describe synthetic components of an artificial material system created by the power politics of greed. It is the capitalist greed in the worker that causes the loss of his/her job to lower wage earners overseas. The concept of the economic man who presumably always acts in his self-interest is a gross abstraction based on the flawed assumption of market participants acting with perfect and equal information and clear understanding of the implication of his actions. The pervasive use of these terms over time disguises the artificial system as the logical product of natural laws, rather than the conceptual components of the power politics of greed.

Just as monarchism first emerged as a progressive force against feudalism by rationalizing itself as a natural law of politics and eventually brought about its own demise by betraying its progressive mandate, social capitalism today places return on capital above not only the worker but also the welfare of the owner of capital. The class struggle has been internalized within each worker. As people facing the hard choice of survival in the present versus wellbeing in the future, they will always choose survival, social capitalism will inevitably go the way of absolute monarchism, and make way for humanist socialism. 

SPV to Skirt Basel II Capital Requirements
 In a May 14, 2002 AToL article: The BIS vs National Banks, I warned about Special Purpose Vehicles (SPV) five years before the credit crisis broke out in July 2007:

“While Third World banks that do not meet BIS capital requirements are frozen from the global interbank funds, BIS rules have been eroded by so-called large, complex banking organizations (LCBOs) in advanced economies through capital arbitrage, which refers to strategies that reduce a bank’s regulatory capital requirements without a commensurate reduction in the bank’s risk exposures. One example of such arbitrage is the sale, or other shift-off, from the balance sheet, of assets with economic capital allocations below regulatory capital requirements, and the retention of those for which regulatory requirements are less than the economic capital burden.
“Aggregate regulatory capital thus ends up being lower than the economic risks require; and although regulatory capital ratios rise, they are in effect merely meaningless statistical artifacts. Risks never disappear; they are always passed on. LCBOs in effect pass their unaccounted-for risks onto the global financial system. Thus the fierce opponents of socialism have become the deft operators in the socialization of risk while retaining profits from such risk socialization in private hands.

“Set for 2004, implementation of the new Basel II Capital Accord is meant to respond to such regulatory erosion by LCBOs. “Synthetic securitization” refers to structured transactions in which banks use credit derivatives to transfer the credit risk of a specified pool of assets to third parties, such as insurance companies, other banks, and unregulated entities, known as Special Purpose Vehicles (SPV), used widely by the likes of Enron and GE. The transfer may be either funded, for example, by issuing credit-linked securities in tranches with various seniorities (collateralized loan obligations or CLOs) or unfunded, for example, using credit default swaps. Synthetic securitization can replicate the economic risk transfer characteristics of securitization without removing assets from the originating bank’s balance sheet or recorded banking book exposures.
“Synthetic securitization may also be used more flexibly than traditional securitization. For example, to transfer the junior (first and second loss) element of credit risk and retain a senior tranche; to embed extra features such as leverage or foreign currency payouts; and to package for sale the credit risk of a portfolio (or reference portfolio) not originated by the bank. Banks may also exchange the credit risk on parts of their portfolios bilaterally without any issuance of rated notes to the market.”

Central Bank uses SPV to Hide Expansion of Balance Sheet

The Treasury's Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008 would finance the first $20 billion of troubles assets purchases by buying distressed debt in the NY Fed’s SPV. If more than $20 billion in assets are bought by the SPV through TALF, the NY Fed will lend the additional money to the SPV. Since a loan is treated in accounting as an asset, the NY Fed, by providing the funds to buy distress debt, actually expands it balance sheet positively while its SPV assumes more liability.

Troubled Assets Relief Program (TARP)

TARP allows the US Treasury to purchase or insure up to $700 billion of  “troubled assets”, defined as:
A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and
B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.”

TARP allows the Treasury to purchase illiquid, difficult-to-value assets at full face value from banks and other financial institutions. The targeted assets can be collateralized debt obligations (CDO), which were sold in a booming market until July 2007, when they were hit by widespread foreclosures on the underlying loans.

TARP is intended to restore liquidity of these assets in a failed market with no other buyers, by purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses.

TARP does not allow banks to recoup losses already incurred on troubled assets, but Treasury officials expect that once trading of these assets resumes, their prices will stabilize and ultimately increase in value, resulting in gains to both participating banks and the Treasury itself. The concept of future gains from troubled assets comes from the hypothesis in the financial industry that these assets are oversold, as only a small percentage of all mortgages are in default, while the relative fall in prices represents losses from a much higher default rate.  Yet the low default rate was not produced by economic conditions, but by the Fed’s financial manipulation. Thus the banks are saved, but not the economy as a whole, which ultimately still has to pay off the undistinguished debt.

The Emergency Economic Stabilization Act of 2008 (EESA) requires financial institutions selling assets to TARP to issue equity warrants (a type of security that entitles, but without the obligation, its holder to purchase shares in the company issuing the security for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock.

This measure is supposedly designed to protect taxpayers by giving the Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their former strength, the government will also be able to profit from their recovery.

Another important goal of TARP is to encourage banks to resume lending again at levels seen before the crisis, both to each other and to consumers and businesses. If TARP can stabilize bank capital ratios, it should theoretically allow them to increase lending instead of hoarding cash to cushion against future unforeseen losses from troubled assets.

The Fed argues that increased lending equates to “loosening” of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets. As banks gain increased lending confidence, the interbank lending interest rates (the rates at which the banks lend to each other on a short term basis) should decrease, further facilitating lending. So far, this goal has not been achieved as bank merely used TARP money to deleverage rather than increase lending.

TARP will operate as a “revolving purchase facility”. The Treasury will have a set spending limit, $250 billion at the start of the program, with which it will purchase the assets and then either sell them or hold the assets and collect the “coupons”. The money received from sales and coupons will go back into the pool, facilitating the purchase of more assets.

The initial $250 billion can be increased to $350 billion upon the president's certification to Congress that such an increase is necessary. The remaining $350 billion may be released to the Treasury upon a written report to Congress from the Treasury with details of its plan for the money. Congress then has 15 days to vote to disapprove the increase before the money will be automatically released. The first $350 billion was released on October 3, 2008, and Congress voted to approve the release of the second $350 billion on January 15, 2009.

One way that TARP money is being spent is to support the “Making Homes Affordable” plan, which was implemented on March 4, 2009, using TARP money by the Treasury. Because “at risk” mortgages are defined as “troubled assets” under TARP, the Treasury has the power to implement the plan. Generally, it provides refinancing for mortgages held by Fannie Mae or Freddie Mac. Privately held mortgages will be eligible for other incentives, including a favorable loan modification for five years.

The authority of the Treasury to establish and manage TARP under a newly created Office of Financial Stability (OFS) became law October 3, 2008, the result of an initial proposal that ultimately was passed by Congress as H.R. 1424, enacting the Emergency Economic Stabilization Act of 2008 and several other related acts.

Collateral assets accepted by TARP include dollar-denominated cash ABS with a long-term credit rating in the highest investment-grade rating category from two or more major “nationally recognized statistical rating organizations (NRSROs)” and do not have a long-term credit rating below the highest investment-grade rating category from a major NRSRO. Synthetic ABS (credit-default swaps on ABS) do not qualify as eligible collateral. The program was launched on March 3, 2009.

Zero Interest Rate and Quantitative Easing

As interest rates cannot go below zero, central banks are forced to resort to quantitative easing to inject money into the financial system which allows insolvent financial institutions to deny the disastrous reality of insolvency from the collapse of the market value of collaterals to pretend that the global financial market is merely facing a temporary liquidity problem and that massive liquidity injection from the central bank would allow an orderly restructuring of the massive overhanging distressed private debt by shifting it to the public sector with no borrower defaults and therefore no “haircuts” for exposed creditors.

The price for this strategy of short-term crisis resolution of excessive private sector debt by increasing public sector debt is the long-term stagnation of the global economy. This is because private sector deleveraging with public sector money drains economic vitality that will take a long time to work through. 

The Cure Worse than the Disease

It is now becoming clear that notwithstanding the Fed’s assertion that its bailouts prevented a systemic melt down of global financial markets, the cure of saving the banking sector at the expense of the economy is looking more like a cure worse than the disease. A faster recovery might have been the net bonus if the banks were left to go belly up on their own.

As it happened, the panic rescue by central banks left the global economy a fate of a lost decade. This is critical because economic recovery and the existing international financial architecture depends on a high rate of growth. And three years after the outbreak of the global financial crisis that began in mid July 2007, the global economy is still plagued by high unemployment and stagnation despite massive amount of liquidity injection by center banks.

Sovereign Debt Denominated in Foreign Currency

To make matters worse, all trading economies, particularly the exporting emerging market economies, that denominate their debts in one of the two prime reserve currencies for international trade, such as the dollar and the euro, will find critically needed counter cyclical monetary measures unavailable to their governments because their central banks cannot issue dollars or euros, thus have to earn more dollars or euros from the global trading system at a time when the global economy has been condemned to suffer demand deficit with a decade of economic decline engineered by central bank monetary measures to save the banking sector in the advanced economies. These emerging economies also cannot borrow more dollars or euros from global capital and debt markets because their credit ratings are being cut by suddenly less-permissive credit rating agencies. They invariably become financial wards of the stronger economies and prisoners of the International Monetary Fund (IMF) conditionalities.

A Complex Rescue Plan for Europe with a Special Purpose Vehicle

A European official told CNBC on the sideline of the IMF meeting in Washington on Saturday, September 17, 2011 that the EU is working on a detailed plan aimed at shoring up the stability of European banks.

The plan appears to involve a complex flow of funds. It would involve money from the European Financial Stability Facility (EFSF), a bailout vehicle created in 2010 to alleviate the sovereign debt crisis in Europe, to capitalize a special purpose vehicle (SPV) that would be created by the European Investment Bank (EIB), the European Union’s finance institution. EFSF shareholders are the 27 member states of the EU, which have jointly subscribed its capital. The Board of Governors of the EIB is composed of the finance ministers of these 27 member states.

The role of the EIB in this plan is to provide long-term financing in support of investment projects. The SPV serves the purpose of isolating the parent (EIB) from financial risk of the plan, a device commonly used in complex financing to separate different layers of equity infusion.

The EIB’s SPV would issue bonds to investors and use the proceeds to purchase sovereign debt of distressed eurozone member states from their state central banks. The hope is that this would alleviate the pressure on the financially distressed member states and on the eurozone banks (primarily French and German banks) that hold a lot of the distressed sovereign debt. The bonds issued by EIB’s SPV could then be used by the EIB as collateral for borrowing from the European Central Bank (ECB), allowing the member state central banks to make loans to commercial banks faced with liquidity shortages.

Banks loaded down with distressed eurozone sovereign debt would be able to sell the debt to the EIB’s SPV financed by the ECB with the distressed sovereign debts as collaterals at full face value so that eurozone commercial banks can access the liquidity facilities of the ECB.

Although the structure is complex, the underlying objective is relatively simple. Banks would essentially be allowed to exchange their distressed sovereign debt at face value for debt issued by a special purpose vehicle created by the EIB capitalized with funds from the EFSF.

In some ways, this resembles the original plan for the Troubled Asset Relief Program (TARP) used by the Federal Reserve on 2008. As originally conceived, the TARP would have purchased “toxic securities” from banks. (This plan was abandoned when U.S. regulators concluded that it was too difficult to price the securities and that the plan would take too long to implement.) In the European case, the “toxic securities” would be distressed sovereign debt rather than securitized mortgage bonds.

Plan to Stabilize Banks Holding Eurozone Sovereign Debt

Over the weekend of September 17, finance leaders from around the world met in the annual IFM/World Bank conference in Washington to discuss the global economic state of affairs. At this meeting European finance ministers said that they would take bolder steps to fight the sovereign debt crisis, which is plaguing recovery of the global economy.

A focal point for the European officials is the stabilization European commercial banks, which have been under a heavy market pressure. European commercial banks, particularly French and German banks, hold significant amounts of sovereign debt from the peripheral eurozone member states, know as PIIGS (Portugal, Italy, Ireland, Greece and Spain). Concern over Greek sovereign default is threatening a European banking crisis.

European TARP

Suggestions have surface for Europe to deal with this possible banking crisis by creating a plan similar to that of the US TARP program of 2008, following the collapse of the US housing market and the bankruptcy of Lehman Brothers, “Troubled Asset Relief Program” (TARP) was created by the US government to strengthen financial institutions. Under TARP $700 billion of capital was injected into US banks.

For a Euro TARP, it is estimated that at least $202 billion of capital will need to be injected into the European Financial Stability Facility (EFSF) to purchase distressed sovereign debt from the European commercial banks. The hope is that this would alleviate the pressure on the peripheral European member states and on the European commercial banks.

Still Higher Leverage as Cure for High Leverage

One question is what the JP Morgan Cazenove approach would mean for the balance sheet of the EFSF, which already carries committed emergency loans to Ireland, Portugal and Greece. It is expected to provide over €100 billion ($134.9 billion) in additional funding for a Greek bailout. After committed loans, the Fed’s war chest will be down to about €298 billion ($402 billion). German Finance Minister Wolfing Schaeuble said on Monday, September 19, that there is no plan to expand the EFSF.

This plan will catapult the EFSF into the category of a highly leveraged fund, which borrows more than its equity capital provided by EU member governments. No official plans have been released. Details of the structure will change as European policymakers fight over the best course of action from the perspective of their different national interest.

Many of the proposed options to expand further the €440 billion ($596 billion) European Financial Stability Facility (EFSF) have problems, including opposition from countries like Germany, which fears a replay of its disastrous inflationary monetary policies of the 1920s during the Weimar Republic.

Meanwhile, euro zone officials played down rumor on Monday, September 19, of emerging plans to cut by half Greece’s sovereign debts and to recapitalize European banks to cope with the fallout, stressing that no such scheme is on the table yet.

Rough calculations suggest the EFSF, which borrows its funds from credit markets backed by guarantees from eurozone member states, might cope with a bailout of Spain but that it would not have enough financial power if Italy needed help.

The EFSF is already committed to providing €17.7 billion ($24 billion) in emergency loans to Ireland and €26 billion ($35.3 billion) to Portugal.

In addition, the EFSF takes over the remainder of Europe’s contribution to an initial bailout of Greece, which is likely to require around €25 billion ($34 billion), and is expected to provide two-thirds of a €109 billion ($147.7 billion) second bailout of Greece.

Taken together, the EFSF’s current commitments total at least €142 billion ($193 billion), leaving it €298 billion ($405 billion). A package for Spain might top €290 billion ($395 billion), while a rescue bill for Italy could total almost €490 billion ($666 billion).

If Greece defaults on its sovereign debt, contagion will spread to cause sovereign defaults by all the other PIIGS governments and a massive failure in financial markets world wide.

Some suggest doubling the funding of EFSF, while others talk of boosting it to “several trillion”. But the way to restore confidence, which will be determined by the reaction of already stressed markets, goes beyond simple mathematics.

Greece only a Detonator of European Sovereign Debt Bomb

The sovereign debt default haunting Europe has its detonator in Greece, one of the smallest yet most heavily indebted economies in Europe. Greece, while not a poor country, desperately needs a next aid payment of $11 billion to avoid running out of cash within weeks, but negotiations between the Greek government and the “troika” of the European Union, European Central Bank, and International Monetary Fund have stalled. The problem is no one believes that the next payment of $11 billion will by itself solve Greece’s sovereign debt problem. Considered unthinkable not too long ago, a Greek default now seems imminent — a subsequent exit from the eurozone no longer improbable.

Orderly Default Option

Talks of a potential “orderly default” of Greek sovereign debt have emerged, even suggestions of a Greek exit from the eurozone as a possible scenario. Time is running out for continuing indecision and denial. In the end, the governments of the stronger economies, such as Germany and France, will have to step up to the plate, as their economies had the most to lose from a wave of falling dominos of sovereign debt default in the eurozone.

French and German Responsibility

In many ways, France and Germany were responsible for the sad state of affair facing eurozone governments today. Financial stability in the eurozone had been guaranteed by the euro convergence criteria as spelled out in the Stability and Growth Pact (SGP) are:
1. Inflation rates:
No more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) member states of the EU.
2. Government finance:
Annual government fiscal deficit:
The ratio of the annual government fiscal deficit to GDP must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
Government debt:
The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
3. Exchange rate:
Applicant countries should have joined the exchange rate mechanism (ERM II) under the European Monetary System (EMS) for two consecutive years and should not have devaluated its currency during the period.
4. Long-term interest rates:
The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.

Had these criteria set by the Stability and Growth Pact (SGP) been observed, it is unlikely that eurozone governments would face any sovereign debt crisis today. Ironically, the watering down of the SGP, which led to the current sovereign debt crisis in the eurozone, had been at the request of Germany and France, two of the strongest of the then 16 eurozone member states. Eurozone financial markets had been imitating the rush to phantom wealth creation through synthetic structured finance and debt securitization invented by fearless young traders in New York and London working with money provided by loose monetary measures of all central banks led the Federal Reserve.

In March 2005, the EU’s Economic and Financial Affairs Council (ECOFIN), under the pressure of France and Germany, relaxed SPG rules to respond to criticisms of insufficient flexibility and to make the pact more enforceable. Permissiveness infested the European theoretical regulatory framework, following the US example.

ECOFIN, one of the oldest configurations of the Council of the European Union, is composed of the Economic and Finance Ministers of the 27 European Union member states, as well as Fiscal Budget Ministers when budgetary issues are discussed.

The EU Council covers a number of EU policy areas, such as economic policy coordination, economic surveillance, monitoring of member state budgetary policies and public finances, the shape of the euro (legal, practical and international aspects), financial markets and capital movements and economic relations with third countries. It also prepares and adopts every year, together with the European Parliament, the budget of the European Union which is about €100 billion ($136 billion).

The Council meets once a month and makes decisions mainly by qualified majority, in consultation or co-decision with the European Parliament, with the exception of fiscal matters which are decided by unanimity. When the ECOFIN examines dossiers related to the euro and EMU, the representatives of the member states whose currency is not the euro do not take part in the vote of the Council.

At the urging of Germany and France, the ECONFIN agreed on a reform of the SGP. The ceilings of 3% for budget deficit and 60% for public debt were maintained, but the decision to declare a country in excessive deficit can now rely on certain new parameters: the behavior of the cyclically adjusted budget, the level of debt, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures. The pact is part of a set of Council Regulations, decided upon the European Council Summit 22-23 March 2005.

Greece a Victim of Structured Finance

Greece fell into the euro debt trap by yielding to the temptation of structured finance, the instruments of which were first developed in the US and adopted by US transnational financial institutions such as Goldman Sachs, Citibank, JPMorgan Chase and Bank of America to generate phenomenal profit for them in deregulated global markets fueled by floods of dollar-denominated liquidity release by the Federal Reserve, the US central bank, through the virtual transaction of synthetic derivatives known as synthetic collateralized debt obligations (CDO).

This new game of phantom wealth creation was soon joined by copycats in Europe such as Barclay, Société Générale, Deutsche Bank and ING. Such synthetic instruments were designed to, among other things, help banks hide their liabilities by pushing them off their balance sheets and thus lowering their capital requirement to increase profit from expanded loan-making to yield higher return on capital.  (Please see my May 9, 2007 AToL article: Liquidity Boom and Looming Crisis, written and published two months before the credit crisis first imploded in New York in July 2007.)

Later, expanding from the private sector, such schemes were sold to EMU member governments to help them mask their true public debt levels to skirt strict EMU rules, in order to engage in permanent monetary easing. Across the eurozone, in obscure and opaque over-the-counter (OTC) derivative deals that traded directly between counterparties off exchanges between “special purpose vehicles” (SPV), and designed to help governments legally skirt EMU criteria, transnational banks provided Eurozone governments with cash upfront in return for future payments by government. Such payments would reduce government fiscal revenue since the revenue from collateral assets has been pledged to investors of CDOs.

The liabilities were taken off their national balance sheets to present a healthy picture of national finance, until the government is forced to make up the revenue shortfall in a recession. Thus it is hypocrisy of the extreme for Germany to hold Greece hostage with demand of severe fiscal austerity that will lead to socio-political instability, by asserting disingenuously that Germans work harder than Greeks, and that the German government is fiscally more responsible than the Greek government, and that Greece cannot expect German taxpayers to bail out Greece from a decade of poor public finance, made possible by German influence on diluting the criteria of the SPG.

Goldman Doing God’s Work Again

Wall Street is directly responsible for Greece’s public finance predicament. In 2005, Goldman Sachs, doing what its chairman told Congress as “God’s work”, sold interest rate swaps it created to the National Bank of Greece (NBG), the country’s largest bank. In 2008, Goldman Sachs helped NGB put the swap denominated in euros into a legal special purpose vehicle (SPV) called Titlos. National then retained the bonds that Titlos issued as collateral to borrow even more euros from the European Central Bank (ECB) and in turn from international banks. The swap will be costly and unprofitable for the Greek government through its long contract term, while Goodman profited handsome in fees up front.

Appropriately, in Greek manuscripts, the titlo was often used to mark the place where a scribe accidentally skipped the letter, if there was no space to draw the missed letter above. SPV Titlos performed the special purpose of skipping the sovereign liability Greece had assumed in order to get more loans from the ECB and international banks than was permitted under SPG criteria. Such SPV deals were not made public even though Titlos obligations are among the weak links in Greek public finance in 2010. Information on them finally trickled out only through government investigations and media investigative reporting.

Der Spiegel reported in early January 2010 that Goldman Sachs two years earlier had helped the government of Greece cover up part of its huge fiscal deficit via a currency swap deal name Titlos, which used artificially high exchange rates. A report commissioned by the Greek Finance Ministry released on February 1, 2010, revealed that Greece had used swaps to defer interest repayments by several years.

On February 15, 2010, Bloomberg reported a Greek government inquiry uncovered a series of swaps agreements with securities firms that allowed it to mask its growing public debts. The document did not identify the securities firms Greece used. But the former head of Greece’s Public Debt Management Agency told Bloomberg that the government turned to Goldman Sachs in 2002 to obtain $1 billion through a swap agreement.
Part XII: Financial Globalization and Recurring Financial Crises
Part XI: Comparing Eurozone Membership to Dollarization of Argentina
Part X: The Trillion Dollar Failure
Part IX: Effect of the Greek Crisis on German Domestic Politics
Part VIII: Greek Tragedy
Part VII: Global Sovereign Debt Crisis
Part VI: Public Debt and Other Issues
Part V: Public Debt, Fiscal Deficit and Sovereign Insolvency
In these articles, I warned against the danger of SPVs that would eventual put Greece into a disastrous sovereign debt crisis.)

Political Hurdles

The fundamental decisions over the future of the European monetary union will be politically difficult, and they will be costly for the richer economies. The costs of not acting decisively now, however, are going to be even higher. The urgency in bailing out Greece is the contagion on Spain and Italy should Greece defaults, and through these economies to the US and Asia.

This fact is validated by the blunt warning from US Treasury Secretary Timothy Geithner on Friday, September 16  to eurozone finance ministers at a closed meeting of in Wroclaw, Poland. Geithner told the Europeans to stop political bickering and take control of the financial aspects of the debt crisis that has brought “catastrophic risk” to global financial markets.

Geithner Warns Europe

Mr. Geithner reportedly said on the sideline of the ministerial meeting: “What’s very damaging is not just seeing the divisiveness in the debate over strategy in Europe but the ongoing conflict between countries and the [European] central bank”, adding that “governments and central banks need to take out the catastrophic risk to markets.”

Geithner’s presence at the meeting of EU financial ministers underlined the concerned of the US government about the danger of financial contagion from the eurozone sovereign debt and banking crisis and its  negative effect on the fragile economic recovery in the US and other parts of the world, including Asia.

In a blunt warning that reflected Washington’s growing concern, Secretary Geithner urged European leaders to halt a months-long clash with the European Central Bank and argued that the EU’s growing reliance on foreign lenders would imperil the zone’s ability to control its own destiny.

“What is very damaging [in Europe] from the outside is not the divisiveness about the broader debate, about strategy, but about the ongoing conflict between governments and the central bank, and you need both to work together to do what is essential to the resolution of any crisis,” Mr Geithner said on the sidelines of a meeting of eurozone finance ministers in Wroclaw, Poland on Friday, September 16.

“Governments and central banks have to take out the catastrophic risk from markets… [and avoid] loose talk about dismantling the institutions of the euro,” he added.

Mr Geithner’s comments came as the Europe’s finance ministers agreed to withhold an €8 billion loan payment to Greece, a move that could leave Athens scrambling to satisfy its lenders before it runs out of cash.

European Response

George Osborns, UK chancellor, echoed Mr Geithner’s comments, telling Sky news on Saturday, September 18, that “people know that time is running out, that the eurozone needs to show it can get a grip on the situation.”

However, some eurozone finance ministers hit back at Mr Geithner’s comments, questioning the usefulness of his visit.  “I found it peculiar that even though the Americans have significantly worse fundamental data than the eurozone, that they tell us what we should do and when we make a suggestion ... that they say no straight away,” said Maria Fekter, Austria’s finance minister.
Sweden’s Anders Borg said: “we need to make progress, but it’s quite clear the US has a big debt problem and the situation would be better if the US could show a sustainable way forward.”
The eurozone’s more fiscally prudent governments – particularly Germany and the Netherlands - are keen to prove to their voters that they were forcing Greece to comply with the deep fiscal budget cuts and other reforms it promised when it accepted a €109 billion rescue package last year.
Several eurozone ministers also dismissed a US suggestion to give additional flexibility to the eurozone’s €440 billion rescue fund, re-opening trans-Atlantic fissures over fiscal and economic policy.
Markets Respond Negatively to EU Postponement on Decision
Finance ministers of the EU extended the time frame to approve a revamp of the €440 billion rescue fund that was agreed by heads of member state in July. After predicting that all 17 governments of eurozone member states would ratify the changes by the end of this September, they are now expecting the process to drag on until mid-October.

Some eurozone ministers expressed unhappiness with Mr Geithner’s comments about Europe ending divisions as such comments actually opened up new divisions.

Austria's Finance Minister Maria Fekter, one eurozone politician at the meeting who voiced her objection to Mr Geithner's comments, said: “I found it peculiar that even though the Americans have significantly worse fundamental [economic] data than the eurozone, that they tell us what we should do.” She was referring to US high national debt and the recurring trade and fiscal deficits, not mentioning the political standoff in Congress over the increase of the national debt ceiling.

Too Little, Too Late
Only two months after a second bailout was agreed to by European leaders, and amid new data indicating that the Greek economy is shrinking at a faster rate than expected, the size of rescue packages currency being discussed already seems to be inadequate. Furthermore, a number of indicators suggest the markets have already begun to discount a default — yields on Greek bonds have soared to record highs, while the price for credit-default swaps to insure Greek debt has rocketed. Many hedge funds are poised to make a killing on a Greek sovereign default.
Despite these punishing moves by investors who react with incomplete and unsubstantiated information, markets may still be under-pricing the total cost of a Greek default. A default on this scale is unprecedented, and its potentially widespread ramifications are unknown. Markets can limit some of their risk, but it is far from certain that an actual default would not lead to further panic and turmoil.

There are a number of other regional organizations that, while not supranational unions, have adopted or intend to adopt policies that may lead to a similar sort of integration in some respects.

  • African Union (AU)
  • Association of Southeast Asian Nations (ASEAN)
  • Caribbean Community (CARICOM)
  • Central American Integration System (SICA)
  • Cooperation Council for the Arab States of the Gulf (CCASG)
  • Eurasian Economic Union (EEU)
  • Inter-Parliamentary Union (IPU)
  • South Asian Association for Regional Cooperation (SAARC)
  • Union of South American Nations (USAN)
  • Union State
  • Turkic Council (TurkKon)
  • Economic Cooperation Organization (ECO)
  • Organization of Ibero-American States (OEI)


Other organizations that have also discussed greater integration include:

  • Arab League into an "Arab Union"
  • North American Free Trade Agreement (NAFTA) into the "North American Union"
  • Pacific Islands Forum into the "Pacific Union"
  • Customs Union of Belarus, Kazakhstan and Russia into the "Eurasian Union"


ASEAN Pursues EU article provides one instance of a region in support of regional integration. “The European Union organized a group of nations with different currencies and languages - and profits followed” (Conde, 2007, para. 1).


Currencies from various nations along with the economic system would build a strong relationship to assist this regional integration. Just as the EU had done, The Association of Southeast Nations (ASEAN) had their desires to try and duplicate the same techniques and integrate currencies in the areas. only to have this idea rejected by the past former prime minister of Singapore Lee Kuan Yew (Jazi, 2008).


The reason for this was, the prime minister believed that the country could achieve this objective but perhaps after 50-80 years. To start the process they would require writing a charter however the organization has opposed during the past because of the different financial systems in the region. This is currently in the starting phases, however, it has been stated that it will be a legally binding charter just like the one in the European Union, taking into consideration that any members who do not abide by this charts principles as well as procedures would need to incur on sanctions.


To put it differently, ASEAN desires to turn into the European Union of the other part of the world. For instance Thailand and Vietnam have strong expanding economies whereas Myanmar is somewhat poor as well as separated from the rest. This integration comes in a time in which communism is not a big issue for these nations. A few of the possibilities this regional integration would provide the organization and the 10 member states are the power as well as capability make business with bigger potencies such as China as well as the United States of America. A few of the advantages and benefits that will come from this venture will be the national reconciliation and democracy, increase trade, and reinforce security to prevent conflicts and terrorism providing this region the chance to perform and get more business from other nations in addition to franchises, corporations, and trade exemption policies in the region.


Against Regional Integration


Prof. Zivojin Jazic explains the elements, similarities and differences between the EU and ASEAN and APEC and describes their point of view regarding world globalization. This short article also integrates as well as describes the key reasons a few organizations aren't in support of regional integration even now and their suggestions to the region they serve.


The EU is the most essential player in politics with regard to Asia as well as Africa because is the second market of foreign trade in the region. In regard to ASEAN and APEC they both have political problems however mostly because they encourage trade andinvested not regional integration in their 21 member countries in said region.


APEC is a strong economy in Asia as well as the Pacific and is continuing to grow as fast rates. That is why the influence of regional integration must not influence their stability as well as status in region these days. APEC has a strong impact in Asia's economic growth also on the globalization process in general. Right now, APEC has 10 Member Countries, but has partners of the dialogue with India, Japan, the United States, China, EU, particularly in regard to security and economic cooperation of these sovereign nations. A few of the hurdles or factors that influence ASEAN regional integration development are: political barrel and of safety, economic barrel, functional barrel, and the barrel of the progress. All of these before described are quite critical to meet the goals of progress. From 2002 ASEAN is thinking about the creation of free trade zone to accomplish their execution of roadmap by 2020.


In comparison to the process of globalization it is clear and is established that this process has not produced any benefits with the large sections of the human population of the world, most likely because the main impulsive force is the trend for the benefit. The article refers that the solution may be to incorporate local organizations as well as projects for the economic cooperation and integration to contribute with two goals: to guarantee the social justice as well as the security of the underprivileged people and to encourage equal benefits with globalization and the economic progress and business opportunities with movements of products, money as well as labor. This continues to be to be EU's mission.


In conclusion, after studying both articles above, one in support of regional integration and one in opposition to it, it has been explained the various disadvantages and advantages of it in regions and how it can relate with their economic system. To conclude, the writer firmly thinks regional integration is useful for both the organization that is attempting to conduct business and to the nation in general for said region. Not just regional integration assists that region grow their economy and develop but also provides them the opportunity to overcome governmental hurdles linked with trade of products to other nations. Regional integration also provides the chance to the organization to progress in other nations and simultaneously make that country develop their economic system and impulse their working labor as well as capital.


The People’s Agenda for Alternative Regionalisms is an effort to promote cross-fertilization of experiences on regional alternatives among social movements and civil society organizations from Asia, Africa, Latin America and Europe. It aims to contribute to the understanding of alternative regional integration as a key strategy to struggle against neoliberal globalization and to broaden the base among key social actors for political debate and action around regional integration.


Specifically, it aims to build trans-regional processes to develop the concept of “people’s integration”, articulate the development of new analyses and insights on key regional issues, expose the problems of neoliberal regional integration and the limits of the export-led integration model, share and develop joint tactics and strategies for critical engagement with regional integration processes as well as the development of people’s alternatives.


The initiative People’s Agenda for Alternative Regionalisms, draws from the work and relates to regional alliances such as Hemispheric Social Alliance (Latin America), Southern African People’s Solidarity Network- SAPSN (Southern Africa),Solidarity for Asian People’s Advocacy – SAPA (South East Asia), People’s SAARC (South Asia) as well as organizations and networks in Europe, includingTransnational Institute (TNI), that struggle for “Another Europe”.

Ultimately, PAAR aims to support these and other networks in their efforts to reclaim the regions, recreate the processes of regional integration and advance people-centered regional alternatives.


The Transnational Institute (TNI) is an international research and advocacy institute committed to building a just, democratic and sustainable planet. For more than 40 years, TNI has served as a unique nexus between social movements, engaged scholars and policy makers.


Stakeholders mull European Union 'Aid for Trade' Strategy


In one of the side events organized in the framework of the 5th Global Review of Aid for Trade, Mr. Stephen Karingi, Director of Regional Integration and Trade Division of the Economic Commission for Africa (ECA), was invited to speak as a panelist at a stakeholder consultation on “The Future of the European Union Aid for Trade strategy”.

Mr Karingi started his intervention by recalling some of the key findings of a joint ECA-WTO report titled “Reducing Trade Costs to support Africa’s Transformation – the Role of Aid for Trade”, which contained a detailed monitoring of Aid for Trade flows to Africa. He recalled that it is encouraging to see the increase in Aid for Trade funds to Africa, as well as the focus on countries with special needs (namely Least Developed Countries, Landlocked countries and Small Island Developing States). However, he pointed out that one source of concern from Africa’s point of view is that recent growth has not translated meaningfully into structural change and industrialization. Aid for Trade strategies should ideally contribute to redressing this situation; yet, over the 2011-2013 period, industry only accounted for 6 percent of Aid for Trade disbursements to Africa.

A related point emphasized by Mr. Karingi was that African countries show relatively high participation in global value chains, but this is driven mainly by exports of raw materials and intermediate goods embodying limited domestic transformation. Accordingly ­– he argued – one way in which Aid for Trade could have greater impact is to support the emergence of regional value chains, harnessing the regional market to foster economic diversification and domestic value addition. In this context, the establishment of the Continental Free Trade Area and the implementation of the African Union Action Plan for Boosting intra-African Trade warrant the adequate support as key avenues to achieve authentic regional integration in the continent.

Mr Karingi also pointed out the critical role played by the services sector in terms of employment creation and contribution to value addition along the value chain. In line with this consideration, he contended that Aid for Trade should target in a more pronounced way those high-end services which promise to exert positive spillovers on the rest of the economy; that is the case of business and financial services, logistics and distribution, as well as infrastructure-related services such as transport and energy provision.


Touching upon the specific theme of this Fifth Global review – trade facilitation – Mr. Karingi warned against the risk of limiting the trade facilitation agenda to those specific measures that respond to the interests of large traders and transnational corporations. He instead argued that Aid for Trade support to Africa should also focus specifically on the needs of small and medium enterprises, as well as informal traders. Moreover, it should support efforts to streamline procedure while enhancing the effectiveness of custom controls, with a view to strengthen domestic resource mobilization and curb illicit financial flows through trade mis-pricing.


Echoing some of the concerns raised also in the African region, other panelists noted that there is scope for reducing the volatility and unpredictability of Aid for Trade support, and improving the degree of alignment with recipient countries’ development strategies. They also mentioned the need to facilitate access to Aid for Trade funds by harmonizing procedures and strengthening the coordination across donors, as well as enhancing the dissemination of information about funding opportunities.


Limitation of Market Forces


No economy, whether modern or ancient, monarchist or democratic, capitalist or socialist, can rely solely on market forces to meet all the needs of society or to direct the development of the nation toward a desired destiny.


A properly regulated market performs many important economic functions that are necessary for any economy, feudal, capitalist or socialist. However, market forces, when unregulated or undirected by government, as neoliberals advocate for capitalist market economies, naturally allocate resources most efficiently toward efforts and investments with the highest potential return on capital rather than where it is needed most by the nation and its people.


These propositions add up to a wholesale reduction of the central role of government in the economy and its primary obligation to protect the weak from the strong, both foreign and domestic. (See the World Order, Failed States and Terrorism series of reports Asia Times Online, February 3, 2005.)


Generally, highly efficient markets, particularly modern financial markets, aside from their fault of misallocating financial resources based on maximum return on capital, do not produce sustainable or balanced financial or economic outcomes if left unregulated by government.


Minsky’s Financial Instability Hypothesis

Hyman P Minsky (1919-1996), American economist and professor of economics at Washington University in St Louis, developed the Financial Instability Hypothesis (FIH) in the 1960s, linking financial market fragility in business cycles with speculative investment bubbles endogenous to financial markets, in a direct challenge to the Efficient Market Hypothesis (EMH), which had been developed by Eugene Fama at the University of Chicago Booth School of Business.


A basic rule in EMH in the field of behavioral finance says that trading profit has always

and will always come from reducing financial market inefficiencies. EMH states that prices of stocks reflect the market’s aggregate response to information. Any one market participant can be wrong about price levels; even every market participant can be wrong. But the market as a whole is always right. After the dot-com bubble burst in 2000, apologists for the EMH defended it by arguing that the dot-com bubble operated within the EMH; only the information behind the rational expectation was false. It was an argument that the operation was a success but the patient died. … continue @ Asia Times Online :: PAY, PROFIT AND GROWTH : Low wages and revolutions


The Westphalian World Order


The world order of sovereign states began with the Peace of Westphalia of 1648 which ended the Thirty Years' War (1618-48) during which the German Protestant princes struggled, with the self-serving help of foreign powers, against the unifying central authority of the Holy Roman Empire, which was under the Hapsburgs in alliance with the German Catholic princes. The Peace of Westphalia established a new world order based on the principle of sovereign states through the recognition of the independent sovereignty of the more than 300 German principalities in the 17th century. These princely states, recognized internationally as sovereign states by the peace, were not nation-states, as they were all of German nationality.

The Peace of Westphalia represented a foreign-policy triumph for France and its Swedish and Dutch allies, since it immobilized political unification of the German nation and delayed it for two centuries. There are clear indications that the "war on terrorism" today aims for a foreign-policy triumph for US imperium that will immobilize the political unification of Arab states as envisaged by Pan-Arabism.

The Peace of Westphalia advanced the modern Staatensystem or the system of sovereign states in international relations and law. From the 17th century to the unification of Germany by Otto von Bismarck in the aftermath of the failed democratic revolutions of 1848, French foreign policy was to keep Europe divided by the sovereign state principles of the Peace of Westphalia, preventing a unified Germany from emerging to threaten France and the other established big powers. To achieve this aim, France, although a Catholic nation, opposed the centralization aims of the Holy Roman Emperor.

German unification was not achieved until after the defeat of France in the Franco-Prussian War of 1870-71 when Bismarck (1815-98) united Germany by having a group of German princes gathering in the French Palace of Versailles proclaim the victorious William I of Prussia emperor of the German Empire. But Bismarck also divided Germany by leaving one-sixth of the Germans outside of the new German Empire, a condition that led a century later to another world war. Bismarck opposed liberalism and advocated the unification of Germany under the aegis of Prussia. Bismarck suppressed socialism with repressive laws that prohibited the circulation of socialist ideas, legalized police power to put down socialist movements and put the trial of socialists under the jurisdiction of police courts. Yet the persecution of social democrats only increased their strength in parliament. To weaken socialist influence and to implement his policy of economic nationalism, Bismarck introduced sweeping social reform. Between 1883 and 1887, despite strong opposition, laws were passed for health, accident and retirement social insurance, prohibiting female and child labor exploitation, and limiting working hours. These laws allowed Germany to circumvent the evils of the Industrial Revolution that beset Britain.

Universalist Ideologies, Wars of Religion

The ideology behind the "war on terrorism" is universal democracy, and in that respect it is analogous to the Holy Roman Empire ideology of universal Catholicism. Yet with the invasion and occupation of Iraq, US foreign policy has challenged the four-century-old Westphalia principle of state sovereignty. This principle has kept the Middle East divided to prevent a unified Arab state from emerging to threaten the superpower status of the United States and the national interests of its neo-imperialist allies. The US invasion of Iraq, while satisfying the myopic mania of the neo-cons who temporarily captured US policy, unwittingly gives legitimacy to pan-Arabism to unleash a frenzy of regime changes unrestrained by the Westphalia principle of sovereign states. The rise of pan-Arabism brought about by the demise of the Westphalia principle of sovereign states in the Middle East will be resisted by the neo-imperialist powers and will inevitably lead to a new global war that will make the Thirty Years' Year look like child's play.

The Thirty Years' War was fought on German soil, carried out by soldiers of fortune who aspired to create principalities of their own with their own political agendas. The "war on terror" today is fought on Islamic soil, carried out by mercenary units and opportunistic local factions hoping to carve out religious or ethnic fiefdoms. The Thirty Years' War dragged on because the warring parties feared each other's success and regularly changed alliances and war aims to keep the conflict going. Peace was not an objective because the purpose of war was to prevent any one party from winning, and as soon as peace was at hand, the potential winner would be neutralized by a new balance of power. Peace is also not an objective in today's "war on terrorism" because the purpose of the war was to prevent indigenous political cultures from overwhelming the injudicious push for universal democracy and collateral US hegemony, which is enhanced by continuing local conflicts with the US as a half-hearted peacemaker and arbitrageur with a not-so-hidden self-serving agenda.

The "war on terrorism" today shares many parallel attributes with the Thirty Years' War of four centuries ago. Both are global religious conflicts conducted with geopolitical maneuverings. Both serve as unwitting cradles for new world orders. While the Thirty Years' War was fought to enforce universal Catholicism, today's "war on terror" is being fought to spread universal democracy based on Judeo-Christian values. Like the Thirty Years' War, the "war on terror" today is also complex and multidimensional. US President George W Bush has repeatedly served notice that it will be a protracted and difficult war. Like the Thirty Years' War, the "war on terrorism" today also has no clear single objective, not even the elimination of terrorism. So far, the war has used the threat of terrorism as a pretext to invade sovereign states not to the superpower's liking. The administration of president George H W Bush launched the first Gulf War to protect the tangible principle of sovereign states by driving Iraq from its reincorporation of Kuwait, thus putting the principle of state sovereignty above the intangible principle pan-Arab nationalism. Yet in the second Gulf War to invade and occupy Iraq, the abstract principle of universal democracy was used to overrule the tangible principle of state sovereignty.

Terrorism is as old as civilization itself and many political movements have been forced to resort to it in varying degrees, especially in their early stages of struggle. Powerful, established political powers regularly resort to state terrorism, known euphemistically as war conducted by overwhelming force applied with shock and awe - in other words, terror. Thus the "war on terror" is in fact fought with state terror. Even the most heinous war is always rationalized with high moral justification.

In its most current manifestation, the "war on terrorism" today is a religious war between a faith-based Christian nation and Islamic extremists, both groups controlled by fundamentalists, not unlike the struggle between the Roman Catholic Church and emerging Protestant movements during the Thirty Years' War. It is an unevenly matched conflict between a powerful state military machine and clandestine cells engaged in asymmetrical warfare reminiscent of the early phases of the Thirty Years' War. It is an unbalanced game between an organized system with visible and open targets everywhere and a vast network of disjointed cells that are impossible to find until after they surface with an attack. The same was true with the Holy Roman Empire in its effort to rein in the Protestant German princes and their religious zealot advisers during the Thirty Years' War.

The "war on terrorism" today is a violent neo-imperialist strategy that unwittingly enhances the unifying aim of pan-Arabism, by threatening the sovereignty of the numerous small Arabic failed states created by the imperialist powers of the last century to frustrate pan-Arab nationalism. Just as the prevention of the unification of Germany played a key role in the strategy of foreign powers during the Thirty Years' War, the eventual emergence and prevention of pan-Arabism will play a key role in the "war on terrorism" today. It is too early to discern how the geopolitical implication of the development will shape up.

The "war on terrorism" is a unilateral war waged primarily by the sole superpower that is putting strains on residual Cold War alliances, forcing Europe to seek independence from post-Cold War US unilateralism. It pushes Cold War US nemeses such as Russia, China and India to converge if not unite in support of a multipolar world order. The Holy Roman Emperor was in a similar situation in its relations with the major powers of Europe at the time of the Thirty Years' War.

Bourbons, Bonaparte and Bush
The Peace of Westphalia that began in 1648 after 30 years of destruction and slaughter marked the triumph of the doctrine of the balance of power. The doctrine was directed against Hapsburg supremacy, which was successfully blocked by a France on its path toward superpower status. Later, when King Louis XIV of France advanced the doctrine of "universal monarchy", or still later when Napoleon Bonaparte expanded the same idea to a multinational, multi-ethnic Empire of the French (not a French empire) based on universal citizenship in the imperial Roman sense, the balance-of-power doctrine was directed specifically against France. Today, there is clear evidence of the balance-of-power doctrine being directed against a hegemonic United States that attempts to construct, by violent regime changes in distant sovereign states, a world order of compulsive neo-liberalism. Unlike the Roman Empire or the Empire of the French, US neo-imperialism has yet to adopt an inclusive citizenship policy. US-led neo-liberal globalization promotes only the cross-border free movement of goods and capital, but not of people.

One and half centuries after the Peace of Westphalia, Napoleon co-opted the democratic ideals of the French Revolution and applied them to the concept of a universal empire ruled by a Bonaparte dynasty consisting of members of his family. The people of Spain proved to be less docile than their aristocratic leaders to the Pax Napoleon. Even before Joseph, Napoleon's brother, was proclaimed king of Spain with alacrity by a Spanish Council of Regency, spontaneous anti-French insurrection had broken out in every province of Spain, without central leadership, systemic organization or preparation. Spain was by that time a mere shadow of its former greatness and, in every sense of the term, a failed state. The popular insurrection was not explainable by any aversion to a foreigner on the Spanish throne. The Spanish Bourbons were a foreign dynasty. Joseph Bonaparte came to Spain with an impressive record of liberal reforms as king of Naples and he had the support of a substantial segment of the Spanish elite, nobles, prelates, financiers, officials and intellectuals who looked to France, even Napoleonic France, as a bearer of the liberal principles of the French Revolution. Had Joseph been allowed to rule in peace, such aspirations might not have been wrong.

The Shanghai Cooperation Organization
Unilateralism in US foreign policy, highlighted by US rejection of the Kyoto Treaty and the Anti-Ballistic Missile Treaty, the hardline approach toward North Korea and China, and until September 11, 2001, support for anti-socialist terrorism in the name of human rights and democracy, has solicited efforts by targeted countries to form their own sets of cooperative multilateral mechanisms that exclude the US. The SCO process, the most significant of such mechanisms, has quietly but steadily built up its economic, military and diplomatic relations, seeking to present itself as more viable counterweight to emerging US hegemony in Central Asia.

The SCO consists of China, Kazakhstan, Kyrgyzstan, Russia, Tajikistan and, most recently, Uzbekistan. Until that sixth member joined, the group was known as the Shanghai Five. The group emerged from a series of talks on border demarcation and demilitarization which the four former Soviet republics held with China. Since 1996, when the group held its first presidential summit meeting in Shanghai, the five-country group has held annual summits. The statement from the July 2000 Dushanbe summit notes the establishment of a "Council of National Coordinators" that would further foster regularized cooperation among the member states. In addition, the joint statement expressed the group's view of the international security situation both within and beyond their borders. The Dushanbe statement pledge the member states to crack down jointly on secession movements, terrorism, and religious extremism within their borders and to oppose intervention in another country's internal affairs on the pretexts of humanitarianism and protecting human rights; and support the efforts of one another in safeguarding the member states' national independence, sovereignty, territorial integrity, and social stability. China has called for strengthening mutual support in safeguarding the national unity and sovereignty of the SCO member nations and jointly resisting all kinds of threat to the security of the region, particularly from outside the region.

With these aims in mind, the SCO defense ministers meet annually along with their foreign ministers, and their militaries conduct joint exercises and training, exchange information about peacekeeping operations, and hold conferences and other exchanges on security issues. The Dushanbe statement also noted the group's opposition to the use of force or threat of force in international relations without United Nations Security Council approval, a direct reference to recent US undertakings in Iraq. The group also opposes any attempt by countries or groups of countries to monopolize global and regional affairs out of selfish interests. In similar terms, the Dushanbe statement also expressed its opposition to US missile-defense strategy by stating its strong support for the Anti-Ballistic Missile (ABM) Treaty of 1972 and its opposition to "bloc-based" (ie, US alliance-based) deployment of theater missile defense systems in the Asia-Pacific region, particularly in Taiwan and Japan.

The SCO maintains that it is not an alliance, and is not aimed at any third parties. Indeed, the group has a number of internal differences that will likely prevent it from becoming like a North Atlantic Treaty Organization (NATO). The two biggest countries in the group, China and Russia, have enjoyed much-improved relations over the past decade, but still harbor mutual long-term strategic distrusts. In addition, individual members of the group differ over other important issues, such as relations with various neighbors such as India, Pakistan and Afghanistan, and over how best to exploit the rich reserves of energy and other natural resources in Central Asia for common use. Russian President Vladimir Putin appears to welcome additional members to the group (such as Uzbekistan; Pakistan, Iran and India have expressed an interest), which, if admitted, would certainly complicate the achievement of consensus within the group. China and India are engaged with serious efforts to improve relations.

The SCO process has resulted in impressive achievements, such as settling border disputes, introducing confidence-building measures, and moving in cooperative ways to combat illicit activities in their region such as terrorism and drug smuggling. It has also issued increasingly pointed statements in op

position to US hegemony. The SCO is indicative of efforts around the world seeking security-related mechanisms independent of US participation.

The Fatal Washington Consensus


It has been said that when economics turns serious, it becomes political. The Washington Consensus, a term coined in 1990 by John Williamson of the Institute for International Economics to summarize the synchronized ideology of Washington-based establishment economists, reverberated around the world for a quarter of a century as the true gospel of reform indispensable for achieving growth in a globalized market economy. 

Initially applied to Latin America and eventually to all developing economies, the term has come to be synonymous with globalized neo-liberalism or market fundamentalism to describe universal policy prescriptions based on free-market principles and monetary discipline within narrow ideological limits. It promotes for all economies macroeconomic control, trade openness, pro-market microeconomic measures, privatization and deregulation in support of a dogmatic ideological faith in the market's ability to solve all socio-economic problems more efficiently, and to assert a blanket denial of an obvious contradiction between market efficiency and poverty eradication. 

Financial-capital growth is to be served at the expense of human-capital growth. Sound money, undiluted by inflation, is to be achieved by keeping wages low through structural unemployment. Pockets of poverty in the periphery are the necessary price for prosperous centers. Such dogmas grant unemployment and poverty, conditions of economic disaster, undeserved conceptual respectability. State intervention has come to focus mainly on reducing the market power of labor in favor of capital in a blatantly predatory market mechanism. 

Unemployment and poverty then are viewed as temporary, transitional fallouts from wholesome natural market selection, as unavoidable effects of economic evolution that in the long run will make the economy stronger. Neo-liberal economists argue that unemployment and poverty, deadly economic plagues in the short term, can lead to macroeconomic benefits in the long term, just as some historians perversely argue that even the Black Death (1348) had long-range beneficial effects on European society. 

The resultant labor shortage from abrupt thigh fatality during the Black death in the short term pushed up wages in the mid-14th century, and the sudden rise in mortality led to an oversupply of goods, causing prices to drop. These two trends caused the standard of living to rise for those still living. Yet the short-term shortage of labor caused by the Black Death forced landlords to stop freeing their serfs, and to extract more forced labor from them. In reaction, peasants in many areas used their increased market power to demand fairer treatment or lighter burdens. Frustrated, guilds revolted in the cities and peasants rebelled in the countryside. The Jacquerie in 1358, the Peasants' Revolt in England in 1381, the Catalonian Rebellion in 1395, and many revolts in Germany, all served to show how seriously the mortality had disrupted traditional economic and social relations. 

Neo-liberalism in the past quarter-century created conditions that manifested themselves in violent political protests all over the globe, the extremist form being terrorism. But at least the bubonic plaque was released by nature and not by human ideological fixation. And neo-liberalism keeps workers unemployed but alive with subsistence unemployment aid, maintaining an ever-ready pool of surplus labor to prevent wages from rising from any labor shortage, eliminating even the cruelly derived long-term benefits of the Black Death. 

The Washington Consensus has since been characterized as a "bashing of the state" (Annual Report of the United Nations, 1998) and a "new imperialism" (M Shahid Alam, "Does Sovereignty Matter for Economic Growth?", 1999). But the real harm of the Washington Consensus has yet to be properly recognized: that it is a prescription for generating failed states around the world among developing economies. Even in the developed economies, neo-liberalism generates a dangerous but generally unacknowledged failed-state syndrome. 

The economics of neo-imperialism

The United States is the leading advocate of the efficacy of free markets and the economic benefits of privatization of the public sector. It prescribes policy measures that aggressively weaken the state apparatus and that inevitably lead to failed statehood. At the same time, the US is also the leading proponent of superpower military intervention in failed states around the world. The number of victims caused by neo-liberalism far exceeds those from ethnic strife in failed states. Yet while neo-liberals, together with their strange bedfellows the neo-conservatives, advocate humanitarian military intervention in failed states, they adamantly oppose government intervention in failed markets that accept unemployment as necessary antidote for inflation (seeTackle

 failed markets, not failed states

, March 26, 2002) 

Neo-imperialists identify failed statehood as the natural outcome of anti-imperialism. Historically, when power vacuums left by failed states threatened great powers, the ready solution was imperialist conquest. Such conquests were justified as necessary for imposing order and civilization over chaos and backwardness. But imperialism lost its legitimacy as a result of the disingenuous promotion of anti-imperialist sentiments by the warring imperialist powers of World War II. These warring powers were compelled to use anti-imperialism as incentives for mobilizing their colonial subjects to support their total war efforts. Imperialism became an unwitting victim of collateral conceptual damage in the second global war to end all wars. 

The world order during the Cold War was a condominium of two superpowers who were opponents in dialectic ideological dispute as well as in conflicting geopolitical state interests. Toward the end of the Cold War, conflicting geopolitical state interests were overwhelming ideology disputes, driving communist China toward strategic convergence with the capitalist US against Soviet imperialism, in response to the Soviet alliance with anti-communist India against China.


Localized ongoing superpower ideological wars by proxy states were wound down and local political struggles were frozen to avoid superpower conflict escalating into nuclear exchanges. The end of the Cold War diminished both the legitimacy and ability of former client states and satellites of the two opposing superpowers to control domestic rival factions, leading to failures of state power in several regions. At the same time, some states that had been divided by Cold War superpower geopolitics were reunited, some only after decades of violence, as in the case of Vietnam, others peacefully with the disintegration of the USSR, as in the case of Germany. Other divided states are still not reunited, such as the two Koreas. 

The USSR itself broke up into separate states, held loosely together by a Commonwealth of Independent States (CIS) that comprise 12 sovereign states that were formerly Soviet republics. The CIS was formed on the basis of sovereign equality of all its members and that the member states are independent and equal subjects of international law. The CIS is not a state - it does not have supranational powers. In September 1993, the heads of the charter states signed a treaty on establishment of the Economic Union, in which they developed the concept of transformation of economic interaction within the commonwealth, taking into consideration residual realities. The treaty was based on the necessity of formation of a common economic space on the principles of free movement of goods, services, workers and capital; elaboration of concerted money and credit, tax, price, customs and foreign economic policies; rapprochement of the methods of management of economic activities; and creation of favorable conditions for development of direct production links. 

Ukraine has since emerged as a danger point for regional peace in its effort to free itself from the Russian sphere of influence and reorient itself toward the West. In former Yugoslavia, a former Soviet bloc state, ethnic strife has embroiled NATO (North Atlantic Treaty Organization) members, primarily the US, in humanitarian intervention. The Middle East continues to be a smoldering powder keg that threatens global peace. In East Asia, US adventurism in trying to set up Taiwan as a separate pretender state from China poses a threat to peace in the region and perhaps even the whole world by turning a long-dormant unfinished civil war into a new international war. 

After the Cold War, with a new form of economic imperialism under the euphemism of neo-liberal globalization ravishing economies around the planet, the post-World War II restraint and the Cold War freeze against political imperialism are now being dismantled as disorder in ravished countries grows more threatening to the sole remaining superpower. The US now mistakes military and economic prowess for moral superiority and views itself as having earned the privileges of a benevolent and indispensable hegemon. Thus the neo-imperialist formula for the new Pax Americana is a two-punch operation. The first punch uses neo-liberalism to cause a weak state's economy to collapse to produce a failed state. The second punch invades by force the failed state to delivery liberty as defined by the new imperialism to set it up as a US protectorate and economic colony. 

Terrorism is only one of the threats that failed states allegedly pose to the sole remaining superpower, albeit it has taken center stage after the tragically spectacular events of September 11, 2001. Much of the world's illegal drug supply comes from alleged failed states, whether it is opium from Afghanistan or cocaine from Colombia.


Yet in the mid-19th century, when Great Britain illegally shipped opium to China from British India and Yankee Clippers shipped opium from , in open violation of Chinese law, neither Britain nor the US was condemned as a failed state. Other kinds of criminal businesses, such as new forms of slave traffic through the hazardous venue of illegal immigration, flourish today under the aegis of what are now identified as failed states while the recipient strong states remain immune. Furthermore, the economy of the southern US had been built by slavery with blatant immunity. For a whole century and through half of its history, the US was in egregious violation of the most obvious and fundamental human rights with its institution of slavery without fear of being liberated by a self-righteous foreign power. 

How the strong define 'failure'

In 1919, Woodrow Wilson presented his self-righteous Fourteen Points of utopian liberty to cynical European diplomats at the Versailles Peace Conference, while at home, a series of immigration quota acts based of racial discrimination were passed; government persecution and deportation of leftists became the unconstitutional and illegal response when 4 million workers went on strike in 1919 and Nicola Sacco and Bartolomeo Vanzetti, both Italian immigrant anarchists, were arrested, convicted on insufficient evidence and executed in 1927; the Ku Klux Klan, dedicated to the persecution of "Negroes", Catholics and Jews, achieved a membership of 5 million by 1924 without being outlawed; and civil rights legislation would not be passed for another half century. A series of Chinese exclusion acts that banned all immigration of Chinese ethnicity and denied the right of Chinese to become naturalized US citizens were not repealed until 1943 when the US needed China as an ally against Japan. Yet through all this, the US was never invaded in the name of foreign humanitarian intervention. 

Today, the strong recipient states of illicit drugs from weak failed states are themselves excused from failed-state status even though state functions to eliminate such illicit traffic consistently fail. Failed states are generally said to be increasingly trapped in a downward cycle of poverty and violence. Notwithstanding that many of the ills of failed states have been caused by globalized neo-liberal market fundamentalism, neo-imperialists argue that the solution is for the sole remaining superpower and its subservient allies to resort to new, improved imperialism again for the good of the world. 

The spread of AIDS in many regions has been associated with failed-state syndrome. Yet the responsibility for failing to contain the spread of the virus at its early stages lies squarely on the shoulders of US president Ronald Reagan, who saw it as God's righteous punishment for sinful sexual deviants. On the issue of AIDS eradication, the US has been in every sense of the term a failed state. 

Failed and collapsed states are a structural trait of the contemporary international system, and not a temporary dysfunction of the Westphalian world order of sovereign states. Failed states are not always weak states. They are sometimes strong states that have voluntarily forfeited basic state functions as a matter of ideology, or allowed them to be usurped by special-interest groups. Strong failed states are states that possess powerful military/police power for advancing the narrow economic interests of a small class of citizens while sacrificing a significant segment of the population as failed market victims. In the US, socio-economic Darwinism is again celebrated as indispensable for the survival of the economy in the market place, while scientific theories of evolution are challenged by Creationism in public schools. Those who believe God created man apparently do not believe he created all men as equals. These structural anomalies and conceptual inconsistencies produce tensions in the international system, with serious consequences for advanced and developing economies alike. 

In the Third World, the notion of "failed states" is problematic since many Third World states collapsed after decolonization simply because they were artificial Western imperialistic constructs in the first place, and not true sovereign states. All failed states in the Third World are located in former Western empires. Some Third World states are deemed failed statehood by the hegemonic superpower if the state apparatus is unable to uphold an effective monopoly of coercion over its entire territory to prevent meta-state activities deemed dangerous to the superpower. Such failed states usually lack an effective judiciary system similar to that in advanced economies to safeguard the rights of foreign and domestic private property, or are unable to fulfill international obligations such as repayment of sovereign or private debts to foreign financial institutions, or cannot prevent and police transactional economic crimes or the use of asymmetrical warfare by meta-state groups against strong states. 

On the other hand, market states with advanced economies increasingly do not consider most human aspects of societies as proper state concerns, such as the provision of a rising standard of welfare to their citizens, which has been conveniently assigned to the indifferent workings of the market, but confining themselves to guarding and strengthening no-holds-barred free-market conditions through which private wealth is generated for the benefit of the strong elite, leaving the weak multitude to perish in a natural selection. Wealth-distribution functions are assigned to the market even though the structural maldistribution of market power is maintained by the state. This amounts to a selective exercise of state power of coercion to favor one preferred segment of the population or one type of institutions at the expense of all others. 

The popular will is repeatedly frustrated through inflated minority rights backed by distorted constitutional interpretation on the part of politically appointed and biased courts. In that respect, states such as the US can also be deemed as having failed through its rule by law, not of law. Other attributes of failed states, such as privatization of basic legitimate state functions, fit the ideological trends in super-strong market states such as the US today. Thus the ideological fixation prevalent in the US today can be seen as moving the US toward a failed-state syndrome. These market states try to coerce other states also to become market economy states to prevent them from exercising sovereign control over their national territories, protecting their economies from structurally predatory global markets that amount to economic tyranny, regulating the behavior and lives of their population for the common good and in general aspiring to be strong states in defiance of globalized market fundamentals that lock them in permanent victimization by strong market states. 

The collapsed state

A collapsed state is a failed state in its advanced stage. It is identifiable by three features, according to neo-imperialists. The first is its colonial legacy and ineffective post-colonial state-building. States formed from residual colonial rule may be confronted with insufficient love or loyalty to and from their artificially constituted population, with their domestic and international authority based not on legitimacy but on dominance, either economic or police/military. The historical process in accumulating centralized power in these states consists of subordination and assimilation that tend to maximize popular resentment, resulting in polarization derived from disillusionment and dissatisfaction by disfranchised minority or even majority groups and their elites. Thus neo-imperialists consider collapsed states to be the illegitimate children of anti-imperialism. In a way, collapsed states are juvenile delinquents of the international system left from the wreckage of the imperialist world order. The proper response to collapsed states is to re-colonize them, so argue neo-imperialists. 

The second feature of a collapsed state is the withdrawal of superpower sponsorship/protection. The world order during the Cold War was a condominium of two superpowers. Local struggles and conflicts were frozen to avoid bringing the two superpowers into nuclear conflict. The end of the Cold War reduced both the legitimacy and the power of the client states of the sole remaining superpower to control domestic rival factions. The solution to this unhappy state of affairs is for the sole remaining superpower to assert its irresistible power by imposing a new world order according to its alleged superior values, camouflaged as freedom and democracy. 

This is the neo-conservative agenda. President George W Bush says that free and democratic states are peaceful states, notwithstanding the historical fact that World War II was launched by an expansionist German Third Reich born of a democratic process and the stubborn resistance by a British emergency coalition government born through the suspension of elections. What Bush really means is that when the whole world subscribes to US values and accepts US power, not only out of fear but also out of respect for its power-backed legitimacy, the world will be peaceful. Adolf Hitler sang the same tune and failed. The US under her governing establishment is attempting an ambitious undertaking of universal ideological control that even Christianity under the Holy Roman Empire failed to accomplish with the Thirty Years' War, having to yield finally to the Peace of Westphalia of independent sovereign states. 

The third feature of a collapsed state is the impact on it from neo-liberal globalization. Unlike globalization in the past, which was implemented through an empire structure, neo-liberal globalization is imposed through a network of failed states by weakening state sovereignty in international relations  and limiting the legitimate role of the state in socio-economic arenas. Imperialist globalization of the past did not recognize the sovereignty of protectorates or colonies. In contrast, neo-imperialist globalization today employs weak client states with restricted sovereign rights as proxies of the strong market state to enforce its exploitative agenda worldwide. 

Neo-liberal ideology is implemented through a venue of integrated global markets, free flow of capital and credit, wholesale deregulation and mandatory structural pro-market conditionalities imposed on weak and poor economies. It strips states of their sovereign authority to intervene in markets on behalf of their national interests, causing state authority to collapse in all area except the protection of foreign and domestic private property rights. Failed states depend on globalized market fundamentals to finance their state functions and inevitably fall into collapsed-state status for insufficient revenue. In a sense, whereas the age of imperialism used Christian values as a pretext for empire, the age of neo-imperialism uses neo-liberalism as its missionary calling. The relationship of the neo-conservatives to the neo-liberals today is similar to the relationship of the Emperor and the Church in history. Missionaries are the velvet gloves of the ruthless hands of imperialists. 

How the strong define 'success'

Success in statism is measured by a state's ability to deliver political goods. Security, both external and internal, is a primary political good the provision of which is the state's primary function. It provides a framework through which all other political goods are delivered. The events of September 11, 2001, revealed that even the most powerful state cannot guarantee its citizen protection from terrorism, a fact since openly acknowledged by the Bush administration. The modus operandi of the "war on terrorism" and the Department of Homeland Security is based on the acceptance of spectacular terrorist attacks continuing in the future and their likelihood of repeated success. The aim is not to eradicate terrorism by removing its root cause, but only to make it more difficult to implement. It is a war lost before it begins. 

Neo-imperialism detaches economic security from legitimate state functions. Freedom from want is not considered a state responsibility recognized by neo-liberalism. Financial security is merely a market risk that should be faced by each individual market participant. Another political good provided by the state is the enforcement of law as expressed in a system of codes and procedures that equitably regulate the affairs and financial interactions of the population. The state is responsible for setting and maintaining standards for equity and acceptable conducts both domestically and in its foreign relations. Neo-liberalism relieves the state from such responsibility and assigns it to the market. 

Friedrich A Hayek (1899-1992) wrote The Road to Serfdom (1944) to warn of the invasion of the welfare state in people's private lives, the fundamental conflict between liberty and bureaucracy. Hayek and his fellow Austrian economists who viewed the market economy working as the calculus of independent individual decisions differed with Milton Friedman and the Chicago School economists who thought macroeconomically in analyzing total quantity of money, total price level, total employment, etc, in aggregates and averages terms. Hayek's rejection of socialist thinking was based on his view that prices are an instrument of communication and guidance that embodies more information than each market participant individually processes. To him, it was impossible to bring about the same price-based order based on the division of labor by any other means. Similarly, the distribution of incomes based on a vague concept of merit or need is impossible. Prices, including the prices of labor, are needed to direct people to where they can do the most good. The only effective distribution is one derived from market principles. On that basis, Hayek intellectually rejected socialism. 

In Hayek's social philosophy, value and merit are and ought to be two distinctly separate issues. Individuals should be remunerated purely on the basis of value contributed and not in accordance with any concept of justice, whether it be Puritan ethic or egalitarianism. Hayek went as far as to deny that the concept of social justice has any meaning whatever, on the basis that justice refers to rules of individual conduct. Since no rules of the conduct of individuals can determine how the good things of life should be distributed, the question of justice is moot. Since a free market is the natural outcome of a multitude of individual decisions, how the market decides is amoral. 

Accordingly, a spontaneously working market, where prices act as guides to action, cannot take account of what people need or deserve, because it operates according to a neutral distribution system that nobody has designed. Such a distribution system cannot be just or unjust. And the idea that things ought to be designed in a "just" manner means, in effect, that one must abandon the market and turn to a planned economy in which somebody decides how much each ought to have. And the price for that justice is the complete abolition of personal liberty. 

Hayek's free-market ideas have been applied to much of unregulated globalization of the past quarter-century, and the socio-economic damage is now very visible. Notwithstanding Hayek's repugnant social philosophy, even his "scientific" claims on the effectiveness of free markets has not been substantiated by events. Hayek's fallacy rest on his blind faith in "spontaneous" prices that neglect the potential of long-term value through excessive instant sub-optimization. 

Another political good is the provision of universal health care and education, the maintenance of a vibrant economy of full employment at living wages that will allow workers to afford decent housing and secure retirement, and a clean environment, without which all rhetoric about liberty becomes irrelevant. Freedom from want is a first freedom that neo-liberalism denies by imposing the tyranny of the market. The logic of a segmented health-insurance market based on tiers of risk profiles is fundamentally flawed. It assigns high premiums to high-risk customers, instead of universal protection for all. For those who are healthy, the fact that they do not need medical care is already worth a fortune; do they need also to deny financial support to others in the insured pool who are unfortunate enough to be ill? For the healthy, not needing medical care is itself the benefit. Who would wish to be ill merely to get their money's worth from insurance? If the healthy in a community do not help the sick, who will? There is no logical or ethical argument against universal health care. 

To deliver such political goods, the state is granted police power and the power to issue sovereign credit to steer the economy toward rewarding activities that produce such political goods. The unregulated market rewards activities that externalize such political goods from their cost structure and siphons off the resultant surplus value as private profit. In fact, failed states are often generated by failed markets. The state has an obligation to preserve and protect its sovereign credit authority from being usurped by private interest groups. Capitalists use globalized finance markets to tilt a level playing field in trade to create private profit out of public poverty. This is done through the private control of money as a legal tender, through a monetary system under a central banking regime that ideologically accepts structural unemployment as the unavoidable means to combat inflation. Central banking is the policy of a failed state. A globalized foreign-exchange market dominated by dollar hegemony is the venue for US superpower financial imperialism (see 
US dollar hegemony has got to go, April 11, 2002). 

A Bank of International Settlement (BIS) regime of global network of central banks whose main function is to protect the value of privately controlled money through unemployment and slave wages is a world order of failed states, not sovereign states. Dollar hegemony, the status of the dollar as a dominant reserve currency in international trade despite its fiat nature, operates in a globalized foreign-exchange market to rob sovereign states of their right and ability to issue sovereign credit for domestic development, by exposing their domestic currencies to market attacks. Since sovereign control over the monetary system and the economy is the sine qua nonprerequisite of sovereignty, the BIS financial world order of failed states has in fact replaced the Westphalian world order of sovereign states through financial globalization 

Both strong and weak states can be failed states. Successful states are those in full control of their territories and economies to provide rising-quality political goods to all their citizens. Failed states contain ethnic, religious, linguistic, or other tensions such as ideology that limit or decrease their ability to deliver political goods. The privatization of education, health care and social security is a formula for state failure. These smoldering tensions, if unattended, eventually explode into violent open conflicts. Some strong states became strong by failing. They abdicated normal legitimate state obligations in order to focus state resources on building up a strong military/police capability to disarm domestic and foreign opposition to their failed-state policies. 

Failed states provide only substandard political goods, if any at all. Weak failed states involuntarily forfeit, and strong failed states do so voluntarily, the responsibility for delivering political goods, and leave it to non-state actors, ie the private sector through the market mechanism. Privatization of the public sector is more than the outsourcing of state functions. It is the selling off of state prerogatives. 

In the military sphere, this is manifested in two ways: 1) the use of mercenaries within the regular army and 2) deferral of state-security functions to contractors. The killing and mutilation last April 2 in Fallujah, a Sunni stronghold 50 kilometers west of Baghdad, of four US contract security personnel - mercenaries in all but name - testified to the hate and rage of an occupied people. More than 30,000 mercenaries serve as armed security guards for foreign private contractors engaged in the rebuilding of Iraq for profit, taking over from the military the responsibility of providing security and maintaining order in a war zone. Even US civilian administrator L Paul Bremer sought protection by contract security personnel, not US soldiers. 

These armed mercenaries are officially not engaged in offensive operations and are authorized to use their weapons only defensively if fired on. The distinction is only technical, since invaders can hardly claim self-defense against hostile fire from the invaded. The very presence of invaders is itself an offensive act that naturally draws hostile response from the invaded. The use of mercenaries is nothing more than the privatization of war, the ultimate epidemic of neo-liberal market fundamentalism. Mercenaries do not enjoy protection under the Geneva Convention on war crimes and the mutilation was not perpetrated by an enemy army but by an angry mob in a country under occupation. The television images of the burned remains of US mercenaries, brutal on one level, were symbolic of failed US policy on another. They represent violence against the crime of regime change for profit. Iraq after US invasion fell deeper into failed statehood. 

The failure to provide security for all citizens is the first sign of a failed state, as is the use of state violence on its own citizens. So is a larger prison population or one that is racially or ethnically disproportioned. An economic infrastructure that failed to deliver income or wealth equitably is another sign of a failed state, measurable with the Ginni coefficient on income inequality. The absence of a universal health-care system is another sign, as is a dysfunctional public educational system primarily reserved only for poor children. An excess of per capita national debt is also a sign of failed statehood, as is pervasiveness of corruption and fraud in government and business. Hunger and food shortage for the poor while food surplus persists in the economy is another sign of failed statehood. Failed states often have a very rich minority that takes advantage of the failed system with the blessing of the state. 

Collapsed states are failed states with a significant vacuum of central authority. They are political black holes with regards to all indicators of institutional health. It is much less costly to stop a state from failing than to reconstruct it after it has failed or collapsed. Neo-liberal efforts aimed at saving weak states have been mostly ceded to financial institutions (banks and funds) that focus their efforts either on profit incentives, returns from loans and investments or export expansion for Western producers, particularly of agriculture, arms and intellectual property. This is a form of blood-letting cure. There is not only no financial reward for populism, but in fact also heavy penalties of operational losses. Wealth and income maldistribution inevitably lead to impending economic collapse and subsequently state collapse. A system of rewards and punishment that leads a state to more populist policies can help to prevent state failure. Financial shocks frequently cause a state to fail, or at least its regime to fall. 

World order in flux

Contemporary world order is a complex, contested and interconnected order. This world order, its rules and institutions that circumscribe the structures of power, is in a process of change, putting stress on the order. The traditional world order based on the primacy of interstate or geopolitical relations is being injected with other ordering principles such as the world order of global politics and global governance is one of such injections. Financial, economic and trade globalization is another. The voluminous literature on humanitarian interventions focuses mostly on security and force. Economic humanitarianism is neglected in favor of a "natural law" of market competition. The increased propensity of states to intervene is, then, on the one hand illustrative of a new world order where states put human-rights principles and norms above the classical principles of sovereignty and non-interference in another state's internal affairs. On the other hand, domestic human suffering from globalized economic exploitation is off limits to state intervention within its sovereign territory. 

Russian President Vladimir Putin, who declared in 2004 that the collapse of the USSR had been a "national tragedy on an enormous scale", in trying to save Russia from the fate of failed statehood by reversing wholesale privatization of state-owned enterprises and media, is being accused by neo-liberals of trying to restore central state power as if that were a terrible thing. His policy on Chechnya is a crucial element in the US-led "global war on terrorism", while Russia's disastrous human-rights record in the breakaway republic conflicts with US standards. 

While sovereignty is the organizing principle of the Westphalian world order, the legitimacy of international actions today is governed by Westphalian principles only if the state relinquishes it responsibility in economic affairs. A clear case of this is the way the sole remaining superpower treats oil-producing states. Nationalization of the oil industry by any member state of the Organization of Petroleum Exporting Countries (OPEC), if coupled with a state policy detrimental to the fundamental oil-import needs of the sole superpower, or measures that upset the pricing structure of oil, will run the risk of being invaded by the superpower. 

Seen from a development-theory perspective, the failed-states phenomenon is based on a universal acceptance of the theory of teleological development of societies toward specific developmental goals. This implies progression from a simple toward a more complex form of society. To Western theorists, this points in the direction of emulating the Western model. To non-Western theorists, it points to development models with indigenous characteristics. The role of the state is crucial in these processes. Failed states have only attracted interest as part of a revisionist revaluation of colonialism, imperialism and dependency as benign blessings, but not as part of a critique of market capitalism, of the folly of universal application of Western democratic processes and social values, and of the destructive impact on community cohesion by a fixation on individual freedom. Superpower intervention seldom acts to prevent failed statehood in a weak state. Rather, it intervenes to stamp out resistance to superpower-instigated failed statehood. 

In a fundamental way, terrorism is the weapon of last resort for resisters of foreign-instigated failed statehood. Historically, terrorism tends to end when terrorists are granted due recognition of their legitimate grievances and promises of equitable redress. The policy of refusal to negotiate with terrorists is a propaganda slogan of little logic or usefulness. 

Since 1990, concerns for failed and failing states have occupied center stage in international politics because the Westphalian order of sovereign states has been challenged at the geopolitical convenience of the sole remaining superpower. States are put in a position of either not being strong enough to deal with their own internal problems and thus risking non-acceptance by other states as sovereign, or being labeled as failed states for violation of human rights in their attempt to maintain internal security.


The structure of the Westphalian international system is based on states upholding one another as sovereign actors. Cross-border intervention on human-rights or economic issues is in conflict with that principle, particularly when the option of intervention belongs exclusively to strong states that on the basis of military strength also claim the privilege to define the standards of human rights and economic equity. The sole reason the US has not been a victim of humanitarian intervention is its military strength, not because it is free of human-rights violations. Humanitarian or human-rights or economic intervention are frequently acts of moral imperialism by strong states. 

World-order principles have historically been crucial in setting the parameters for how failed-state intervention has been rationalized and conducted. With the end of the Cold War, different world-order principles have gained prominence as competing political cultures for how state power and national interests are to be translated into policy. World-order principles are products of political cultures. They form the structure of the international system, provide the content for state and national interests and add ideological meaning to state power. 

The structure of the international system both in its political and socio-economic forms has historically set very different rules of the game for how failed states are identified and dealt with. The Roman Empire was seen as a model for later attempts to provide international governance. The idea is that a hegemonic system with dominant power can serve best as guarantor of world or regional order. The concept of the United Nations was a community of sovereign states governed by a Security Council of major powers. 

In contrast to the strict notion of territoriality behind the Roman Empire, the Middle Ages saw several competing non-territorial organizing institutions: the Holy Roman Empire, the Church, and feudalism. In the early Middle Ages, world order was contested even though the non-territorial systems co-existed. There was no clear conception of sovereignty, and lines of authority were mixed at best. Failed and failing states made no real sense in such a system except in a religious sense as defenders of the faith. 

It is with the growth of territoriality that an international order of sovereign states was constructed whereby states were empowered by recognition by other states, rather than by the Church. The coming of age of the nation-state in the 18th and 19th centuries gave enduring strength to the Westphalian system, with state sovereignty at its core. This sovereignty may be seen to have a constitutional and a functional dimension. On the one hand, the state is the actor in international relations. It alone has the political authority to deal with other states. On the other hand, the state has sovereignty over all functions in society and defines the rules of the domestic game. Thus states may vary in how they define their domestic setups and how they claim their functional sovereignty. Tyranny, even as repulsive as it has become in modern society, has not been a basis for disqualification of state sovereignty. 

On this foundation of state sovereignty was built the system of balance of power as an ordering principle in international relations. Since states are sovereign with reference to one another, they must build alliances in order to guard themselves against the dominance of the powerful over the less powerful. The balance-of-power logic reflects both a systemic logic and a historical reality in the 19th century. 

In this system, failed and failing states constituted a serious problem. The system had a dual logic with regard to failed and failing states. Outside of the European balance-of-power system, non-European states were subjugated and made into colonies in order to maintain stability. To prevent fighting over the colonies, the balance-of-power logic could be applied as it was with the founding in 1871 of the German Empire. 

The European system was a rational system that matured during the age of reason when statesmen worked out the mechanics of power and balancing in order to create a stable international order. Beyond Europe, the state system was introduced in the colonies after the age of imperialism, and the international system was in fact created and based on the rules and functionalities of the European state system.


In East Asia, the world order until the advent of European imperialism was one of tributary states to China as the central kingdom whose international relations were based on generous gifts from the central kingdom in return for meager tributes from lesser states. The Asian world order of a prosperous and benevolent center showering gifts on the less prosperous periphery was different from the European system of empire of the center exploiting the periphery. This was due to both the relatively advanced stage of Chinese civilization and the sheer size of the Chinese economy, which did not need much from outside. The West had to use force to open trade with China. 

World order, then, is the network of economic and strategic pressures that both holds a system together and constrains its members to act in acceptable ways through commonly accepted rules and institutions. When those rules and institutions are set by a hegemon or an empire, failed-state status will be defined by those rules and institutions. When the rules of balance of power are dominant, state failure is a different phenomenon. Modern state failures are not associated with losses on the battlefield, but with fractional fighting and a crisis of legitimacy that feeds the fighting, or with the loss of sovereignty due to globalization. State failure is inseparably connected with the problems of authority and political legitimacy, as well of recognition of sovereignty. World-order principles define the sovereign foundations for legitimacy and authority. The type of world order is thus connected directly to why and how states fail, and how actions to remedy state failure are perceived. 


As a new century begins, the US advances the notion of "failed states" in international affairs, which claims a mandate for the sole remaining superpower to stage regime changes in any nation deemed a failed state in the world order of nation states that has existed since the Peace of Westphalia of 1648.

Edmund Burke (1729-1797), PC (His Majesty's Most Honourable Privy Council),  Anglo-Irish statesman, author, orator, political theorist, and philosopher, philosophical founder of conservatism, prophetically recognized the first partition of Poland in 1773 as the beginning of the crumbling of the old international order. The principle of the balance of power had historically been invoked to preserve the independence of European states, to secure weak or small states against universal monarchy. Poland was the first nation in the European system to be partitioned out of existence without a war, a source of great satisfaction to the participating powers: Russia, Austria and Prussia.

The event showed that in a world where great powers had risen, controlling modern apparatus of state, it was dangerous for a sovereign state not to be strong. A century later, Africa, lacking strong governments, was also partitioned without war among the states of Europe. Furthermore, the partition of Poland profoundly altered the balance of power in Europe. Emerging Western European powers, such as France and England, began championing the cause of Polish resistance and nationalism for anti-Germanic geopolitical purpose.

Resistance to the coercive internationalism of the Napoleonic empire gave rise to modern European nationalism in protest against the Napoleonic idea of a European continent united by uniform law and administration, with a single economic system and foreign policy and a unified command of its armed forces, the forerunner of the European Union. Since the international system was essentially French, nationalist movements were generally anti-French, except in territories outside French influence.

The nationalism of the Napoleonic epoch was a mélange of conservative and liberal forces, with conservatives emphasizing the preservation of traditional national culture, while liberals emphasized self-determination and decentralization. Nationalism thus was highly complex and dependent on a larger political context that was different in each country. Patriotism in England during the Napoleonic Wars helped her through the social crisis of the evolving Industrial Revolution, caused by dislocation, unemployment and associated revolutionary agitation. With minor exceptions, Spanish nationalism was counterreformation and counterrevolution, aiming to restore the corrupt clergy and the dethroned Bourbons.

German nationalism rebelled not only against progressive Napoleonic rule, but also against century-long ascendancy of French civilization. The age of the French Revolution and Napoleonic triumph coincided with German cultural efflorescence, with Beethoven, Goethe, Schiller, Herter, Kant, Fichte, Hegel, etc, who embodied German romanticism against the rational dryness of the French-dominated Age of Reason.

During the Peace of Westphalia, German nationalism was largely dormant until the late 18th century. The German upper class was contemptuous of anything German: their taste and mannerism and literature were French; their music, art and architecture were Italian. Frederich the Great (1740-86) hired French tax collectors and wrote in French.


Not until 1784, five years before the French Revolution, did J G Herder write his Ideas on the Philosophy of the History of Mankind in which he asserted that all true culture must rise from native roots, the life of the common people "the volk", not from the cosmopolitan mannerism of the upper classes. A sound civilization must express the volksgeist, or national character.


Mozart’s first composition with a German libretto was written in 1767, Die Schuldigkeit des ersten Gebots, Part I (Eng: The Obligation of the first and foremost Commandment) K35, a sacred Singspiel by Librettist Ignaz von Weiser.  Die Zauberflöte (Eng: The Magic Flute) K.620, was written in 1791, a Singspiel in two acts with libretto in German by Emanuel Schikaneder.

The French, in comparison, had a less developed tolerance for cultural relativity. The idea of volksgeist became a highly significant idea through Europe and later around the world. It was the fundamental appeal in romantic thought against rationalism. It celebrates difference along with similarity in mankind, in contrary paths against the Age of Enlightenment and its coercive universality. Hegel asserts that for a people to enjoy freedom, order, and dignity, it must be in control of a potent and independent state, the institutional embodiment of collective reason and liberty.

In economics, Friedrich List, in his National System of Political Economy (1841), asserts that political economy as espoused in England, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List's institutional school of economics asserts that the doctrine of free trade at the time was devised to keep England rich and powerful at the expense of its trading partners and it must be fought with protective tariffs and other compensatory measures of economic nationalism by the weaker countries. Henry Clay's "American system" was a national system of political economy.

The failure of the Frankfort Assembly in the 1850s was more nationalist than social. Its desire to retain non-Germans in the new Germany at a time when nationalism was on the rise, forced it to depend fatally on the military. After its failure, German liberal and revolutionaries emigrated in large numbers to the US, known as "Forty-Eighters", contributing to American socialist tradition.

From 1870 on, a nation-state system prevailed in modern world politics, with the consolidation of large nation states. War between capitalist states dominated the 20th century. Nationalist sentiments overran socialist internationalism at the start of World War I. The anti-war Zimmerwald program
at the International Socialist Conference held in Zimmerwald in September 1915 consisted of delegates from the Central Committee of the R.S.D.L.P., the Left Social-Democrats of Sweden, Norway, Switzerland and Germany, the Polish Social-Democratic opposition and the Social-Democrats of the Latvian area.


Led by Lenin, the Zimmerwald Left group waged a struggle against the Centrist majority of the Conference and moved resolutions condemning the First World War, exposing the betrayal by the social-chauvinists, and urging the necessity of active struggle against the war. These draft resolutions were rejected by the Centrist majority.


The Zimmerwald Left succeeded, however, in getting a number of important points from its own draft resolution included in the manifesto adopted by the Conference. Regarding this manifesto as a first step in the fight against the war, the Zimmerwald Left voted for it.


The Zimmerwald left issued a special statement detailing the inadequacy and inconsistency of the manifesto and their reasons for voting for it. They declared that while remaining within the Zimmerwald organisation they would disseminate their views and work independently on an international scale. The group elected an executive body – Lenin, Zinoviev and Radek. The Zimmerwald Left published a journal Vorbote (Herald) in German, which carried a number of articles by Lenin.


The Bolsheviks were the guiding force in the Zimmerwald Left. The Zimmerwald Left soon became the rallying point for internationalist elements of world Social-Democracy. The Social-Democrats of various countries who belonged to the Ziminerwald Left group carried on active revolutionary work and played an important role in the establishment of Communist parties in their countries.


Its aim was revolution in the belligerent countries caused by the continuation of war, while the rest aimed for peace. It was the first step towards forming what later became the Comintern. The Stalinist split with Trotskyism centered on the conflict between socialism in one country and international revolution.

The Asian financial crises of 1997 revived latent economic nationalism around the world against US-led neo-liberal globalization, while the North Atlantic Treaty Organization attack on Yugoslavia revived military nationalism. Market fundamentalism as espoused in the US, far from being a valid science universally, is increasingly viewed as merely US national opinion, suited only to US historical conditions. Just as anti-Napoleonic internationalism was essentially anti-French, anti-globalization and anti-humanitarian intervention are essentially anti-US. US unilateralism and exceptionism have become the midwife for a new revival of political and economic nationalism. The Bush Doctrine of nuclear posture pours gasoline on the smoldering fire of nationalism everywhere.

The notion of failed states advanced by US neo-liberals is not accompanied by any notion of failed markets, despite signs of market failure everywhere. Yet a real failed state is one that tolerates, nay, promotes failed markets.

When the market does not provide efficient outcomes for society, economists say that the market has "failed". Economists have identified different types of market failures.

Monopolies are the market failure of competition. Microsoft has been convicted of monopolistic practices, although the final legal decision is still pending. AT&T was a monopoly that the US Supreme Court broke up in 1983 after a 10-year legal battle. The US Congress passed the Sherman Antitrust Act in 1890. It declared illegal every contract, combination (be it a trust, monopoly or otherwise), or conspiracy that restrained interstate and foreign trade. The Supreme Court refused to uphold its constitutionality.

US president Theodore Roosevelt's "trust-busting" campaigns and a change in the opinion of the court achieved some results. In 1914, Congress passed the Clayton Act and established the Federal Trade Commission, expanding and tightening antitrust laws by explicitly forbidding actions taken to force competitors out of business by slashing prices, buying up and hoarding supplies, bribery or intimidation.

When a firm such as Microsoft has market power, it tends to restrict production in order to drive up prices and increase profit margins. This results in too few goods and innovation being produced in non-competitive markets. The recent rejection of the GE/Honeywell merger by the EU was primarily based on GE's financial market power in vendor financing. The world is awash with overcapacity in manufacturing and telecommunication because finance capitalism promotes monopolies in finance that thrive on ruinous over-investment in manufacturing and telecommunication. It also means that income is concentrated in the hands of those who have market power at the expense of those who do not. Under financial capitalism, dollar hegemony is a fundamental monopoly that permeates all sectors of the global economy.

Another market failure economists have identified is the underprovision of public goods. Examples of public goods range from national defense to street lights. Public goods will either be underprovided or not provided at all by the market. Because the benefits from a public good enjoyed by any individual are almost always less than the cost of producing the public good, the market does not provide them. The market has tended to under supply insurance for particular kinds of activities or risk (especially health insurance).

The post-September 11 insurance crisis surrounding the US airlines and the property casualty sector is another example. AIG, Citigroup and GE are selling their property casualty units. The US market, on its own, also fails to supply adequate loans for education and small-business ventures, as well as urban development for black neighborhoods. In each of these cases, government programs to complete or supplement the naturally incomplete markets are the only solution. Medicaid and Medicare are government financed "insurance" programs for the poor and the elderly.

The Department of Education and state and local student loan agencies find it necessary to underwrite or guarantee loans to students attending accredited colleges and universities. And the Small Business Administration helps individuals secure the funding they need to start their own businesses. Globalization based on the rules of market fundamentalism in the past decade has grossly underprovided public goods. The mostly obvious examples are environmental protection and poverty elimination.

When someone other than the recipient of a benefit bears the costs for its production, the costs of the benefit are external to its enjoyment. Economists call these external costs negative "externalities". These amount to a market failure to distribute costs and benefits efficiently. Globalization is basically a game of negative externalities, as evidenced by the infamous Summer World Bank memo on the immaculate logic of locating pollution in the poorest countries. Inhuman wages and working conditions, together with unfunded environmental protection and cleanup, are other negative externalities that benefit the US inflation rate.

Another market failure stems from the market's inadequate provision of information. The effect of asymmetrical information on the proper functioning of the market has been well recognized, having been cited as the basis for selecting last year's Nobel Prize on Economics. But the real information market failure is Western domination of the world media. Thirty years after developing countries first called for a new world information order, Western media are still being faulted for distorting and ignoring much of the world around them. Even as Western media bolster their domination of global news, Western news content seems less and less informative, particularly about issues not central to Western concerns.

Another form of information monopoly is structurally built into TRIPS (Agreement on Trade-Related Aspects of Intellectual Property Rights), which is Annex 1C of the Marrakesh Agreement Establishing the World Trade Organization, signed in Marrakesh, Morocco, on April 15, 1994. Under TRIPS, the less developed nations will be condemned to intellectual feudal serfdom perpetually.

Incomplete markets are another form of failure. There are some goods and services that may not be "pure" public goods, which are nonetheless undersupplied by the market. There are numerous goods and services that have the potential to improve the economic fortunes of individuals and of society that are not widely available. In such circumstances, the need or demand for a particular good or service is higher than the available supply of that good or service, hence there is an incomplete market.

In many circumstances the amount of coordination required to complete a market is so extensive that government intervention is required. In the case of the Internet, governmental support is largely responsible for the creation of a massive multibillion-dollar complementary market. While the world is faced with food overproduction, famines continue to be regular occurrences.

All governments coordinate, if not regulate, businesses and the markets in which they operate. For years, Japan's Ministry International Trade and Industry (MITI) has been held up as a shining example of successful governmental coordination of a nation's economy through an industrial policy. Economic setbacks in Japan during the last decade have been blamed by Western analysts on the inability of MITI to outguess and outperform the natural forces of the market. A case can be built that MITI's error was not industrial policy per se, but its failure to understand the destructive power of dollar hegemony under finance capitalism. It is not enough to plan. Planning needs to be intelligent. Japan's failure was that it played the game of industrial capitalism while the US moved to finance capitalism.

The "Business Cycle" is a structural and recurring market failure of market capitalism. Unemployment as a devise to combat inflation is a policy market failure.

In a market system, there is a structural tendency for income to be distributed unevenly. Even in the US, the consummate beneficiary of globalized markets, 26.3 percent of all children in the US live in families that are below the official poverty level, according to the United Nations Children's Fund (UNICEF). On the global level, 30 percent of the population lives on less than US$1 a day, mostly women and children. No amount of sophist argument can deny such obvious market failure.

Failed markets threaten the future of the world much more than failed states. To preserve world peace, the real regime change needs to be on failed markets.


Merely two years before the end of the first decade of the 21st century, the post-Cold-War world economic order found itself facing its most serious crisis under the weight of unsustainable deregulated debt capitalism created by dollar hegemony. There are clear signs that out of this current crisis a new world economic order will emerge. China is in a promising position to influence this development toward a sustainable, balanced and cooperative world order of global fairness and universal justice.


The root cause of the current crisis can be traced to the dismantlement of the Bretton Woods international finance architecture by the US in 1971 when president Richard Nixon suspended the dollar's link to gold, and the subsequent deregulation of globalized financial markets that has allowed free cross-border movement of funds.


Toward the end of the World War II, the United States, through its dominance in the Bretton Woods Conference of 1944, constructed a post-war international finance architecture based on a gold-back dollar as a reserve currency to revive world trade. The Bretton Woods monetary regime allowed the US, which at that time was in possession of most of the world's gold, to take over the role of financial and economic hegemon in a new age of neo-imperialism under finance capitalism previously played by Britain in the age of imperialism under industrial capitalism.


Economics thinking prevalent immediately after World War II, drawing lessons from the 1930s' Great Depression, had deemed international capital flow undesirable and unnecessary for national economic development. Trade, a relatively small aspect of most national economies at the time, was to be mediated through fixed exchange rates pegged to a gold-backed dollar. These fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the economies participating in international trade, which was expected to augment, but not overwhelm, the national economies.


The impact of exchange rates was limited to the settlement of international trade. Exchange rate considerations were not expected to dictate domestic monetary and fiscal policies, the chief function of which was to support domestic development and regarded as the inviolable province of national sovereignty.


During the Cold War, there was no global trade. The economies of the two contending ideology blocks were completely disconnected and did not trade outside of their own blocks. Within each block, allied economies interacted through foreign aid from and memorandum trade with their respective superpowers. The competition was not for profit but for the hearts and minds of the people in the two opposing blocks, as well as those in the non-aligned nations in the Third World. The competition between the two superpowers was to give rather than to take from their separate fraternal economies.

Convergence to equality the aim


The population of the superpowers worked hard to help the poor within their separate blocks. Convergence toward equality was the policy aim even if not always the practice. The Cold War era of foreign aid and memorandum trade had a better record of poverty reduction within either of the two camps than post-Cold War, globalized, neo-liberal trade dominated by one single superpower. The aim was not only to raise income and increase wealth, but also to reduce income and wealth disparity between and within economies.


In the world economic order that emerged after the Cold War, income and wealth disparity has been rationalized as a necessity for capital formation even in the rich economies. From 1980 to 2007, the total after-tax income earned by the top 0.1% of earners in the US more than quadrupled, while the share earned by everyone else in the top 10% rose far less and the share of the bottom 90% actually declined in purchasing power.


In China, privatization of state-owned-enterprises since 1978 has pushed a large segment of the working population outside of the socialist sphere of free social benefits in healthcare, education and retirement entitlements. Unemployment is now a serious structural problem everywhere, including in the Chinese socialist market economy.


Excessive reliance on export financed by foreign capital has also left developmental imbalances between China's exporting coastal regions and the isolated interior. Despite recurring big trade surpluses denominated in dollars, China has been prevented by dollar hegemony from using sovereign credit to finance domestic development. China is now the world's biggest creditor nation, yet the Chinese economy continues to require foreign capital that demands rates of return higher than such capital could get in their home economies.


Ironically, much of this "foreign" capital comes from the US which is deeply indebted to China. The US is investing in China with money it borrows from China. The US is able to do this because the debt and capital are both denominated in dollars that the US can print at will.


Today's post-industrial financial market economies are all plagued by overcapacity created by insufficient consumer purchasing power. The Chinese market economy is a glaring example of this structural contradiction which arises from the need of companies to keep down wages to maximize corporate profit. Workers everywhere are not able to afford all the products they produce, thus causing overcapacity that has to be absorbed by export.

American entrepreneur Henry Ford (1867-1943) understood this structural contradiction in industrial market economies and identified rising wages as a solution to overcapacity caused by rising labor productivity. But foreign capital denominated in foreign currency (dollars) rejects the need for high local wages because it earns its dollar profits from export to foreign markets. This is the main reason why emerging economies must avoid excess dependence on export for dollars financed by foreign capital in dollars.


China needs to accelerate its domestic development with sovereign credit denominated in Chinese currency to proportionally reduce its excessive dependence on export for dollars financed by foreign capital in dollars. China needs to denominate its export trade in Chinese currency to break free from dollar hegemony. This is the key strategy for positively influencing a new world economic order of universal justice to replace current predatory terms of international trade under dollar hegemony.


Since the Cold War, which officially ended with the dissolution of the USSR in 1991, world economic growth has been distorted by a shift from aggregate domestic development with sovereign credit within sovereign nations to excessive reliance on globalized neo-liberal trade engineered and led by the US as the sole remaining superpower. International trade has since been denominated in the US dollar, a fiat currency after 1971, as the main reserve currency. International trade has been driven by the huge US consumer market made possible by the high wages of US workers backed, not by rising productivity, but by US dollars that the US, and only the US, can print at will through its central bank.


In China, rising worker productivity has not resulted in higher wages, but only in lower export prices. This is the main reason why the Chinese domestic market lags behind in consumer demand despite enormous rise in Chinese worker productivity. Many Western critics erroneously pressure China to revalue its currency to address the persistently large trade imbalance. The only effective measure to deal with this trade imbalance is for China to raise wages rather than to revalue the exchange rate of its currency.


For the two decades before the global financial crisis that first broke out in mid 2007, economic growth in the dysfunctional world economic order has been, and still is, based primarily on free cross-border flow of capital and speculative funds driven by cross-border wage and regulatory arbitrage. This growth has been sustained by knocking down national tariffs worldwide through the authority of supranational institutions such as the World Trade Organization, and financed by a deregulated foreign exchange market working in concert with a global central banking regime independent of national political pressure, lorded over by the supranational Bank of International Settlement and the International Monetary Fund.


Domestic development overwhelmed by World Trade


Ever since the end of the Cold War in 1991, which actually began winding down in the early 1970s with US policy of detente, trade has increasingly overwhelmed domestic development in the global economy, as superpower competition to win the hearts and minds of the world in the form of aid subsided. Persistent fiscal and trade deficits forced the US to suspend in 1971 the peg of the dollar to gold at $35 per ounce, in effect abandoning the Bretton Woods regime of fixed exchange rates linked to a gold-back dollar. The flawed international finance architecture that resulted has since limited the global growth engine to operating with only the one cylinder of international trade, leaving all other cylinders of domestic development in a state of permanent stagnation.


The venue of sovereign credit for national development has been foreclosed permanently. China needs to free itself from dollar hegemony to use sovereign credit to develop her domestic economy.


Since 1978, China has exposed itself to the disadvantages of export trade denominated in dollars. Much of the wealth created in China during the last 30 years has ended up in the US, leaving China in an extended state of capital shortage despite being the largest holder of foreign reserves in the world. When it comes to consumer power and environmental pollution, China is only the kitchen; the dining room is in the US. In a new world economic order, China should move the dining room back inside China.


The global economy is a comprehensive and complex system of which trade is only one sector. Yet economists and policy-makers promoting neo-liberal globalization tend to view trade as the entire global economy itself, downplaying the importance of non-trade-related domestic development. Neo-liberals promote market fundamentalism as the sole, indispensable path for national economic growth, despite ample evidence in the past three decades that trade globalization tends to distort balanced domestic development in ways that hurt not only the less developed, but also the developed economies.


This is why a new world economic order must restore domestic development, with sovereign credit as the driving force, and reduce world trade as an auxiliary force in which export should be denominated in the exporting country's currency.


The distributional consequences of predatory terms of global trade liberalization under dollar hegemony work against the developing economies in the world. Such predatory terms of trade also work against the poor and the financially weak in all economies, including the advance economies, putting the less-educated and the less-skilled in a downward spiral of chronic unemployment and persistent hopelessness.


Reductions in tariffs reduce tax revenues for public spending that can help poor people and weaken needed protection for endangered domestic industries. While distributional consequences of trade liberalization are complex and country-specific, the general trend has been to exacerbate income disparity everywhere, which in turn leads to economic underperformance and political instability in all countries.


In the United States, the Mecca of free-market entrepreneurship, spending by the statist sectors - government operations, public finance, defense, health care, social security and public education - have kept the economy afloat in recurring protracted recessions, while entrepreneurial ventures in corporate finance, insurance, high-tech manufacturing, airlines and communication languish in extended doldrums needing government bailouts.

Unregulated markets lead naturally to monopolistic consolidation and abuses in corporate governance and finance through the concentration of market power. It has become clear and undeniable that "free" markets are inherently self-destructive of their own freedom. Free markets depend on enlightened government regulations to remain free and to prevent them from turning into failed markets.


Government, from monarchy to democracy, within capitalist market economies or socialist economies, exists to protect the weak from the strong and to maintain socio-political stability with a just socio-economic order. A new world economic order will have to be based on this principle of universal justice between and within sovereign nations. For China to exert influence on the formation of this new world economic order, it must construct its domestic economic order on the same principle of equality and fairness.


World trade is now a game in which the US produces fiat dollars of uncertain exchange value and zero intrinsic value, and the rest of the world produces goods and services that fiat dollars can buy. The world's interlinked economies no longer trade to capture Ricardian comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign capital and debts and to accumulate dollar reserves to stabilize the value of their currencies in world currency markets.


To prevent speculative and manipulative attacks on their currencies, central banks of all trading governments must acquire and hold dollar reserves in amounts that can withstand market pressure on their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. Only the Federal Reserve is exempt from this pressure, because the US Treasury can print dollars at will with relative immunity. This creates a built-in support for a strong dollar that in turn forces the world's central banks to acquire and hold more dollar reserves, making the dollar even stronger.


Dollar hegemony


This phenomenon is known as dollar hegemony, which is created by a geopolitically constructed peculiarity through which critical commodities, among the most notable being oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance for the oil-exporting cartel since 1973. The trade value of a currency is no longer tied to the productivity of its issuing economy, but to the size of dollar reserves held by its central bank.


By definition, dollar reserves must be invested in dollar assets, creating an automatic capital-accounts surplus for the dollar economy. Even though the US has been a net debtor since 1986, its net income on the international investment position has remained positive, as the rate of return on US investments abroad continues to exceed that on foreign investments in the US.


This reflects the overall strength of the US economy, and that strength is derived from the US being the only nation that can enjoy the benefits of sovereign credit utilization while amassing external debt denominated in dollars, largely due to dollar hegemony. Unlike other economies, the US economy incurs no foreign debt, only domestic debt denominated in dollars held by foreigners. These debts can always be repaid by the Federal Reserve, the US central bank, printing more dollars.


Since such a move will devalue the exchange rate of the dollar, foreign holders of the US dollar sovereign or private debt are prevented from demanding payment. Further, when basic commodities are denominated in dollars, the US essentially owns all such commodities. Foreign owners of dollar assets are merely unwitting temporary agents of the US dollar hegemony.


Under the Westphalian world order of sovereign nation states, which has framed international relations since 1648, only coordinated economic nationalism that focuses on domestic development can pull the world economy out of its current downward spiral.

Economic nationalism should not be confused with trade protectionism. Decades of predatory cross-border neo-liberal finance and trade have generated strong anti-globalization sentiments in every country around the world. It has become a class struggle between the financial elite and the working poor in rich and poor countries alike.


Before the end of the first decade of the 21st century, in a world where market fundamentalism has become the operative norm, misguided trade protectionism appears to be fast re-emerging and developing into a new global trade war with complex dimensions. The irony is that this new trade war is being launched not by the abused poor economies that have been receiving the short end of the trade stick, but by the US, as leader of rich nations which have been winning more than they have been losing in the current economic order and trade system.


Much of this protectionism is designed to protect industries that the rich nations have voluntarily moved offshore for financial and environmental advantage. Such protectionism aims to protect non-existent economic activities by imposing tariffs on goods that the importing nations chose not to produce.


The biggest battles of this new trade war are being fought on the currency exchange rate front under dollar hegemony, a global monetary regime in which export nation ship real wealth produced with low wages and high environmental abuse in exchange for fiat paper money of uncertain exchange value and zero intrinsic worth.

Rich nations need to recognize that their efforts to squeeze every last drop of advantage at all levels from already unfair finance and trade will only plunge the world into deeper depression. History has shown that while the poor suffer more in economic collapse, the rich, even as they are financially cushioned by their ill-gained wealth and structural advantage, are hurt by the sociopolitical repercussions of such a collapse, in the form of war, revolution or both.


The structural problem of the Chinese economy can be described in one sentence: China produces from plants on its soil financed by foreign investment that operate with low domestic wages for foreign markets that pay with dollars that cannot be used in the Chinese domestic economy.


Domestic Market is the Key


The solution to this structural problem can also be summed up in one sentence: China must finance Chinese plants with sovereign credit to produce for the domestic market where consumer purchasing power will come from high wages, with sovereign credit repaid by increased tax revenue from a vibrant domestic economy.


The adverse impact from the current global financial crisis on the Chinese economy originates from the bloated export sector financed in large part by foreign capital denominated in dollars. Foreign markets have abruptly contracted since mid-2007 to cause massive closure of tens of thousands of foreign joint-ventures or wholly owned enterprises, big, medium and small, in the Chinese export sector located along the coastal regions that has caused serious unemployment.


Economic recovery through the shifting from export dependency to domestic development requires coordinated actions by both the state and the private sectors. The government's role is to guide state-owned enterprises and private-sector incentives toward a national full employment program through tax incentives and regulatory regimes.


Government fiscal spending should be limited to funding infrastructure, both physical and social, that cannot be efficiently financed by private or even collective capital. Consumer demand should be enhanced as a priority in a national income policy to quickly raise wage levels in parallel with a well-funded social security program to eliminate the need for compulsory over-saving out of concern for emergency health expenses and provision for old-age security.


In conclusion, China can exert a positive influence on a new world economic order by setting an example with its own national development policy. To achieve this goal, China needs to adopt the following policy initiatives:


1. China must recognize that a deregulated market economy is counterproductive to national development. The clear evidence of this is what deregulated markets have done to the US economy, destroying US superpower status within three decades. China must revitalize central planning to guide national development and to use the market mechanism only to augment central planning targets. National destiny and national interest cannot be subjected to the dictation of market profit incentives.


2. China must place full employment with rising wages as a national economic priority and shift from the current market fundamentalist, macro-management on growth in gross domestic product, with unemployment as a natural outcome of a monetary policy of price stability. Economic equality and justice must be the guiding developmental principle within the context of merit-based compensation.


3. China must break free from dollar hegemony to use sovereign credit to finance balanced domestic development and to reduce excessive dependence on export for dollars and reliance on foreign capital denominated in dollars. A first step in this direction is to require all Chinese exports be settled in yuan, not in dollars.


4. China should conduct its foreign trade on the principle of mutual development for both trading partners rather than as a financial profit center for Chinese capital. China must reject the predatory terms of international trade developed during the age of imperialism. Unlike 19th century England and Japan, the huge size of the Chinese economy and its domestic market does not require imperialist terms of trade to survive. The US model failed because it aped the British model of empire after World War II. China must avoid making the same error.


5. China must guard against the fallacy of hoping to use green-tech investment as a stimulus to recover from the current global financial crisis. The global environment needs protection. But the time-scale concerning the needs of the environment is not congruent with that of the current global financial crisis. The environmental protection problem cannot be solved without first solving the global financial crisis. Attempting to use green-tech investment to jump-start the current economic crisis is putting the cart before the horse. Such an approach will only end up falling short on both environmental and economic aims.


Dollar Hegemony Against Sovereign Credit

This article appeared in AToL on June 24, 2005

Global trade has forced all countries to adopt market economy.  Yet the market is not the economy. It is only one aspect of the economy. A market economy can be viewed as an aberration of human civilization, as economist Karl Polanyi (1886-1964) pointed out. The principal theme of Polanyi’s Origins of Our Time: The Great Transformation(1945) was that market economy was of very recent origin and had emerged fully formed only as recently as the 19th century, in conjunction with capitalistic industrialization. The current globalization of markets following the fall of the Soviet bloc is also of recent post-Cold War origin, in conjunction with the advent of the electronic information age and deregulated finance capitalism. A severe and prolonged depression can trigger the end of the market economy, when intelligent human beings are finally faced with the realization that the business cycle inherent in the market economy cannot be regulated sufficiently to prevent its innate destructiveness to human welfare and are forced to seek new economic arrangements for human development.  The principle of diminishing returns will lead people to reject the market economy, however sophisticatedly regulated.

Prior to the coming of capitalistic industrialization, the market played only a minor part in the economic life of societies. Even where market places could be seen to be operating, they were peripheral to the main economic organization and activities of society. In many pre-industrial economies, markets met only twice a month. Polanyi argued that in modern market economies, the needs of the market determined social behavior, whereas in pre-industrial and primitive economies the needs of society determined market behavior. Polanyi reintroduced to economics the concepts of reciprocity and redistribution in human interaction, which were the original aims of trade. 

Reciprocity implies that people produce the goods and services they are best at and enjoy most in producing, and share them with others with joy. This is reciprocated by others who are good at and enjoy producing other goods and services. There is an unspoken agreement that all would produce that which they could do best and mutually share and share alike, not just sold to the highest bidder, or worse to produce what they despise to meet the demands of the market. The idea of sweatshops is totally unnatural to human dignity and uneconomic to human welfare. With reciprocity, there is no need for layers of management, because workers happily practice their livelihoods and need no coercive supervision. Labor is not forced and workers do not merely sell their time in jobs they hate, unrelated to their inner callings. Prices are not fixed but vary according to what different buyers with different circumstances can afford or what the seller needs in return from different buyers. The law of one price is inhumane, unnatural, inflexible and unfair. All workers find their separate personal fulfillment in different productive livelihoods of their choosing, without distortion by the need for money. The motivation to produce and share is not personal profit, but personal fulfillment, and avoidance of public contempt, communal ostracism, and loss of social prestige and moral standing.

This motivation, albeit distorted today by the dominance of money, is still fundamental in societies operating under finance capitalism.  But in a money society, the emphasis is on accumulating the most financial wealth, which is accorded the highest social prestige.


The annual report on the world's richest 100 as celebrities by Forbes is a clear evidence of this anomaly. The opinion of figures such as Bill Gates and Warren Buffet are regularly sought by the media on matters beyond finance, as if the possession of money itself represents a diploma of wisdom.  In the 1960s, wealth was an embarrassment among the flower children in the US. It was only in the 1980s that the age of greed emerged to embrace commercialism.  


In a speech on June 3 at the Take Back America conference in Washington, D.C, Bill Moyers drew attention to the conclusion by the editors of The Economist, all friends of business and advocates of capitalism and free markets, that “the United States risks calcifying into a European-style class-based society.”  A front-page leader in the May 13, 2005 Wall Street Journal concluded that “as the gap between rich and poor has widened since 1970, the odds that a child born in poverty will climb to wealth - or that a rich child will fall into middle class - remain stuck....Despite the widespread belief that the U.S. remains a more mobile society than Europe, economists and sociologists say that in recent decades the typical child starting out in poverty in continental Europe (or in Canada) has had a better chance at prosperity.”  


The New York Times ran a 12-day series in June 2005 under the heading of “Class Matters” which observed that class is closely tied to money in the US and that “the movement of families up and down the economic ladder is the promise that lies at the heart of the American dream. But it does not seem to be happening quite as often as it used to.”  The myth that free markets spread equality seems to be facing challenge in the heart of market fundamentalism.
People trade to compensate for deficiencies in their current state of development. Free trade is not a license for exploitation. Exploitation is slavery, not trade. Imperialism is exploitation by systemic coercion on an international level. Neo-imperialism after the end of the Cold War takes the form of neo-liberal globalization of systemic coercion.  Free trade is hampered by systemic coercion. Resistance to systemic coercion is not to be confused with protectionism.


To participate in free trade, a trader must have something with which to trade voluntarily in a market free of systemic coercion. All free trade participants need to have basic pricing power which requires that no one else commands monopolistic pricing power. That tradable something comes from development, which is a process of self-betterment. Just as equality before the law is a prerequisite for justice, equality in pricing power in the market is a prerequisite for free trade. Traders need basic pricing power for trade to be free.  Workers need pricing power for the value of their labor to participate in free trade.

Yet trade in a market economy by definition is a game to acquire overwhelming pricing power over one’s trading partners. Wal-Mart for example has enormous pricing power both as a bulk buyer and a mass retailer.  But it uses its overwhelming pricing power not to pay the highest wages to workers in factories and in its store, but to deliver the lowest price to its customers. The business model of Wal-Mart, whose sales volume is greater than the GDP and trade volume of many small countries, is anti-development.  The trade off between low income and low retail price follows a downward spiral. This downward spiral has been the main defect of trade de-regulation when low prices are achieved through the lowering of wages. The economic purpose of development is to raise income, not merely to lower wages to reduce expenses by lowering quality. International trade cannot be a substitute for domestic development, or even international development, although it can contribute to both domestic and international development if it is conducted on an equal basis for the mutual benefit of both trading partners. And the chief benefit is higher income.

The terms of international trade needs to take into consideration local conditions not as a reluctant tolerance but with respect for diversity. Former Japanese Vice Finance Minister for International Affairs, Eisuke Sakakibara, in a speech“The End of Market Fundamentalism” before the Foreign Correspondent's Club, Tokyo, Jan. 22, 1999, presented a coherent and wide ranging critique of global macro orthodoxy. His view, that each national economic system must conform to agreed international trade rules and regulations but needs not assimilate the domestic rules and regulations of another country, is heresy to US-led one-size-fits-all globalization. In a computerized world where output standardization has become unnecessary, where the mass production of customized one-of-a-kind products is routine, one-size-fit all hegemony is nothing more than cultural imperialism. In a world of sovereign states, domestic development must take precedence over international trade, which is a system of external transactions made supposedly to augment domestic development. And domestic development means every nation is free to choose its own development path most appropriate to its historical conditions and is not required to adopt the US development model. But neo-liberal international trade since the end of the Cold War has increasingly preempted domestic development in both the center and the periphery of the world system.  Quality of life is regularly compromised in the name of efficiency. 

This is the reason the French and the Dutch voted against the EU constitution, as a resistance to the US model of globalization. Britain has suspended its own vote on the constitution to avoid a likely voter rejection.  In Italy, cabinet ministers suggested abandoning the euro to return to an independent currency in order to regain monetary sovereignty. Bitter battles have erupted between member nations in the EU over national government budgets and subsidies. In that sense, neo-liberal trade is being increasingly identified as an obstacle, even a threat, to diversified domestic development and national culture.  Global trade has become a vehicle for exploitation of the weak to strengthen the strong both domestically and internationally. Culturally, US-style globalization is turning the world into a dull market for unhealthy MacDonald fast food, dreary Walt-Mart stores, and automated Coca Cola and ATM machines. Every airport around the world is a replica of a giant US department store with familiar brand names, making it hard to know which city one is in. Aside from being unjust and culturally destructive, neo-liberal global trade as it currently exists is unsustainable, because the perpetual transfer of wealth from the poor to the rich is unsustainable anymore than drawing from a dry well is sustainable in a drought, nor can a stagnant consumer income sustain a consumer economy. Neo-liberal claims of fair benefits of free trade to the poor of the world, both in the center and the periphery, are simply not supported by facts. Everywhere, people who produce the goods cannot afford to buy the same goods for themselves and the profit is siphoned off to invisible investors continents away.

Trade and Money

Trade is facilitated by money. Mainstream monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking. This view is valid only for specie money, which is a debt certificate that entitles the holder to claim on demand a prescribed amount of gold or other specie of value. Government-issued fiat money, on the other hand, is not a sovereign debt but a sovereign credit instrument, backed by government acceptance of it for payment of taxes. This view of money is known as the State Theory of Money, or Chartalism. The dollar, a fiat currency, entitles the holder to exchange for another dollar at any Federal Reserve Bank, no more, no less. Sovereign government bonds are sovereign debts denominated in money. Sovereign bonds denominated in fiat money need never default since sovereign government can print fiat money at will. Local government bonds are not sovereign debt and are subject to default because local governments do not have the authority to print money. When fiat money buys bonds, the transaction represents credit canceling debt. The relationship is rather straightforward, but of fundamental importance.

Credit drives the economy, not debt.  Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the distorted reflection in the mirror as a perfect representation. Mirror, mirror on the wall, who is the fairest of them all?  The answer is: your backside.

In the language of monetary economics, credit and debt are opposites but not identical.  In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern finance economy, which is driven by credit and stalled by debt.  Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Debt turns corporate shares into Giffen goods, demand for which increases when their prices go up, and creates what Federal Reserve Board Chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad. 


If fiat money is not sovereign debt, then the entire financial architecture of fiat money capitalism is subject to reordering, just as physics was subject to reordering when man’s world view changed with the realization that the earth is not stationary nor is it the center of the universe. For one thing, the need for capital formation to finance socially useful development will be exposed as a cruel hoax. With sovereign credit, there is no need for capital formation for socially useful development in a sovereign nation. For another, savings are not necessary to finance domestic development, since savings are not required for the supply of sovereign credit. And since capital formation through savings is the key systemic rationale for income inequality, the proper use of sovereign credit will lead to economic democracy. 


Sovereign Credit and Unemployment


In an economy financed by sovereign credit, labor should be in perpetual shortage, and the price of labor should constantly rise. A vibrant economy is one in which there is a persistent labor shortage and labor enjoys basic, though not monopolistic, pricing power. An economy should expand until a labor shortage emerges and keep expanding through productivity rise to maintain a slight labor shortage. Unemployment is an indisputable sign that the economy is underperforming and should be avoid as an economic plague.


The Phillips curve, formulated in 1958, describes the systemic relationship between unemployment and wage-pushed inflation in the business cycle. It represented a milestone in the development of macroeconomics. British economist A. W. H. Phillips observed that there was a consistent inverse relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957.  Whenever unemployment was low, inflation tended to be high. Whenever unemployment was high, inflation tended to be low. What Phillips did was to accept a defective labor market in a typical business cycle as natural law and to use the tautological data of the flawed regime to prove its validity, and made unemployment respectable in macroeconomic policymaking, in order to obscure the irrationality of the business cycle.


That is like observing that the sick are found in hospitals and concluding that hospitals cause sickness and that a reduction in the number of hospitals will reduce the number of the sick. This theory will be validated by data if only hospital patients are counted as being sick and the sick outside of hospitals are viewed as “externalities” to the system.  This is precisely what has happened in the US where an oversupply of hospital beds has resulted from changes in the economics of medical insurance, rather than a reduction of people needing hospital care.  Part of the economic argument against illegal immigration is based on the overload of non-paying patients in a health care system plagued with overcapacity.

Nevertheless, Nobel laureates Paul Samuelson and Robert Solow led an army of government economists in the 1960s in using the Phillips curve as a guide for macro-policy trade-offs between inflation and unemployment in market economies.  Later, Edmund Phelps and Milton Friedman independently challenged the theoretical underpinnings by pointing out separate effects between the “short-run” and “long-run” Phillips curves, arguing that the inflation-adjusted purchasing power of money wages, or real wages, would adjust to make the supply of labor equal to the demand for labor, and the unemployment rate would rest at the real wage level to moderate the business cycle. This level of unemployment they called the "natural rate" of unemployment. The definitions of the natural rate of unemployment and its associated rate of inflation are circularly self-validating. The natural rate of unemployment is that at which inflation is equal to its associated inflation. The associated rate of inflation rate is that which prevails when unemployment is equal to its natural rate.

A monetary purist, Friedman correctly concluded that money is all important, but as a social conservative, he left the path to truth half traveled, by not having much to say about the importance of the fair distribution of money in the market economy, the flow of which is largely determined by the terms of trade. Contrary to the theoretical relationship described by Phillips curve, higher inflation was associated with higher, not lower, unemployment in the US in the 1970s and contrary to Friedman’s claim, deflation was associated also with high unemployment in Japan in the 1990s.  The fact that both inflation and deflation accompanied high unemployment ought to discredit the Phillips curve and Friedman’s notion of a natural unemployment rate. Yet most mainstream economists continue to accept a central tenet of the Friedman-Phelps analysis that there is some rate of unemployment that, if maintained, would be compatible with a constant rate of inflation. This they call the “non-accelerating inflation rate of unemployment” (NAIRU), which over the years has crept up from 4% to 6%.

NAIRU means that the price of sound money for the US is 6% unemployment. The US Labor Department reported the “good news” that in May 2005, 7.6 million persons, or 5.1% of the workforce, were unemployed in the US, well within NAIRU range.  Since the low income tend to have more children than the national norm, that translates to households with more than 20 million children with unemployed parents. On the shoulders of these unfortunate, innocent souls rests the systemic cost of sound money, defined as having a non-accelerating inflation rate, paying for highly irresponsible government fiscal policies of deficits and a flawed monetary policy that leads to sky-rocketing trade deficits and debts. That is equivalent to saying that if 6% of the world population dies from starvation, the price of food can be stabilized. And unfortunately, such is the terms of global agricultural trade. No government economist has bothered to find out what would be the natural inflation rate for real full employment.

It is hard to see how sound money can ever lead to full employment when unemployment is necessary to keep money sound. Within limits and within reason, unemployment hurts people and inflation hurts money. And if money exists to serve people, then the choice between inflation and unemployment becomes obvious. The theory of comparative advantage in world trade is merely Say’s Law internationalized. It requires full employment to be operative. 


Wages and Profit


And neoclassical economics does not allow the prospect of employers having an objective of raising wages, as Henry Ford did, instead of minimizing wages as current corporate management, such as General Motors, routinely practices.  Henry Ford raised wages to increase profits by selling more cars to workers, while Ford Motors today cuts wages to maximize profit while adding to overcapacity. Therein resides the cancer of market capitalism: falling wages will lead to the collapse of an overcapacity economy.


This is why global wage arbitrage is economically destructive unless and until it is structured to raise wages everywhere rather than to keep prices low in the developed economies.  That is done by not chasing after the lowest price made possible by the lowest wages, but by chasing after a bigger market made possible by rising wages.  The terms of global trade need to be restructured to reward companies that aim at raising wages and benefits globally through internationally coordinated transitional government subsidies, rather than the regressive approach of protective tariffs to cut off trade that exploits wage arbitrage. This will enable the low-wage economies to begin to be able to afford the products they produce and to import more products from the high wage economies to move towards balanced trade. Eventually, certainly within a decade, wage arbitrage would cease to be the driving force in global trade as wage levels around the world equalize. When the population of the developing economies achieves per capita income that matches that in developed economies, the world economy will be rid of the modern curse of overcapacity caused by the flawed neoclassical economics of scarcity.


When top executives are paid tens of million of dollars in bonuses to cut wages and worker benefits, it is not fair reward for good management; it is legalized theft.  Executives should only receive bonuses if both profit and wages in their companies rise as a result of their management strategies.


Sovereign Credit and Dollar Hegemony


In an economy that can operate on sovereign credit, free from dollar hegemony, private savings are needed only for private investment that has no clear socially redeeming purpose or value. Savings are deflationary without full employment, as savings reduces current consumption to provide investment to increase future supply. Savings for capital formation serve only the purpose of bridging the gap between new investment and new revenue from rising productivity and increased capacity from the new investment.  With sovereign credit, private savings are not needed for this bridge financing.  Private savings are also not needed for rainy days or future retirement in an economy that has freed itself from the tyranny of the business cycle through planning. Say’s Law of supply creating its own demand is a very special situation that is operative only under full employment.


Say’s Law ignores a critical time lag between supply and demand that can be fatal to a fast-moving modern economy without demand management. Savings require interest payments, the compounding of which will regressively make any financial system unsustainable by tilting it toward overcapacity caused by overinvestment. The religions forbade usury also for very practical reasons.  Yet interest on money is the very foundation of finance capitalism, held up by the neoclassical economic notion that money is more valuable when it is scarce. Aggregate poverty then is necessary for sound money.  This was what President Reagan meant when he said that there is always going to be poor people.


The Bank of International Finance (BIS) estimated that as of the end of 2004, the notional value of global OTC interest rate derivatives is around $185 trillion, with a market risk exposure of over $5 trillion, which is almost half of US 2004 GDP.  Interest rate derivatives are by far the largest category of structured finance contracts, taking up $185 trillion of the total $250 trillion of notional values. The $185 trillion notional value of interest rate derivatives is 41 times the outstanding value of US Treasury bonds. This means that interest rate volatility will have a disproportioned impact of the global financial system in ways that historical data cannot project.


Fiat money issued by government is now legal tender in all modern national economies since the 1971 collapse of the Bretton Woods regime of fixed exchange rates linked to a gold-backed dollar. The State Theory of Money (Chartalism) holds that the general acceptance of government-issued fiat currency rests fundamentally on government’s authority to tax. Government’s willingness to accept the currency it issues for payment of taxes gives the issuance currency within a national economy. That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government, known as fiat money. When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment.

A central banking regime operates on the notion of government-issued fiat money as sovereign credit. That is the essential difference between central banking with government-issued fiat money, which is a sovereign credit instrument, and free banking with privately issued specie money, which is a bank IOU that allows the holder to claim the gold behind it.

With the fall of the USSR, US attitude toward the rest of the world changed.  It no longer needs to compete for the hearts and minds of the masses of the Third /Fourth Worlds. So trade has replaced aid. The US has embarked on a strategy to use Third/Fourth-World cheap labor and non-existent environmental regulation to compete with its former Cold War Allies, now industrialized rivals in trade, taking advantage of traditional US anti-labor ideology to outsource low-pay jobs, playing against the strong pro-labor tradition of social welfare in Europe and Japan.  In the meantime, the US pushed for global financial deregulation based on dollar hegemony and emerged as a 500-lb gorilla in the globalized financial market that left the Japanese and Europeans in the dust, playing catch up in an un-winnable game. In the game of finance capitalism, those with capital in the form of fiat money they can print freely will win hands down.


The tool of this US strategy is the privileged role of the dollar as the key reserve currency for world trade, otherwise known as dollar hegemony. Out of this emerges an international financial architecture that does real damage to the actual producer economies for the benefit of the financier economies.  The dollar, instead of being a neutral agent of exchange, has become a weapon of massive economic destruction (WMED) more lethal than nuclear bombs and with more blackmail power, which is exercised ruthlessly by the IMF on behalf of the Washington Consensus. Trade wars are fought through volatile currency valuations. Dollar hegemony enables the US to use its trade deficits as the bait for its capital account surplus. 


Foreign direct investment (FDI) under dollar hegemony has changed the face of the international economy. Since the early 1970s, FDI has grown along with global merchandise trade and is the single most important source of capital for developing countries, not net savings or sovereign credit. FDI is mostly denominated in dollars, a fiat currency that the US can produce at will since 1971, or in dollar derivatives such as the yen or the euro, which are not really independent currencies.  Thus FDI is by necessity concentrated in exports related development, mainly destined for US markets or markets that also sell to US markets for dollars with which to provide the return on dollar-denominated FDI. US economic policy is shifting from trade promotion to FDI promotion.


The US trade deficit is financed by the US capital account surplus which in turn provides the dollars for FDI in the exporting economies. A trade spat with the EU over beef and bananas, for example, risks large US investment stakes in Europe.  And the suggestion to devalue the dollar to promote US exports is misleading for it would only make it more expensive for US affiliates to do business abroad while making it cheaper for foreign companies to buy dollar assets. An attempt to improve the trade balance, then, would actually end up hurting the FDI balance.  This is the rationale behind the slogan: a strong dollar is in the US national interest.


Between 1996 and 2003, the monetary value of US equities rose around 80% compared with 60% for European and a decline of 30% for Japanese.  The 1997 Asian financial crisis cut Asia equities values by more than half, some as much as 80% in dollar terms even after drastic devaluation of local currencies.  Even though the US has been a net debtor since 1986, its net income on the international investment position has remained positive, as the rate of return on US investments abroad continues to exceed that on foreign investments in the US.  This reflects the overall strength of the US economy, and that strength is derived from the US being the only nation that can enjoy the benefits of sovereign credit utilization while amassing external debt, largely due to dollar hegemony.


In the US, and now also increasingly so in Europe and Asia, capital markets are rapidly displacing banks as both savings venues and sources of funds for corporate finance. This shift, along with the growing global integration of financial markets, is supposed to create promising new opportunities for investors around the globe. Neo-liberals even claim that these changes could help head off the looming pension crises facing many nations. But so far it has only created sudden and recurring financial crises like those that started in Mexico in 1982, then in the UK in 1992, again in Mexico in 1994, in Asia in 1997, and Russia, Brazil, Argentina and Turkey subsequently.


The introduction of the euro has accelerated the growth of the EU financial markets. For the current 25 members of the European Union, the common currency nullified national requirements for pension and insurance assets to be invested in the same currencies as their local liabilities, a restriction that had long locked the bulk of Europe’s long-term savings into domestic assets. Freed from foreign-exchange transaction costs and risks of currency fluctuations, these savings fueled the rise of larger, more liquid European stock and bond markets, including the recent emergence of a substantial euro junk bond market.


These more dynamic capital markets, in turn, have placed increased competitive pressure on banks by giving corporations new financing options and thus lowering the cost of capital within euroland. How this will interact with the euro-dollar market is still indeterminate.  Euro-dollars are dollars outside of US borders everywhere and not necessarily Europe, generally pre-taxed and subject to US taxes if they return to US soil or accounts. The term also applies to euro-yens and euro-euros. But the idea of French retirement accounts investing in non-French assets is both distasteful and irrational for the average French worker, particularly if such investment leads to decreased job security in France and jeopardizes the jealously guarded 35-hour work-week with 30 days of paid annual vacation which has been part of French life.


Take the Japanese economy as an example, the world’s largest creditor economy. It holds over $800 billion in dollar reserves in 2005. The Bank of Japan (BoJ), the central bank, has bought over 300 billion dollars with yen from currency markets in the last two years in an effort to stabilize the exchange value of the yen, which continued to appreciate against the dollar. Now, BoJ is faced with a dilemma: continue buying dollars in a futile effort to keep the yen from rising, or sell dollars to try to recoup yen losses on its dollar reserves. Japan has officially pledged not to diversify its dollar reserves into other currencies, so as not to roil currency markets, but many hedge funds expect Japan to soon run out of options.

Now if the BoJ sells dollars at the rate of $4 billion a day, it will take some 200 trading days to get out of its dollar reserves. After the initial 2 days of sale, the remaining unsold $792 billion reserves would have a market value of 20% less than before the sales program began. So the BoJ will suffer a substantial net yen paper loss of $160 billion. If the BoJ continues its sell-dollar program, everyday Y400 billion will leave the yen money supply to return to the BoJ if it sells dollars for yen, or the equivalent in euro if it sells dollars for euro. This will push the dollar further down against the yen or euro, in which case the value of its remaining dollar reserves will fall even further, not to mention a sharp contraction in the yen money supply which will push the Japanese economy into a deeper recession.


If the BoJ sells dollars for gold, two things may happen. There would be not enough sellers because no one has enough gold to sell to absorb the dollars at current gold prices. Instead, while price of gold will rise, the gold market may simply freezes with no transactions. Gold holders will not have to sell their gold; they can profit from gold derivatives on notional values. Also, the reverse market effect that faces the dollar would hit gold.  After two days of Japanese gold buying, everyone would hold on to their gold in anticipation for still higher gold prices.  There would be no market makers. Part of the reason central banks have been leasing out their gold in recent years is to provide liquidity to the gold market.  


The second thing that may happen is that price of gold will sky rocket in currency terms, causing a great deflation in gold terms. The US national debt as of June 1, 2005 was $7.787 trillion. US government gold holding is about 261,000,000 ounces. Price of gold required to pay back the national debt with US-held gold is $29,835 per ounce. At that price, an ounce of gold will buy a car. Meanwhile, market price of gold as of June 4, 2005 was $423.50 per ounce. Gold peaked at $850 per ounce in 1980 and bottom at $252 in 1999 when oil was below $10 a barrel. At $30,000 per ounce, governments then will have to made gold trading illegal, as FDR did in 1930 and we are back to square one. It is much easier for a government to outlaw the trading of gold within its borders than it is for it to outlaw the trading of its currency in world markets.  It does not take much to conclude that anyone who advices any strategy of long-term holding of gold will not get to the top of the class.


Heavily indebted poor countries need debt relief to get out of virtual financial slavery. Some African governments spend three times as much on debt service as they do on health care. Britain has proposed a half measure that would have the IMF sell about $12 billion worth of its gold reserves, which have a total current market value of about $43 billion to finance debt relief. The US has veto power over gold decisions in the IMF.  Thus Congress holds the key. However, the mining industry lobby has blocked a vote. In January, a letter opposing the sale of IMF gold was signed by 12 US senators from Western mining states, arguing that the sale could drive down the price of gold. A similar letter was signed in March by 30 members of the House of Representatives.


Lobbyists from the National Mining Association and gold mining companies, such as Newmont Mining and Barrick Gold Corp, persuaded the Congressional leadership that the gold proposal would not pass in Congress, even before it came up for debate. The BIS reports that gold derivatives took up 26% of the world’s commodity derivatives market yet gold only composes 1% of the world's annual commodity production value, with 26 times more derivatives structured against gold than against other commodities, including oil. The Bush administration, at first apparently unwilling to take on a congressional fight, began in April to oppose gold sales outright.  But President Bush and UK Prime Minister Tony Blair announced on June 7 that the US and UK are “well on their way” to a deal which would provide 100% debt cancellation for  some poor nations to the World Bank and African Development Fund as a sign of progress in the G-8 debate over debt cancellation.


Jude Wanniski, a former editor of the Wall Street Journal, commenting in his Memo on the Margin on the Internet on June 15, 2005, on the headline of Pat Buchanan’s syndicated column of the same date: Reviving the Foreign-Aid Racket, wrote: “This not a bailout of Africa’s poor or Latin American peasants. This is a bailout of the IMF, the World Bank and the African Development Bank….  The second part of the racket is that in exchange for getting debt relief, the poor countries will have to spend the money they save on debt service on "infrastructure projects," to directly help their poor people with water and sewer line, etc., which will be constructed by contractors from the wealthiest nations…  What comes next? One of the worst economists in the world, Jeffrey Sachs, is in charge of the United Nations scheme to raise mega-billions from western taxpayers for the second leg of this scheme. He wants $25 billion A YEAR for the indefinite future, as I recall, and he has the fervent backing of The New York Times, which always weeps crocodile tears for the racketeers. It was Jeffrey Sachs, in case you forgot, who, with the backing of the NYTimes persuaded Moscow under Mikhail Gorbachev to engage in "shock therapy" to convert from communism to capitalism. It produced the worst inflation in the history of Russia, caused the collapse of the Soviet federation, and sank the Russian people into a poverty they had never experienced under communism.”


The dollar cannot go up or down more than 20% against any other major currencies within a short time without causing a major global financial crisis. Yet, against the US equity markets the dollar appreciated about 40% in purchasing power in the 2000-02 market crash, so had gold.  And against real estate prices between 2002 and 2005, the dollar has depreciated 60% or more. According to Greenspan’s figures, the Fed can print $8 trillion more fiat dollars without causing inflation. The problem is not the money printing. The problem is where that $8 trillion is injected. If it is injected into the banking system, then the Fed will have to print $3 trillion every subsequent year just to keep running in place. If the $8 trillion is injected into the real economy in the form of full employment and higher wages, the US will have a very good economy, and much less need for paranoia against Asia or the EU. But US wages cannot rise as long as global wage arbitrage is operative.  This is one of the arguments behind protectionism. It led Federal Reserve Chairman Alan Greenspan to say on May 5 he feared what appeared to be a growing move toward trade protectionism, saying it could lessen the US and the world's economy ability to withstand shock.  Yet if democracy works in the US, protectionism will be unstoppable as long as free trade benefits the elite at the expense of the voting masses.


Fiat Money is Sovereign Credit


Money is like power: use it or lose it. Money unused (not circulated) is defunct wealth.  Fiat money not circulated is not wealth but merely pieces of printed paper sitting in a safe. Gold unused as money is merely a shiny metal good only as ornamental gifts for weddings and birthdays.  The usefulness of money to the economy is dependent on its circulation, like the circulation of blood to bring oxygen and nutrient to the living organism. The rate of money circulation is called velocity by monetary economists. A vibrant economy requires a high velocity of money.  Money, like most representational instruments, is subject to declaratory definition. In semantics, a declaratory statement is self validating. For example: “I am King” is a statement that makes the declarer king, albeit in a kingdom of one citizen. What gives weight to the declaration is the number of others accepting that declaration. When sufficient people within a jurisdiction accept the kingship declaration, the declarer becomes king of that jurisdiction instead of just his own house. When an issuer of money declares it to be credit it will be credit, or when he declares it to be debt it will be debt. But the social validity of the declaration depends on the acceptance of others.

Anyone can issue money, but only sovereign government can issue legal tender for all debts, public and private, universally accepted with the force of law within the sovereign domain. The issuer of private money must back that money with some substance of value, such as gold, or the commitment for future service, etc. Others who accept that money have provided something of value for that money, and have received that money instead of something of similar value in return. So the issuer of that money has given an instrument of credit to the holder in the form of that money, redeemable with something of value on a later date.

When the state issues fiat money under the principle of Chartalism, the something of value behind it is the fulfillment of tax obligations. Thus the state issues a credit instrument, called (fiat) money, good for the cancellation of tax liabilities. By issuing fiat money, the state is not borrowing from anyone. It is issuing tax credit to the economy.

Even if money is declared as debt assumed by an issuer who is not a sovereign who has the power to tax, anyone accepting that money expects to collect what is owed him as a creditor. When that money is used in a subsequent transaction, the spender is parting with his creditor right to buy something of similar value from a third party, thus passing the “debt” of the issuer to the third party. Thus no matter what money is declared to be, its functions is a credit instrument in transactions. When one gives money to another, the giver is giving credit and the receiver is incurring a debt unless value is received immediately for that money. When debt is repaid with money, money acts as a credit instrument. When government buys back government bonds, which is sovereign debt, it cannot do so with fiat money it issues unless fiat money is sovereign credit.

When money changes hands, there is always a creditor and a debtor. Otherwise there is no need for money, which stands for value rather than being value intrinsically. When a cow is exchanged for another cow, that is bartering, but when a cow is bought with money, the buyer parts with money (an instrument of value) while the seller parts with the cow (the substance of value). The seller puts himself in the position of being a new creditor for receiving the money in exchange for his cow. The buyer exchanges his creditor position for possession of the cow. In this transaction, money is an instrument of credit, not a debt.

When private money is issued, the only way it will be accepted generally is that the money is redeemable for the substance of value behind it based on the strong credit of the issuer. The issuer of private money is a custodian of the substance of value, not a debtor. All that is logic, and it does not matter how many mainstream monetary economists say money is debt.

Economist Hyman P Minsky (1919-1996) observed correctly that money is created whenever credit is issued. He did not say money is created when debt is incurred. Only entities with good credit can issue credit or create money. Debtors cannot create money, or they would not have to borrow. However, a creditor can only be created by the existence of a debtor. So both a creditor and a debtor are needed to create money. But only the creditor can issue money, the debtor accepts the money so created which puts him in debt.

The difference with the state is that its power to levy taxes exempts it from having to back its creation of fiat money with any other assets of value. The state when issuing fiat money is acting as a sovereign creditor. Those who took the fiat money without exchanging it with things of value is indebted to the state; and because taxes are not always based only on income, a tax payer is a recurring debtor to the state by virtue of his citizenship, even those with no income. When the state provides transfer payments in the form of fiat money, it relieves the recipient of his tax liabilities or transfers the exemption from others to the recipient to put the recipient in a position of a creditor to the economy through the possession of fiat money. The holder of fiat money is then entitled to claim goods and services from the economy.  For things that are not for sale, such as political office, money is useless, at least in theory. The exercise of the fiat money’s claim on goods and services is known as buying something that is for sa<>le.

There is a difference between buying a cow with fiat money and buying a cow with private IOUs (notes). The transaction with fiat money is complete. There is no further obligation on either side after the transaction. With notes, the buyer must either eventually pay with money, which cancels the notes (debt) or return the cow. The correct way to look at sovereign government-issued fiat money is that it is not a sovereign debt, but a sovereign credit good for canceling tax obligations. When the government redeems sovereign bonds (debt) with fiat money (sovereign credit), it is not paying off old debt with new debt, which would be a Ponzi scheme.

Government does not become a debtor by issuing fiat money, which in the US is a Federal Reserve note, not an ordinary bank note. The word “bank” does not appear on US dollars. Zero maturity money (ZMM), which grew from $550 billion in 1971 when Nixon took the dollar off gold, to $6.63 trillion as of May 30, 2005 is not a Federal debt. It is a Federal credit to the economy acceptable for payment of taxes and as legal tender for all debts, public and private. Anyone refusing to accept dollars within US jurisdiction is in violation of US law. One is free to set market prices that determine the value, or purchasing power of the dollar, but it is illegal on US soil to refuse to accept dollars for the settlement of debts.  Instruments used for settling debts are credit instruments. When fiat money is used to buy sovereign bonds (debt), money cannot be anything but an instrument of sovereign credit. If fiat money is sovereign debt, there is no need to sell government bonds for fiat money.  When a sovereign government sells a sovereign bond for fiat money issues, it is withdrawing sovereign credit from the economy. And if the government then spends the money, the money supply remains unchanged.  But if the government allows a fiscal surplus by spending less than its tax revenue, the money supply shrinks and the economy slows. That was the effect of the Clinton surplus which produce the recession of 2000.  While run-away fiscal deficits are inflationary, fiscal surpluses lead to recessions. Conservatives who are fixated on fiscal surpluses are simply uninformed on monetary economics.

For euro-dollars, meaning fiat dollars outside of the US, the reason those who are not required to pay US taxes accept them is because of dollar hegemony, not because dollars are IOUs of the US government. Everyone accept dollars because dollars can buy oil and all other key commodities. When the Fed injects money into the US banking system, it is not issuing government debt; it is expanding sovereign credit which would require higher government tax revenue to redeem. But if expanding sovereign credit expands the economy, tax revenue will increase without changing the tax rate. Dollar hegemony exempts the dollar, and only the dollar, from foreign exchange implication on the State Theory of Money. To issue sovereign debt, the Treasury issues treasury bonds. Thus under dollar hegemony, the US is the only nation that can practice and benefit from sovereign credit under the principle of Chartalism. <>

Money and bonds are opposite instruments that cancel each other. That is how the Fed Open Market Committee (FOMC) controls the money supply, by buying or selling government securities with fiat dollars to set a fed funds rate target. The fed funds rate is the interest rate at which banks lend to each other overnight. As such, it is a market interest rate that influences market interest rates throughout the world in all currencies through exchange rates. Holders of a government bond can claim its face value in fiat money at maturity, but holder of a fiat dollar can only claim a fiat dollar replacement at the Fed. Holders of fiat dollars can buy new sovereign bonds at the Treasury, or outstanding sovereign bond in the bond market, but not at the Fed. The Fed does not issue debts, only credit in the form of fiat money. When the Fed FOMC buys or sells government securities, it does on behalf of the Treasury. When the Fed increases the money supply, it is not adding to the national debt. It is increasing sovereign credit in the economy. That is why monetary easing is not deficit financing.

Money and Inflation

It is sometimes said that war’s legitimate child is revolution and war’s bastard child is inflation. World War I was no exception. The US national debt multiplied 27 times to finance the nation’s participation in that war, from US$1 billion to $27 billion. Far from ruining the United States, the war catapulted the country into the front ranks of the world’s leading economic and financial powers. The national debt turned out to be a blessing, for government securities are indispensable as anchors for a vibrant credit market.<>

Inflation was a different story. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead. In response, the Federal Reserve Board raised the discount rate in quick succession, from 4 to 7%, and kept it there for 18 months to try to rein in inflation. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility--the discount window. The result was that in 1921, 506 banks failed. Deflation descended on the economy like a perfect storm, with commodity prices falling 50% from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, adding 4 million to the jobless count. The economy came to a screeching halt. From the Fed’s perspective, declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained. 

At this point, a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interest, preeminent influence over the Federal Reserve Board in Washington, the composition of which represented a more balanced national interest. The initial operation of the Fed did not use the open-market operation of purchasing or selling government securities to set interest rate policy as a method of managing the money supply. The Fed could not simply print money to buy government securities to inject money into the money supply because the dollar was based on gold and the amount of gold held by the government was relatively fixed. Money in the banking system was created entirely through the discount window at the regional Federal Reserve Banks. Instead of buying or selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the "real bills" doctrine to maintain the gold standard. The regional Feds bought government securities not to adjust money supply, but to enhance their separate operating profit by parking idle funds in interest-bearing yet super-safe government securities, the way institutional money managers do today. 

Bank economists at that time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macro-economic implications of injecting "high power" money into the banking system, with which commercial banks could create more money in multiple by lending recycles based on the partial reserve principle. When the government sold bonds, the reverse would happen. When the Fed made open market transactions, interest rates would rise or fall accordingly in financial markets. And when the regional Feds did not act in unison, the credit market could become confused or become disaggregated, as one regional Fed might buy while another might sell government securities in its open market operations. 

Benjamin Strong, first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds formed an Open Market Investment Committee, to be run by the New York Fed for the purpose of maximizing overall profit for the whole system. This committee became dominated by the New York Fed, which was closely linked to big-money center bank interests which in turn were closely tied to international financial markets. The Federal Reserve Board approved the arrangement without full understanding of its full implication: that the Fed was falling under the undue influence of the New York internationalist bankers. For the US, this was the beginning of financial globalization. This fatal flaw would reveal itself in the Fed's role in causing and its impotence in dealing with the 1929 crash. 

The deep 1920-21 depression eventually recovered by the lowering of the Fed discount rate into the Roaring Twenties, which, like the New Economy bubble of the 1990s, left some segments of economy and the population in them lingering in a depressed state. Farmers remained victimized by depressed commodity prices and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30% of their membership because of high unemployment in boom time. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression. Historical data showed that when New York Fed president Strong leaned on the regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest.  It is an issue of debate that continues in Congress today. Like Greenspan, Strong argued that it was preferable to deal with post-crash crisis management by adding liquidity than to pop a bubble prematurely with preventive measures of tight money. It is a strategy that requires letting a bubble to pop only inside a bigger bubble.

The speculative boom of easy credit in the 1920s attracted many to buy stocks with borrowed money and used the rising price of stocks as new collateral for borrowing more to buy more stocks. Broker’s loans went from under $5 million in mid 1928 to $850 million in September of 1929. The market capitalization of the 846 listed companies of the New York Stock Exchange was $89.7 billion, at 1.24 times 1929 GDP. By current standards, a case could be built that stocks in 1929 were in fact technically undervalued. The 2,750 companies listed in the New York Stock Exchange had total global market capitalization exceeding $18 trillion in 2004, 1.53 times 2004 GDP of $11.75 trillion.<>

On January 14, 2001, the DJIA reached its all time high to date at 11,723, not withstanding Greenspan’s warning of “irrational exuberance” on December 6, 1996 when the DJIA was at 6,381.  From its August 12, 1982 low of 777, the DJIA began its most spectacular bull market in history.  It was interrupted briefly only by the abrupt and frightening crash on October 19, 1987 when the DJIA lost 22.6% on Black Monday, falling to 1,739.  It represented a 1,020-point drop from its previous peak of 2,760 reached less than two months earlier on August 21.  But Greenspan’s easy money policy lifted the DJIA to 11,723 in 13 years, a 674% increase. In 1929 the top came on September 4, with the DJIA at 386. A headline in The New York Times on October 22, 1929, reported highly-respected economist Irving Fisher as saying: “Prices of Stocks Are Low.” Two days later, the stock market crashed, and by the end of November, the New York Stock Exchange shares index was down 30%. The index did not return to the 9/3/29 level until November, 1954. At its worst level, the index dropped to 40.56 in July 1932, a drop of 89%. Fisher had based his statement on strong earnings reports, few industrial disputes, and evidence of high investment in research and development (R&D) and in other intangible capital. Theory and supportive data not withstanding, the reality was that the stock market boom was based on borrowed money and false optimism.  In hindsight, many economists have since concluded that stock prices were overvalued by 30% in 1929.  But when the crash came, the overshoot dropped the index by 89% in less than three years.

Money and Gold

When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central bank. No responsible government will voluntarily let the market set the exchange value of its currency, market fundamentalism notwithstanding. Yet central bankers tend to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going. 

Yet even a gold standard is based on a fixed value of money to gold, set by someone to reflect the underlying economical conditions at the time of its setting. Therein lies the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy temporarily out of sync with that fixed rate. It seldom occurs to central bankers that the fixed rate was the problem, not the dynamic economy. When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency. 

The return to the gold standard in war-torn Europe in the 1920s was engineered by a coalition of internationalist central bankers on both sides of the Atlantic as a prerequisite for postwar economic reconstruction. Lenders wanted to make sure that their loans would be repaid in money equally valuable as the money they lent out, pretty much the way the IMF deals with the debt problem today.  President Strong of the New York Fed and his former partners at the House of Morgan were closely associated with the Bank of England, the Banque de France, the Reichsbank, and the central banks of Austria, the Netherlands, Italy, and Belgium, as well as with leading internationalist private bankers in those countries. Montagu Norman, governor of the Bank of England from 1920-44, enjoyed a long and close personal friendship with Strong as well as ideological alliance. Their joint commitment to restore the gold standard in Europe and so to bring about a return to the “international financial normalcy” of the prewar years was well documented. Norman recognized that the impairment of British financial hegemony meant that, to accomplish postwar economic reconstruction that would preserve pre-war British interests, Europe would “need the active cooperation of our friends in the United States.” 

Like other New York bankers, Strong perceived World War I as an opportunity to expand US participation in international finance, allowing New York to move toward coveted international-finance-center status to rival London’s historical preeminence, through the development of a commercial paper market, or bankers' acceptances in British finance parlance, breaking London’s long monopoly. The Federal Reserve Act of 1913 permitted the Federal Reserve Banks to buy, or rediscount, such paper. This allowed US banks in New York to play an increasingly central role in international finance in competition with the London market. 

Herbert Hoover, after losing his second-term US presidential election to Franklin D Roosevelt as a result of the 1929 crash, criticized Strong as "a mental annex to Europe", and blamed Strong's internationalist commitment to facilitating Europe's postwar economic recovery for the US stock-market crash of 1929 and the subsequent Great Depression that robbed Hoover of a second term. Europe's return to the gold standard, with Britain’s insistence on what Hoover termed a "fictitious rate" of US$4.86 to the pound sterling, required Strong to expand US credit by keeping the discount rate unrealistically low and to manipulate the Fed’s open market operations to keep US interest rate low to ease market pressures on the overvalued pound sterling. Hoover, with justification, ascribed Strong’s internationalist policies to what he viewed as the malign persuasions of Norman and other European central bankers, especially Hjalmar Schacht of the Reichsbank and Charles Rist of the Bank of France. From the mid-1920s onward, the US experienced credit-pushed inflation, which fueled the stock-market bubble that finally collapsed in 1929. 

Within the Federal Reserve System, Strong's low-rate policies of the mid-1920s also provoked substantial regional opposition, particularly from Midwestern and agricultural elements, who generally endorsed Hoover's subsequent critical analysis. Throughout the 1920s, two of the Federal Reserve Board's directors, Adolph C Miller, a professional economist, and Charles S Hamlin, perennially disapproved of the degree to which they believed Strong subordinated domestic to international considerations. 

The fairness of Hoover's allegation is subject to debate, but the fact that there was a divergence of priority between the White House and the Fed is beyond dispute, as is the fact that what is good for the international financial system may not always be good for a national economy. This is evidenced today by the collapse of one economy after another under the current international finance architecture that all central banks support instinctively out of a sense of institutional solidarity.  The same issue has surfaced in today’s China where regional financial centers such as Hong Kong and Shanghai are vying for the role of world financial center.  To do this, they must play by the rules of the international financial system which imposes a cost on the national economy. The nationalist vs. internationalist conflict, as exemplified by the Hoover vs. Strong conflict of the 1930s, is also threatening the further integration of the European Union.  Behind the fundamental rationale of protectionism is the rejection of the claim that internationalist finance places national development as its priority.  The Richardian theory of comparative advantage of free trade is not the issue.

The issue of government control over foreign loans also brought the Fed, dominated by Strong, into direct conflict with Hoover when the latter was Secretary of Commerce. Hoover believed that the US government should have right of approval on foreign loans based on national-interest considerations and that the proceeds of US loans should be spent on US goods and services. Strong opposed all such restrictions as undesirable government intervention in free trade and international finance and counterproductively protectionist. Businesses should be not only allowed, but encouraged to buy when it is cheapest anywhere in the world, including shopping for funds to borrow, a refrain that is heard tirelessly from free traders also today. Of course, the expanding application of the law of one price to more and more commodities, including the price of money, i.e. interest rates adjusted by exchange rates, makes such dispute academic.  The only commodity exempt from the law of one price is labor. This exemption makes the trade theory of comparative advantage a fantasy. 

In July and August 1927, Strong, despite ominous data on mounting market speculation and inflation, pushed the Fed to lower the discount rate from 4 to 3 percent to relieve market pressures again on the overvalued British pound. In July 1927, the central bankers of Great Britain, the United States, France, and Weimar Germany met on Long Island in the US to discuss means of increasing Britain’s gold reserves and stabilizing the European currency situation. Strong’s reduction of the discount rate and purchase of 12 million pound sterling, for which he paid the Bank of England in gold, appeared to come directly from that meeting. One of the French bankers in attendance, Charles Rist, reported that Strong said that US authorities would reduce the discount rate as "un petit coup de whisky for the stock exchange". Strong pushed this reduction through the Fed despite strong opposition from Miller and fellow board member James McDougal of the Chicago Fed, who represented Midwestern bankers, who generally did not share New York's internationalist preoccupation. 

Frank Altschul, partner in the New York branch of the transnational investment bank Lazard Freres, told Emile Moreau, the governor of the Bank of France, that “the reasons given by Mr Strong as justification for the reduction in the discount rate are being taken seriously by no one, and that everyone in the United States is convinced that Mr Strong wanted to aid Mr Norman by supporting the pound.” Other correspondence in Strong’s own files suggests that he was giving priority to international monetary conditions rather than to US export needs, contrary to his public arguments. Writing to Norman, who praised his handling of the affair as “masterly”, Strong described the US discount rate reduction as “our year’s contribution to reconstruction.” The Fed’s ease in 1927 forced money to flow not into the overheated real economy, which was unable to absorb further investment, but into the speculative financial market, which led to the crash of 1929. Strong died in October 1928, one year before the crash, and was spared the pain of having to see the devastating results of his internationalist policies. 

Scholarly debate still continues as to whether Strong's effort to facilitate European economic reconstruction compromised the US domestic economy and, in particular, led him to subordinate US monetary policies to internationalist demands. In 1930, the US economy had yet to dominate the world economy as it does now. There is, however, little disagreement that the overall monetary strategy of European central banks had been misguided in its reliance on the restoration of the gold standard. Critics suggest that the ambitious but misguided commitment of Strong, Norman, and other internationalist bankers to returning the pound, the mark, and other major European currencies to the gold standard at overly-high parities to gold, which they were then forced to maintain at all costs, including indifference to deflation, had the effect of undercutting Europe's postwar economic recovery. Not only did Strong and his fellow central bankers through their monetary policies contribute to the Great Depression, but their continuing fixation on gold also acted as a straitjacket that in effect precluded expansionist counter-cyclical measures. 

The inflexibility of the gold standard and the central bankers’ determination to defend their national currencies’ convertibility into gold at almost any cost drastically limited the policy options available to them when responding to the global financial crisis. This picture fits the situation of the fixed-exchange-rates regime based on the fiat dollar that produced recurring financial crises in the 1990s and that has yet to run its full course by 2005. In 1927, Strong’s unconditional support of the gold standard, with the objective of bringing about the rising financial predominance of the US which had the largest holdings of gold in the world, exacerbated nascent international financial problems. In similar ways, dollar hegemony does the same damage to the global economy today. Just as the international gold standard itself was one of the major factors underlying and exacerbating the Great Depression that followed the 1929 crash, since the conditions that had sustained it before the war no longer existed, the breakdown of the fixed-exchange-rates system based on a gold-backed dollar set up by the Bretton Woods regime after World War II, without the removal of the fiat dollar as a key reserve currency for trade and finance, will cause a total collapse of the current international financial architecture with equally tragic outcomes. Stripped of its gold backing, the fiat dollar has to rely on geopolitical factors for its value, which push US foreign policy towards increasing militaristic and belligerent unilateralism. With dollar hegemony today, as it was with the gold standard of 1930, the trade war is fought through currencies valuations on top of traditional tariffs.

The nature of and constraints on US internationalism after World War I had parallels in US internationalism after World War II and in US-led globalization after the Cold War. Hoover bitterly charged Strong with reckless placement of the interests of the international financial system ahead of US national interest and domestic development needs. Strong sincerely believed his support for European currency stabilization also promoted the best interests of the United States, as post-Cold War neo-liberal market fundamentalists sincerely believe its promotion enhances the US national interest. Unfortunately, sincerity is not a vaccine against falsehood. 

Strong argued relentlessly that exchange rate volatility, especially when the dollar was at a premium against other currencies, made it difficult for US exporters to price their goods competitively. As he had done during the war, on numerous later occasions, Strong also stressed the need to prevent an influx of gold into the US and the consequent domestic inflation, by the US making loans to Europe, pursuing lenient debt policies, and accepting European imports on generous terms. Strong never questioned the gold parities set for the mark and the pound sterling. He merely accepted that returning the pound to gold at prewar exchange rates required British deflation and US efforts to use lower dollar interest rates to alleviate market pressures on sterling. Like Fed chairman Paul Volcker in the 1980s, but unlike Treasury Secretary Robert Rubin in the 1990s, Strong mistook a cheap dollar as serving the national interest, while Rubin understood correctly that a strong dollar is in the national interest by sustaining dollar hegemony. In either case, the price for either an over-valued or under-valued dollar is the same: global depression. Dollar hegemony in the 1990s pushed Japan and Germany into prolonged depression.<>

The US position in 2005 is that a strong dollar is still in the US national interest, but a strong dollar requires an even stronger Chinese yuan in the 21st century. Just as Strong saw the need for a strong British pound paid for by deflation in Britain in exchange for the carrot of continuing British/European imports to the US, Bush and Greenspan now want a stronger Chinese yuan, paid for with deflation in China in exchange for curbing US protectionism against Chinese imports.  The 1985 Plaza Accord to force the appreciation of the Japanese yen marked the downward spiral of the Japanese economy via currency-induced deflation.  Another virtual Plaza Accord forced the rise of the euro that left Europe with a stagnant economy. A new virtual Plaza Accord against China will also condemn the Chinese economy into a protracted period of deflation.  Deflation in China at this time will cause the collapse of the Chinese banking system which is weighted down by the BIS regulatory regime that turned national banking subsidies to state-own-enterprises into massive non-performing loans. A collapse of the Chinese banking system will have dire consequences for the global financial system since the robust Chinese economy is the only engine of growth in the world economy at this time.

When Norman sent Strong a copy of John Maynard Keynes’ Tract on Monetary Reform (1923), Strong commented “that some of his [Keynes’] conclusions are thoroughly unwarranted and show a great lack of knowledge of American affairs and of the Federal Reserve System.” Within a decade, Keynes, with his advocacy of demand management via deficit financing, became the most influential economist in post-war history. 

The major flaw in the European effort for post-World War I economic reconstruction was its attempt to reconstruct the past through its attachment to the gold standard, with little vision of a new future. The democratic governments of the moneyed class that inherited power from the fall of monarchies did not fully comprehend the implication of the disappearance of the monarch as a ruler, whose financial architecture they tried to continue for the benefit of their bourgeois class. The broadening of the political franchise in most European countries after the war had made it far more difficult for governments and central bankers to resist electoral pressures for increased social spending and the demand for ample liquidity with low interest rates, as well as high tolerance for moderate inflation to combat unemployment, regardless of the impact of national policies on the international financial architecture. The Fed, despite its claim of independence from politics, has never been free of US presidential-election politics since its founding. Shortly before his untimely death, Strong took comfort in his belief that the reconstruction of Europe was virtually completed and his internationalist policies had been successful in preserving world peace. Within a decade of his death, the whole world was aflame with World War II.

But in 1929, the dollar was still gold-backed. The government fixed the dollar at 23.22 grains of gold, at $20.67 per troy ounce. When stock prices rose faster than real economic growth, the dollar in effect depreciated.  It took more dollars to buy the same shares as prices rose.  But the price of gold remained fixed at $20.67 per ounce. Thus gold was cheap and the dollar was overvalued and the trading public rushed to buy gold, injecting cash into the economy which fueled more stock buying on margin. Price of gold mining shares rose by 600%. But with a gold standard, the Fed could not print money beyond its holding of gold without revaluing the dollar against gold.  The Quantity Theory of Money caught up with the financial bubble as prices for equity rose but the quantity of money remained constant and it came into play with a vengeance.  Because of the gold standard, there reached a time when there was no more money available to buy without someone first selling.  When the selling began, the debt bubble burst, and panic took over. When the stock market collapsed, panic selling quickly wiped out most investors who bought shares instead of gold.  As gold price was fixed, it could not fall with the general deflation and owners of gold did exceptionally well by comparison to share owners.

What Strong did not figure was that when the Fed lowered the discount rate to relieve market pressure on the overvalued British pound sterling after its gold convertibility had been restored in 1925, the world economy could not expand because money tied to gold was inelastic, leaving the US economy with a financial bubble that was not supported by any rise in earnings. The British-controlled gold standard proved to be a straightjacket for world economic growth, not unlike the deflationary Maastricht "convergence criteria" based on the strong German mark of the late 1990’s. The speculation of the Coolidge-Hoover era was encouraged by Norman and Strong to fight gold-induced deflation. The accommodative monetary policy of the US Federal Reserve led to a bubble economy in the US, similar to Greenspan’s bubble economy since 1987. There were two differences: the dollar was gold-backed in 1930 while in 1987 it was a fiat currency; and in 1930, the world monetary system was based on sterling pound hegemony while today it is based on dollar hegemony. When the Wall Street bubble was approaching unsustainable proportions in the autumn of 1929, giving the false impression that the US economy was booming, Norman sharply cut the British bank rate to try to stimulate the British economy in unison.  When short-term rates fell, it created serious problems for British transnational banks which were stuck with funds borrowed long-term at high interest rates that now could only be lent out short-term at low rates.  They had to repatriating British hot money from New York to cover this ruinous interest rate gap, leaving New York speculators up the creek without an interest rate paddle.  This was the first case of hot money contagion, albeit what hit the Asian banks in 1997 was the opposite: they borrowed short-term at low interest rates to lend out long-term at high rates. And when interest rates rose because of falling exchange rate of local currencies, borrowers defaulted and the credit system collapsed.

The contagion in the 1997 Asian financial crisis devastated all Asian economies. The financial collapse in Thailand and Indonesia in July 1997 caused the strong markets of high liquidity such as Hong Kong and Singapore to collapse when investors sold in these liquid markets to raise funds to rescue their positions in illiquid markets that were wrongly diagnosed by the IMF as mere passing storms that could be weathered with a temporary shift of liquidity. Following badly flawed IMF advice, investors threw good money after bad and brought down the whole regional economy while failing to contain the problem within Thailand.

The financial crises that began in Thailand in July 1997 caused sell-downs in other robust and liquid markets in the region such as Hong Kong and Singapore that impacted even Wall Street in October. But prices fell in Thailand not because domestic potential buyers had no money.  The fact was that equity prices in Thailand were holding in local currency terms but falling fast in foreign exchange terms when the peg of the baht to the dollar began to break.  Then as the baht devalued in a free fall, stocks of Thai companies with local currency revenue, including healthy export firms that contracted local currency payments, logically collapsed while those with hard currency revenue actually appreciated in local currency terms.  The margin calls were met as a result of investors trying not to sell, rather than trying to liquidate at a loss.  The incentive for holding on with additional margin payments was based on IMF pronouncements that the crisis was only temporary and imminent help was on the way and that the problem would stabilize within months. But the promised help never come.  What came was an IMF program of imposed “conditionalities” that pushed the troubled Asian economies off the cliff, designed only to save the foreign creditors. The “temporary” financial crisis was pushed into a multi-year economic crisis.

Geopolitics played a large role. US Treasury Secretary Robert Rubin decided very early the Thai crisis was a minor Asian problem and told the IMF to solve it with an Asian solution but not to let Japan take the lead.  Hong Kong contributed US$1 billion and China contributed US$1 billion on blind faith on Rubin's assurance that the problem would be contained within Thai borders (after all, Thailand was a faithful US ally in the Cold War).  Then Korea was hit in December 1997. Rubin again thought it was another temporary Asian problem.  The Korean Central Bank was bleeding dollar reserves trying to support an overvalued won pegged to the dollar, and by late December had only several days left before its dollar reserves would run dry.  Rubin was holding on to his moral hazard posture until his aides in the Department of Treasury told him one Sunday morning that the Brazilians were holding a lot of Korean bonds.  If Korea were to default, Brazil would collapse and land the US banks in big trouble.  Only then did Rubin get Citibank to work out a restructuring the following Tuesday in Korea by getting the Fed to allow the American banks to roll over the short-term Korean debts into non-interest paying long-term debts without having to register them as non-performing, thus exempting the US banks from the adverse impacts of the required capital injection that would drag down their profits.

The Great Depression that started in 1929 was made more severe and protracted by the British default on gold payment in September, 1931 and subsequent British competitive devaluations as a national strategy for a new international trade war. British policy involved a deliberate use of pound sterling hegemony, the only world monetary regime at that time, as a national monetary weapon in an international trade war, causing an irreversible collapse of world trade.  In response to British monetary moves, alternative currency blocs emerged in rising economies such as the German Third Reich and Imperial Japan.  It did not take these governments long to realize that they had to go to war to obtain the oil and other natural resources needed to sustain their growing economies that collapsed world trade could no longer deliver in peace.  For Britain and the US, a quick war was exactly what was needed to bring their own economies out of depression. No one anticipated that WWII would be so destructive. German invasion of Poland on September 1, 1939 caused Britain and France to declared war on Germany on September 3, but the British and French stayed behind the Maginot Line all winter, content with a blockade of Germany by sea.  The inactive period of the “phony war” lasted 7 months until April 9, 1940 when Germany invaded Demark and Norway. On May 10, German forces overrun Luxemburg and invaded the Netherlands and Belgium. On March 13, they outflanked the Maginot Line and German panzer divisions raced towards the British Channel, cut off Flanders and trapped the entire British Expeditionary Force of 220,000 and 120,000 French troops at Dunkirk. The trapped Allied forces had to be evacuated by civilian small crafts from May 26 to June 4.  On June 22, France capitulated.  If Britain had failed to evacuate its troops from Dunkirk, it would have to sue for peace as many had expected, the war would have been over with German control of Europe. Unable to use Britain as a base, US forces would never be able to land in Europe. Without a two-front war, Germany might have been able to prevail over the USSR. Germany might have then emerged as the hegemon.

Franklin D. Roosevelt was inaugurated as president on March 4, 1933. In his first fireside chat radio address, Roosevelt told a panicky public that “the confidence of the people themselves” was “more important than gold.”  On March 9, the Senate quickly passed the Emergency Banking Act giving the Secretary of the Treasury the power to compel every person and business in the country to relinquish their gold and accept paper currency in exchange. The next day, Friday March 10, Roosevelt issued Executive Order No. 6073, forbidding the public from sending gold overseas and forbidding banks from paying out gold for dollar. On April 5, Roosevelt issued Executive Order No. 6102 to confiscate the public’s gold, by commanding all to deliver their gold and gold certificates to a Federal Reserve Bank, where they would be paid in paper money. Citizens could keep up to $100 in gold, but anything above that was illegal. Gold had become a controlled substance by law in the US. Possession was punishable by a fine of up to $10,000 and imprisonment for up to 10 years. On January 31, 1934, Roosevelt issued another Executive Order to devalue the dollar by 59.06% of its former gold quantum of 23.22 grains, pushing the dollar down to be worth only13.71 grains of gold, at $35 per ounce, which lasted until 1971.

1929 Revisited and More

Shortsighted government monetary policies were the main factors that led to the market collapse but the subsequent Great Depression was caused by the collapse of world trade. US policymakers in the 1920s believed that business was the purpose of society, just as policymakers today believe that free trade is the purpose of civilization. Thus, the government took no action against unconstructive speculation believing that the market knew best and would be self-correcting. People who took risks should bear the consequences of their own actions.  The flaw in this view was that the consequences of speculation were largely borne not by professional speculators, but by the unsophisticated public who were unqualified to understand how they were being manipulated to buy high and sell low. The economy had been based on speculation but the risks were unevenly carried mostly by the innocent. National wealth from speculation was not spread evenly. Instead, most money was in the hands of a rich few who quickly passed on the risk and kept the profit. They saved or invested rather than spent their money on goods and services. Thus, supply soon became greater than demand. Some people profited, but the majority did not. Prices went up faster than income and the public could afford things only by going into debt while their disposable income went into mindless speculation in hope of magically bailing borrowers out from such debts. Farmers and factory/office workers did not profit at all. Unevenness of prosperity made recovery difficult because income was concentrated on those who did not have to spend it.  The situation today is very similar.

After the 1929 crash, Congress tried to solve the high unemployment problem by passing high tariffs that protected US industries but hurt US farmers. International trade came to a stand still both because of protectionism and the freezing up of trade finance. <>
This time, world trade may also collapse, and high tariffs will again be the effect rather than the cause. The pending collapse of world trade will again come as a result of protracted US exploitation of the advantages of dollar hegemony, as the British did in 1930 regarding sterling pound hegemony.  The dollar is undeservedly the main trade currency without either the backing of gold or US fiscal and monetary discipline. Most of the things people want to buy are no longer made in the US, so the dollar has become an unnatural trade currency. The system will collapse because despite huge US trade deficits, there is no global recycling of money outside of the dollar economy. All money circulates only within the dollar money supply, overheating the US economy, financing its domestic joyrides and globalization tentacles, not to mention military adventurism, milking the rest of the global economy dry and depriving the non-dollar economies of needed purchasing power independent of the US trade deficit. World trade will collapse this time not because of trade restricting tariffs, which are merely temporary distractions, but because of a global mal-distribution of purchasing power created by dollar hegemony.

Central banking was adopted in the US in 1913 to provide elasticity to the money supply to accommodate the ebb and flow of the business cycle. Yet the mortal enemy of elasticity is structural fatigue which is what makes the rubber band snap.  Today, dollar hegemony cuts off monetary recirculation to all non-dollar economies, forcing all exporting nations with mounting trade surpluses into the position of Samuel Taylor Coleridge’s Ancient Mariner: “Water, water, everywhere, nor any drop to drink.” 


Trade in the Age of Overcapacity 
This article appeared in 
AToL on July 8, 2005

Neo-liberals have created a false dichotomy between so-called command economies and market economies. The spurious distinction is propagated by ideologue free traders in order to give market fundamentalism an aura of truth beyond reality. Market fundamentalism is the belief that the optimum common interest is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants each seeking to maximize his own private gain and that such market equilibrium should not be distorted by any collective measures in the name of the common good. It is summed up by Margaret Thatcher’s infamous declaration that there is no such thing as society.

The fact is that in a world of sovereign states, all economies are command economies. The US, the Mecca of market fundamentalism, commands her alleged market economy in the name of national security. While the US tirelessly advocates free trade, foreign trade is a declared instrument of US foreign policy.  President Bush declares that “open trade is a moral imperative” to spread democracy around the world. The White House Council of Economic Advisors is organizationally subservient to the National Security Council. National security concerns dictate trade policies the US adopts for its economic relations with different foreign countries.  World trade today is free only to the extent of being free to support US unilateralism.  For the US imperium, the line between foreign policy and domestic policy is disappearing to make room for global policy. The sole superpower views the world as its oyster and global trade is to replace foreign trade in a global economy the rules for which is set by a world trade organization dominated by the sole superpower.

Free trade and national security

US trade policy with regard to China, the world’s fastest growing and most populous economy, is a case in point. The US is undecided on whether China is a strategic partner or a strategic competitor or a potential foe. National security concerns envelope the current controversy over the bid from a Chinese 70% state-owned enterprise, China National Offshore Oil Corporation (CNOOC), to acquire Unocal, a US-based independent oil company, even though 70% of Unocal asset and operations are located in Asia.  The proposed deal is subject to review and approval by the secretive Committee on Foreign Investment in the US (CFIUS), a federal multi-agency group chaired by the Treasury Secretary that rules on foreign investment on national security grounds. In 1988, Congress enacted the Exon-Florio legislation authorizing the President to suspend or prohibit foreign acquisitions, mergers, or takeovers of U.S. companies when there is credible evidence that a foreign controlling interest might threaten national security and when other legislation cannot provide adequate protection. The President delegated authority to review foreign investment transactions to an interagency group, the CFIUS.

Some members of Congress have publicly served notice to the White House that they expect the proposed deal by CNOOC to be dealt with as one with serious geopolitical dimensions that directly impact US national security.  The CNOOC/Unocal deal is precedent-setting because it moves the CFIUS beyond its normal high-tech concerns into strategic commodities. It is also a signal of a trend of more to come.<><>

In 1989, the President ordered China National Aero-Technology Import and Export Corporation, a People’s Republic of China aerospace company, to divest from MAMCO, which involved a US aircraft parts manufacturer.  This was the only case blocked out of 1,500 CFIUS notifications in 15 years.<>

In 2003, a negative review by the CFIUS caused Hong Kong-based Hutchison-Whampoa Limited (HWL), a publicly-traded multinational corporation, to withdraw from a joint bid in partnership with Singapore Technologies Telemedia Ltd (STT) for Global Crossing (GC), a distressed telecom carrier in bankruptcy, leaving STT as the sole acquirer of GC. STT was allowed to acquire GC because Singapore is considered an ally of the US.<>

Richard Perle, former Assistant Secretary of Defense for International Security Policy under Reagan, and one of the key architects of the War on Terrorism and the Iraqi War, had to resign from the chair of the US Defense Policy Board after it became known that he was lobbying on behalf of GC. Perle was reported to be helping to make it possible for HWL to overcome US national security concerns in order to buy the bankrupt GC. The FBI found at the time that selling GC to HWL would give it control of the world’s largest fiber optic network, and allow it to oversee existing contracts for secure Pentagon communications. Perle was to receive a total payment of $725,000 for his advisory work, $650,000 of which would be contingent on the sale going through. The neo-conservatives in the Bush administration, while aggressively militant to China on security issues, are solidly in bed with the neo-liberals on in the US business community with regard to trade with China.<>

According to New York Times columnist Maureen Dowd, Perle might have had a conflict of interest in that he was Chairman of the Pentagon’s Defense Advisory Board.  Perle defended himself: “Maureen Dowd’s view of this is very misleading. Ms. Dowd’s recent editorial suggested that I was retained to ‘help overcome Pentagon resistance’ to the proposed sale of Global Crossing to Hutchison Whampoa. That is not why I was retained.” Perle asserted that “I have not been retained by Hutchison Whampoa, nor have I been retained by Global Crossing to represent them in any way with the US government. I have been retained by Global Crossing to help them put together a security arrangement that is acceptable to the US government.” 

In March 2003, an exposé in The New Yorker by Seymour Hersh that Richard Perle had improperly represented Saudi Arabian interests. Perle, in turn, has vowed to sue Hersh and the New Yorker for libel. In an effort to address national security concerns, the prospective purchasers offered to place GC’s US assets within a “secure” domestic subsidiary staffed by US persons. When that proposal did not persuade CFIUS, the parties withdrew their application and re-filed after formulating a new plan whereby HWL’s ownership interest in GC would be held in trust by a proxy group of four distinguished US citizens who would exercise HWL’s voting and corporation governance rights. This arrangement would reduce HWL to a mere passive investor in GC, an option that caused many foreign investors in previous deals to abandon their proposed acquisitions. Usually, such concessions have been sufficient to garner CFIUS approval. However, CFIUS has decided to conduct a full 45-day investigation of the GC transaction, which implies that CFIUS was not satisfied with the latest arrangements. Following this announcement, HWL dropped its bid, leaving STT to proceed alone.

HWL, a venerable century-old China trade firm dating back to the British empire, is now controlled by Hong Kong tycoon Li Ka-shing who has just donated $40 million to University of California at Berkley. HWL is a leading international corporation with businesses spanning the globe. Its diverse array of holdings ranges from some of the world’s biggest retailers to property development and infrastructure to the most technologically-advanced and market-savvy telecommunications operators. HWL reports consolidated revenue of US$23 billion for 2004. With operations in 52 countries and about 200,000 employees worldwide, Hutchison has five core businesses: ports and related services, telecommunications, property hotels, retail and manufacturing and energy and infrastructure.In 1991, HWL acquired the United Kingdom’s busiest port, the Port of Felixstowe, without political opposition. Reflecting its global expansion and internationalization, Hutchison Port Holdings (HPH) was formally set up in 1994 to hold and manage the HWL’s ports and related services worldwide. Since 1994, HPH has expanded globally to strategic locations in 19 countries throughout Asia, the Middle East, Africa, Europe and the Americas. Today, HPH operates a total of 219 berths in 39 ports along with a number of transportation related service companies. In 2004, HPH handled 47.8 million TEUs (Twenty-foot equivalent unit containers).

HWL is a leading global telecommunications and data services provider operating with a high growth strategy in 17 countries and territories.  Hutchison Telecommunications International Limited (Hutchison Telecom) has been listed on the Hong Kong and New York stock exchanges since October 2004, but not on any Chinese exchanges. Hutchison Telecom has a significant presence, and in many cases is a market leader, in developed or rapidly-growing markets in eight countries and territories, operating mobile networks in Hong Kong and Macau, Ghana, India, Israel, Paraguay, Sri Lanka, Thailand and Vietnam. HWL sold EUR1 billion in 10-year bonds on June 22, marking it the largest euro-denominated bond from Asia this year.  In November 2003, HWL raised a mammoth $5 billion in euros and dollars to a gargantuan $9.5 billion from five different offerings.

When the United States gave Panama full control of the canal on December 31, 1999, critics raised concerns about foreign influence and control over the canal’s operation, particularly during an international crisis. Congressman John L. Mica (R – Florida) gave a speech on April 27, 1999 entitled: “China’s Interest in the Panama Canal” in which he asserted: “Hutchison has worked closely with the China Ocean Shipping Company, COSCO. . . . [which] you may remember is the PLA, and the PLA is the Chinese Army, PLA-controlled company that almost succeeded in gaining control of the abandoned naval station in Long Beach, California. . . .”  The offer by HWL and COSCO to purchase the decommissioned military port of Long Beach, California failed after the US Department of Defense raised national security concerns over the proposed sale.

A June 1997 Rand report, “Chinese Military Commerce and U.S. National Security” stated: “Hutchison Whampoa of Hong Kong, controlled by Hong Kong billionaire Li Ka-shing, is also negotiating for PLA wireless system contracts, which would build upon his equity interest in PLA arms company Poly Tech-owned Yangpu Land Development Company, which is building infrastructure on China's Hainan Island.”<>

Prompting the national security concern was the alleged potential strategic reach of the Chinese military through the financial interests of Hong Kong billionaire tycoon Li Ka-shing, whose fortune and power were inaccurately linked by misinformed US politicians to his alleged links to the Chinese government. Panama Ports Company, a subsidiary of Hutchison Port Holdings of HWL, began a 25-year lease (with a 25-year renewal option) in1999 to operate port facilities at Balboa (Pacific side of the canal) and Cristobal (Atlantic side of the canal). This arrangement produces more efficient handling of shipping that benefits all shipping nations, including China, which is the third-largest user of the canal and sells more than $1 billion in goods a year through the Colón Free Zone.

A headline in the Miami Herald on August 25 1999 read: “Canal Deal Gives Strategic Edge to China, Critics Charge China-Panama Canal Deal Draws Scrutiny.” According to Miami Herald, “Li and his business empire are linked to several companies known as fronts for Chinese military and intelligence agencies. One of the companies has been indicted for smuggling automatic weapons into the United States. . . . Li has also been accused of helping to finance several deals in which military technology was transferred from American companies to the Chinese army.”

All these accusations were subsequently proved baseless by official US investigations. Anyone with knowledge about the history of the business world in Hong Kong knows that Li was a favorite son of British colonialism long before his cozying up to China. Li got his start in business exporting plastic flowers from Hong Kong to the US in the 1950s and later became a real estate tycoon in Hong Kong with the help of British-owned Hong Kong and Shanghai Bank (HSBC) which saw Li as a promising leader of a new generation of the comprador class the British were looking to nurture in post-war colonial Hong Kong. Li’s friendly overture to China was embarrassingly belated and undeniably opportunistic, and his sympathy for communism totally non-existent even today. Following the mode of many other successful international businessmen, Li has donated more than $100 million to medical research institutions in the US, Canada and the UK.

In October 1999, the Clinton White House publicly denied that billionaire Li Ka-shing was “working for the communists in Beijing.” The White house press secretary labeled such accusations as “silly” and dismissed them as “the kind of thing you see around here from time to time.” Most US corporations active in China are working hard to develop the same degree of cooperative relationship with the Chinese government and its state-owned enterprises. This includes IBM, General Electric, General Motors, Microsoft, United Technology, Boeing and many other big name defense and space contractors. Nevertheless, the propaganda effect on a US public long conditioned to view China with hostility lingered.

Taiwan also has a container-handling operation at Coca Solo, at the Caribbean end of the canal, and the Evergreen Group of Taiwan, which runs it, also has construction, port and hotel projects there. Ten Taiwanese companies are installed in the Fort Davis industrial park, and the Taiwanese construction company King Hsin submitted a bid to build a second bridge over the canal, at a cost of US $270 million. But the US is not concerned with Taiwan because it is a virtual US protectorate.

Panama Ports Company, a subsidiary of Hutchison Port Holdings of HWL, began a 25-year lease (with a 25-year renewal option) in 1999 to operate port facilities at Balboa (Pacific side of the canal) and Cristobal (Atlantic side of the canal). This arrangement benefits all shipping countries, including China, which is the third-largest user of the canal and sells more than $1 billion in goods a year through the Colón Free Zone.  Notwithstanding that HWL is not even a Chinese company and its shares are not traded in any Chinese stock exchanges on the mainland, HWl was accused of being closely linked to, or perhaps even directly controlled by China.  In reality, HWL investment in the canal is reflective of it attraction to commercial opportunities in Panama, rather than a threat from China to control the operations of the waterway. Taiwan also has an extensive business presence in the canal area. Besides, the Constitution of Panama reserves direct authority and control over the canal.  Chinese officials dismissed the idea that China is attempting to influence or take over the Panama Canal is "sheer fabrication with ulterior motives.” Chinese residents in Panama are descendants of immigrants who originally formed the main source of forced labor on the Trans-isthmian railroad. They now represent about between 4 and 8 percent of the local population depending on the definition of ethnicity as much integration has occurred through inter-ethnic marriages. This is about the same number of citizens as Panama’s indigenous peoples of the Kuna, Guaymie and Chocoe tribes. There are more US citizens living and working in China than there are Chinese citizens in Panama. With a history of being a main target of US embargo for more than three decades, China’s interest in Latin America is unrestricted access to trade and natural resources for all countries. From a Panamanian point of view, intervention by the US is a more credible threat than a Chinese takeover.

No free trade for oil

While the current rise in oil prices reflects systemic dynamics in oil economics (see The Real Problem of $50 Oil - May 26, 2005 AToL), many in US political circles find it convenient to blame it on a single component of increased demand by China and India.  On April 26, 2005, President George W Bush, meeting with Saudi Crown Prince Abdullah at his ranch in Crawford, Texas, told the press that “the price of crude is up because not only is our economy growing, but economies such as India and China’s economies are growing as well,” notwithstanding that the announced purpose of the US-Saudi summit was to get Saudi Arabia to increase production, the short fall of which was driving oil prices up.

The Vice Chairman of Chevron, the rival bidder for Unocal, publicly suggested that “this is sort of geopolitics we are playing here, not commercial business.”  He explained that Chevron would put oil on the market for sale to the highest bidder whereas a Chinese-owned CNOOC would use the oil it produces for domestic consumption that would yield “less oil on the world market which meant higher prices for US consumers.”  Yet CNOOC’s interest in Unocal is mainly in its natural gas reserves in Asia, which poses no national security threat to the US. North American gas supply, counting both US and Canada, faces no shortage. Both the US and China are rich in coal which generates more than half of the electricity in both economies. In a public statement, Fu Chengyu, Chairman and CEO of CNOOC reaffirmed that substantially all of the oil and gas produced by Unocal in the US will continue to be sold in the US, and the development of properties in the Gulf of Mexico will provide further supplies of oil and gas for US markets. Fu also repeated the commitment on behalf of CNOOC to retain the jobs of substantially all of Unocal employees, as opposed to Chevron’s plan to lay off redundant employees after the merger, especially in the Unite States.  Secretary of State Condoleezza Rice was a director of Chevron for a decade before joining the Bush team, and even had a Chevron tanker named for her.

It’s a tossup how the CFI will eventually rule, assuming CNOOC can put together the winning financials to request a CFI ruling.  There are reservations in China that CNOOC may be forced to pay too much for a company that is worth less than $1 billion even at high current energy prices.  But the CNOOC/Unocal deal is an early signal of a rising trend, which has already ignited a visible split between anti-China forces in some faction in the US political establishment and the pro-trade forces in the US business community which view China as a great market the US cannot afford to pass up. To China, a negative ruling will look as if the US will welcome China to buy as much oil as it needs at market prices, but not will welcome it to own any oil resources even if such resources are not critical to US national security. Yet, the history of the US using the supply of oil as a geopolitical weapon is long and obvious. It was a key factor behind the Japanese attack on Pearl Harbor in 1940. Further, even on a commercial basis, the US for decades had restricted the export of domestic oil to keep domestic prices lower than world prices. Now it is trying to prevent China from doing the same.

And in the two decade since China began to integrate its economy into the global economy, China has received far more foreign direct investment (FDI) than it has made overseas.  In 2004, China received $61 billion of FDI while Chinese companies invested only $3.6 billion overseas, even when China has become the world’s second largest creditor nation with foreign exchange reserves of over $660 billion by the end of March 2005.  Congress is heading towards a vote to impose a 27.5% tariff on Chinese goods if China does not revalue the yuan at the command of the US, despite Federal Reserve Chairman Alan Greenspan’s public warning that the yuan’s revaluation would have no significant impact on the US trade deficit and job loss and that protectionism against China would put the US economy at risk for no discernable purpose or advantage.

There are those who argue that Chinese companies would be welcome to participate freely in the US market if they were not state-owned enterprises (SOE) controlled by the Chinese government.  The counter argument is that allowed Chinese SOEs to invest abroad will accelerate the withdrawal of government control over commerce in China. Besides, European and OPEC member state-owned enterprises routinely participate in international mergers and acquisition. Every US oil company, including Chevron, is also eying business opportunities in the development of Chinese offshore oil exploration.  Many major US corporations are aggressively trying to invest and acquire Chinese government-owned companies in China. It is hard to argue that Chinese government-owned companies should not be allowed to acquire US corporations in the US. Thus the argument of a two-way street is a strong one.

British Nuclear Fuels plc (BNFL), owned by the British government, acquired without controversy Westinghouse Electric Company, the commercial nuclear power businesses of CBS in 1999. (Westinghouse acquired CBS in 1995).  Britain is of course an ally of the US.

On a trip to China last April to discuss high-stakes issues of terrorism and North Korea nuclear proliferation, Vice President Dick Cheney made a pitch for Westinghouse’s nuclear power technology. At stake could be billions of dollars in business in coming years and thousands of jobs in the US. The initial installment of four reactors, costing $1.5 billion apiece, would also help narrow the huge US trade deficit with China. China’s latest economic plan anticipates more than doubling its electricity output by 2020 and the Chinese government, facing enormous air pollution problems, is looking to shift some of that away from coal-burning plants. Its plan calls for building as many as 32 large 1,000-megawatt reactors over the next 16 years.

The US Department of Energy reported in March 2005 that Chinese industries were energy intensive with significant economy-wide waste. The country uses three times more energy per dollar of its GDP than the global average and 4.7 times more than the United States. Westinghouse faces French and Russian competition in contracts for third generation China National Nuclear Corporation (CNNC) plants at Sanmen (Zhejiang) and Yanjiang (Guandong) to be awarded this year. Recognizing that nuclear technology sales to China would help address massive US trade imbalance with China, the US Nuclear Regulatory Commission has cleared the transfer of technology while the US Export-Import bank has approved $5 billion in loan guarantees for the Westinghouse bid. Domestic political opposition to US participation in the China nuclear power program is mounting to stop the pending deal. Meanwhile, Chinese planners are warning investor to exercise caution to avoid blindly over-investing in the Chinese energy sector.

The reason the US never got excited about Japanese and German acquisition of US assets is that these countries, as once-defeated nations and now-subservient allies, know their place in the pecking order in geopolitics enough to voluntarily restrict their acquisitions to non-strategic real estate, and stay clear of strategic sectors such as oil.  The Japanese and Germans have dutifully kept themselves restricted to oil trading and refrained from aspiring to be owners of oil assets, a sector reserved exclusively for Anglo-US interests as war trophies.  But the Chinese, encouraged by US neo-liberal advisors to imitate the US model of globalized business strategy, are beginning to accept the propaganda of free trade to assume the audacity of daring to buy into US strategic assets with the fiat dollars they earned in their trade surpluses with the US.  China appears to be tired of merely holding US papers, and want some real asset for a change in return for shipping real wealth created by cheap Chinese labor to the US. The zealous convert, who has become a fervent believer in the God of free trade, is challenging the Pope. US policymakers are beginning to realize that a capitalist China in a neo-liberal world order is by far more of a threat to US national interests as a superpower than a communist China in the Cold War.

The June 24, 2005 Wall Street Journal reported that celebrated economist Kenneth Courtis, Vice Chairman of Goldman Sachs Asia and outside director of CNOOC, caused a postponement of the initial planned $16.7 billion offer in April.  The delay opened the way for Chevron to strike a deal to buy Unocal instead, causing CNOOC to have to bid in June $2 billion more than it had contemplated in its initial offer in April.  Courtis, an expert on Asian economies, had been humbled by facts divergent from his optimistic pronouncements on the Japanese economy at its strongest in 1989 with regard to strong future prospects, which promptly began in a downhill slide ever since.  His bullish projections on the continuing growth of Asia just before the Asian financial crisis of 1997 proved to be another embarrassment. But economists are like cats with nine lives who can afford to leave clients who followed their bad advice to perish while they themselves move on to new theories. Courtis, the free-trade enthusiast, resurrected his tarnished reputation by playing a revisionist role against market fundamentalism in the decision of the Hong Kong government to make a defensive “market incursion” to ward off manipulative speculation of the Hong Kong market by overseas hedge funds.  The Hong Kong Monetary Authority, with a war chest of over $100 billion, easily demolished the hedge funds by using $18 billion in three days to stabilize the Hong Kong equity market where the normal daily trading volume was only around $1 billion. For three days, Hong Kong, consistently voted by the Heritage Foundation as the world’s freest market economy reverted back to a command economy to protect its stock market from the destructive effects of manipulation by hedge funds on the fixed exchange rate of its currency.

While no outsider knows why Courtis reclused himself on the CNOOC decision, it would not be unreasonable to suspect that geopolitics was part of the consideration.  For a Chinese state-owned enterprise to buy a US oil company might have been a bridge too far at this time in view of rising hostility in US domestic politics toward China.  After all, do the Chinese, with thousands of years of sophisticated political culture, and decades of exposure to Marxist theories, not know that free trade is merely a slogan in US policy?  Or is China, advised by US neo-liberals, simply making the US face its own music?

General Motors and China

China has also become something of a whipping boy in the US debate about job loss to nations with super-low wages, based on a misguided conclusion, springing from the recent growth of China's trade surplus with the United States to $124 billion in 2004. Total US trade deficit for 2004 with all countries was $666.2 billion in 2004, $164 billion of which was in oil import at an average price of $32 per barrel. What has happened is that other Asian exporting economies, notably Japan, Korea, Taiwan and Hong Kong, have moved much production to mainland China on products destined for export to the US. So China’s trade surplus with the US has soared while US balance of trade with other Asian economies has flattened or dipped slightly.

The Chairman of Toyota Motor Corporation, Hiroshi Okuda, is urging Japanese automakers to raise prices or find other ways to level the playing field for ailing US rivals General Motors and Ford in hopes of heading off a possible protectionist backlash in the crucial North American market. The world’s largest automaker, General Motors, had $52.6 billion in cash and marketable securities on its balance sheet at the end of the first quarter 2005, even as it reported a $1.1 billion net loss for the quarter. The GM finance unit, GMAC, made $729 million profit in the first quarter. And even though GMAC commercial paper was cut to junk bond status along with the debts of the rest of the company, the finance unit still has sufficient access to cheap capital to keep posting strong profits going forward. But GM has serious enough problems that its executives would not even project when it might return to profitability. The downgrade to junk bond status is one warning sign. Another is its market capitalization sliding below $19 billion, well below its cash on hand of $52 billion, with a debt of $300 billion. This means investors are saying that the company has negative value if its cash is taken out. By contrast, and as an indication of a bubble economy, Google’s market capitalization, less than 11 months since its IPO, has topped $81 billion, trading at 50 times estimated earnings, compared to 22 times for Time Warner, 21 times for Disney and 19 times for Viacom.  Google sales in 2004 totaled just $3.2 billion while Time Warner stood at $42 billion. GM sales in 2004 totaled $193.5 billion with net income of $2.8 billion, yielding a market capitalization of only 6.8 times of earnings.

The problem is that GM’s key product -- its gas-guzzling sport/utility vehicles -- are seeing declining demand that has forced the company to step up the cash-back offers needed to maintain sales.  That should not have been a surprise, given rising gasoline prices that are not expected to moderate because of a shortage of refining capacity. But GM has not responded effectively to sudden market changes. Instead of introducing new vehicles to fit new market conditions, it has tried to keep sales of unpopular vehicles strong through ever-increasing financial incentives. It is very unwise for a high-cost producer to lead a price war. The result was financial loss accompanying market share loss to more cost-effective foreign competitors.

GM is in talks with the United Auto Workers union (UAW) over its health care costs, which cost GM an average of $1,500 more per vehicle than that of foreign competitors, even on cars and trucks made at the Japanese automakers’ US plants.  Some observers thinks the best alternative could be to file for bankruptcy protection, and try to have the court force health care savings and other cutbacks on the UAW. Another alternative is that only the auto operations file for bankruptcy, thus preserving the corporation’s finance unit and other assets, such as its horde of cash. The rating agencies and stock market are sending a clear message that they think GM will continue to lose money for the foreseeable future and eventually go bankrupt. Bankruptcy is a defensive strategic option or an unavoidable eventuality.

But even the profitability of GMAC, the finance unit, would be under threat as the Fed raises short-term interest rates.  The rising cost of funds will make it more difficult for GMAC to offer attractive financial incentives to sell unpopular GM cars.  GM has been following the strategy of GE to try to turn itself into a global finance company which incidentally also manufactures, selling its uncompetitive manufactured products with aggressive compensatory vendor financing. This finance game has overtaken the entire US economy where all the profit is being made by the financial sector, while its manufacturing base in the US falls into decay through outsourcing to low-wage locations overseas.  GM’s strategy now is to be the finance and marketing arm of an auto sector in the process of being relocated from Detroit to China, while maintaining its profit margin from finance.

When the outspoken Toyota chairman said he feared the possibility that U.S. policy could turn against Japanese auto makers if domestic giants such as GM and Ford were to collapse, he was not being truly outspoken. “Many people say the car industry wouldn’t revisit the kind of trade friction we saw in the past because Japanese auto makers are increasing local production in the United States, but I don't think it’s that simple,” Okuda said in a press conference, “General Motors Corp. and Ford Motor Co. are symbols of U.S. industry, and if they were to crumble it could fan nationalistic sentiment. I always have a fear that that in turn could manifest itself in policy decisions,” speaking as the head of the nation's biggest business lobby, the Japan Business Federation.  But what was not said was that Toyota has a more serious hidden apprehension than a revival of US protectionism from the collapse of GM or Ford. What Toyota really wants is to keep GM manufacturing in the US where it can never achieve cost competitiveness, and not move its manufacturing to China with a new business paradigm to compete with Japanese auto makers there.

Okuda raised eyebrows and invited criticism on both sides of the Pacific with his call for fraternal aid to U.S. auto makers, such as by raising Japanese product prices, as US producers reel under massive health-care costs and sliding sales. It is a call for price signaling if not outright price fixing.  According to US anti-trust laws, inviting competitors to match your price increases can be illegal price signaling, says lawyer Jim Weiss, former head of an antitrust unit at the Justice Department.

GM has announce plans to cut at least 25,000 manufacturing jobs and close more US assembly and  component plants over the next few years. Both GM and Ford have been cutting back output as they lose sales to Asian brands led by Toyota, which now controls 13.4% of the US car market, the world’s biggest to date. But the China market is looming large as a new opportunity for GM, which ended 2004 with a market share of 9.3% in China.  The GM China Group includes seven joint ventures and two wholly owned enterprises in China. In 2004, GM’s vehicle sales in China grew 27.2% on an annual basis to 492,014 units, an all-time high.  China’s market is still in its infancy, with less than 5 percent of the population able to afford even a tiny car. GM Chairman and CEO Rick Wagoner predicts China will overtake Japan as the world's second-largest car market within five years.

Detroit Free Press columnist Tom Walsh reports that in 2003, GM and its Chinese partners made $2,267 per car sold in China while in North America, GM made about $145 per vehicle. GM and its Chinese partners had a combined net profit of nearly $875 million, or about $2,267 per vehicle sold in China.  In North America, GM's net profit last year was only $811 million on sales of 5.6 million cars and trucks in the United States, Canada and Mexico, or about $145 per vehicle.  That means GM China was nearly 15 times more profitable, per vehicle sold, than GM North America. GM, for example, is selling Buick Regal models in China for more than $40,000 that are less powerful than a 3.8-liter, 4-door Regal sedan that costs about $24,000 in the US.

“GM is making money hand over fist in China, selling cars as fast as they can make them, at very attractive prices,” says Kenneth Lieberthal, a University of Michigan professor and China expert who was senior director for Asian affairs on the National Security Council under President Bill Clinton. “Most of the jobs lost to Asia were lost years ago. Now they're moving around Asia,” says Lieberthal.  “If what’s good for General Motors is good for America, as former GM President Charlie Wilson once said, China’s emergence as an economic powerhouse can’t be all bad,” writes columnist Walsh.

Okuda told the press: “If you think about GM's current output volume and vehicle lineup, laying- off 25,000 to 30,000 employees is inevitable.” But within a decade, GM could be again the world’s largest profitable car producer if its China strategy is successful. And its success is dependent on whether GM can become a truly multinational corporation instead of merely a transnational US corporation active in China. Chinese consumers will relieve the global overcapacity problem in the auto industry, but they cannot do so if transnational corporations continue keep robbing them of the consumption power by keeping Chinese wages low to siphon profits home.

GM has been closing and idling plants over the past four years and will have to cut its annual North American assembly capacity to 5 million vehicles by the end of 2005 from 6 million in 2002. Meanwhile, top Japanese auto makers are adding jobs and assembly lines in North America to meet shifting demand there at the expense of GM and Ford, but not the US economy, prompting executives, including Toyota President Fujio Cho, to dismiss concerns that their success would reignite a political backlash. Thus Okuda’s concern is not about US protectionism, a concern refuted by Toyota’s own president. It is about GM plans in China.

Car companies now are merely brand-name designers and assemblers of a generic world car.  All cars today are assembled from parts produced all over the world where they can be produced at the lowest cost. Different band-name designs package the same world car for varying appeals in different market segments, some for speed and power, some for styling and luxury, some for economy, etc. As US car-assembling giants face market resistance, US auto-parts companies have begun to fall like rows of dominoes, made worse by rising material and energy prices and uncompetitive wages. Recently, auto-parts supplier Collins & Aikman Corporation was the latest to file for bankruptcy protection, lining up behind fellow suppliers Meridian Automotive Systems, Tower Automotive Inc. and Intermet Corporation. Whether those companies and the others that might join them at the bankruptcy court will recover – and what form they will take after bankruptcy – is an open question. A restructuring of the entire US auto manufacturing industry and its supplier network is shifting the center of gravity outside the US, possibly to China. Japan has its own ambitious plans for China where Japanese car makers have already invested over $5 billion. Honda Motors just announced that its joint venture in China has begun exporting made-in-China Hondas to Europe. This is why the Japanese, with their own ambitious plans in China, are thinking about helping Detroit, to keep a terminally ill competitor on anemic life support, not to ward off US protectionism, but to pre-empt unwanted US competition in China. A trade war between the US and China will play directly into Japanese hands, not to mention the EU.

The sudden decline in the popularity of SUVs - where US auto companies have for more than a decade clocked big profits in the era of cheap oil - has joined with rising material costs, mounting worker benefits costs and expensive unionized workforces to eat into huge chunks of the sector’s profits. Add to that the relentless pressure from foreign automakers, and the result has been a steep slide for any company that relies on the Detroit automakers for its bread and butter. In April, while North American auto sales rose, both GM and Ford sales of SUVs dropped – as did their total sales. 

As the supply sector shrinks along with declining US automakers market share, an industry that once seemed ripe for consolidation is now plagued by the question of who would want to acquire companies in a sector that has had such hard time making money lately and in the foreseeable future. The pool of likely acquirers from within the sector is also dwindling as virtually the whole sector slides in concert. It is hard to consolidate when earnings are weak to non-existent, balance sheet weak, with no access to capital markets and equity merger and acquisition funds dry up. Buying auto-supply companies that are dependent on the struggling US automakers for its business is not the most attractive business proposition at this time for other companies. The only exception is a Chinese acquirer who may buy to facilitate opportunities in the Chinese domestic market and eventual entrance to the US market to increase long-term global market share rather than immediate return. But with current political controversy over Chinese acquisition of Maytag and Unocal, China will likely adopt a wait and see posture to see how US domestic politics on free trade plays out. This delay will make bankruptcy more likely to a host of distressed US companies in many sectors besides autos.

With General Motors’ significant cash reserves, it could be several years before the company is forced to face the music, despite its dwindling market share and mounting loss. With over $50 billion in cash, even with losses at the rate of $5 billion a year, it will take 10 years before GM runs dry. Long before that, GM’s China strategy may already bear fruit if no trade war erupts to derail its plan.

The steel and airline industries have dumped under-funded pension plans on the federal government’s Pension Benefit Guaranty Corporation (PBGC). The auto industry may be next. Beyond the airline industry, the federal insurance program faces tremendous exposure from the auto sector. PBGC says the pension assets of auto makers and parts companies fall short of the pension promises they have made to workers by up to $50 billion, more than the $31 billion shortfall in the airline industry’s pension plans.  A Credit Suisse First Boston analysis of pension plans in 54 US industries, based on 2003 public filings, ranks the auto industry’s plans the weakest of all. Half-dozen auto-supply companies recently sought Chapter 11 bankruptcy protection, which is likely to result in $837 million in unfunded pension obligations being transferred to the PBGC. A total of 26 companies in the auto industry have pension plans with assets that fall at least $50 million short of obligations. 

The company that worries the PBGC most to date is Delphi Corporation, the Troy, Michigan, parts operation of GM that was spun off in 1999. Delphi’s plans have pension obligations valued at $11.4 billion but assets of only $7.4 billion. Delphi relies on GM for about half of its $28 billion in annual revenue and is saddled with high labor and raw-materials costs at the same time that GM's production is falling. PBGC calculates pension liabilities based on what it would cost to pay retirement benefits if the plans were terminated; companies give snapshots of the current health of their plans, often a rosier view. PBGC says that if Delphi were to turn over its pension plan to the agency today, the under-funding would total $5.1 billion rather than the roughly $4 billion indicated by Delphi. UBS suggested in a recent report that Delphi should consider a Chapter 11 filing, in part to shed its pension obligations and to pressure the United Auto Workers to help it cut costs. “Bankruptcy has become a management tool these days,” the UBS report noted. 
Bush administration proposals to bolster PBGC finances could intensify the pressure on companies with low credit ratings. The plan calls for flat-rate premiums for companies to jump to $30 annually from $19 for each employee covered by a pension plan, and higher for companies with low credit ratings. It also seeks to limit the ability of financially weak companies to make new pension promises to workers. 

Overcapacity and trade

Tapping into a growing China market will significantly contribute to less painful resolutions of these problems, both for the auto giants and for the government pension agency.  This is one of the reasons why Greenspan says anti-China protectionism hurts the US economy more than it helps and why the White House is dodging the CNOOC/Unocal controversy.  In an age of global overcapacity, the economies with large population and massive untapped consumer power hold the key to the future.  This presents a dilemma for US policy toward countries like China and India. On one level, the world economy needs to develop these populous markets to relieve global overcapacity; on another level, the rise of income necessary for such expanded consumption translates into a leveling of the power differential long enjoyed by the world’s sole superpower.  Suddenly, the needs of the global market to overcome global overcapacity with new consumers are turning against the traditional security and economic interests of the US.  In response, the US is turning back towards its own history of command economy. Emotional debates have emerged within US policy circles on the merits of globalized neo-liberal market fundamentalism versus the need for protectionist economic nationalism.

In some economies, such as the US, policymakers traditionally achieve their command objective through macro management while in others economies, such as Japan until the 1980s, Korea and Taiwan even today, policymakers prefer to do so through micro management. China has recently moved towards macro management of its economy, reportedly with some success, while the US, as exemplified by the ruling authority of FICUS that leads to presidential actions, appears to be reverting to a micro approach to deal with command economy objectives on a case by case basis. Policymakers in self-proclaimed market economies normally manage their policy objective through monetary and tax policies in accordance to macro-economic theories, but even then they do so with national objectives in mind. Such national objectives are known as national interests in policy nomenclature. For example, the Fed defers to the Treasury on determination of the proper exchange rate for the dollar. When market forces move against the Treasury’s view on dollar, moving it either too high or too low in relation to other currencies, the Fed supports the Treasury as a matter of national security in its effort to intervene in the market to bring the dollar back in line, or at least moderate the volatility. All nations employ industrial policy when it comes to defense and defense related sectors. And as military/civilian dual-use definition expands, more and more of research and development, high tech production, heavy manufacturing and strategic materials are removed from free trade to rely on government subsidies and procurement contracts.  Dual use restriction is one of the major factors contributing to trade imbalances between the US and China. Beyond dual use technology, the US has very little to sell. Free trade in the US perspective is not remotely the same as freedom to trade.

Market Economies and Privatization

The idea that market economies are governed by the unseen hand of the market is pure fantasy. The US has been relying on its petroleum reserves to moderate the rise in oil prices since 1973 and China is only beginning to realize the need of a national petroleum reserves.  And the idea that market forces always produce the best possible social outcomes or the best protection of national security is blatantly false. Without government control, markets merely become command economies that are commanded by powerful special interests. The aim of government command in all economies is to protect the interests of all the people fairly within the nation and to protect national interests beyond a nation’s borders. No nation will allow the market to threaten its national interests or security. The idea that market economies require privatization to operate effectively is also pure fantasy. Markets can operate quite well in socialist economies. All it needs is a different framework from capitalist economies. Some economies are privatized more than others. Even in capitalist economies, privatization is never total. Mutual funds are a sector of voluntary collective ownership. The insurance sector in the US used to be predominantly mutually organized companies, as were credit unions. They operated very well until laws protecting them were rescinded for ideological rather than economic reasons.

Privatization of social security is an oxymoron. It is either private security or social security, but not both simultaneously.  Historically, social security was introduced in the US after private security failed the average US worker in the 1930 depression. How on earth can private security in a market economy be expected to save social security when social security grew out of the failure of private security in a business cycle?   There is an iron law of the market: that when sellers outnumber buyers, prices go down.  Now, actuary problems of social security arise when the number of living retirees is growing faster than the number of tax-paying young workers, causing a bigger draw on the social security trust fund than concurrent contributions.  So if young workers buy stocks during their working years to provide for their future retirement and retirees must sell the shares they have accumulated over their previous earning years in order to live in retirement, and if retirees outnumber young workers by a wider margin with every passing year, how is the market going to rise with more sellers than buyers?

Even in the privatized sectors in capitalist economies, the government still decides what is profitable. In fact, it even decides what profit is, and how much to tax it. Much of the recent issues on corporate fraud have to do with illegally booking debt as profit to mislead the market. Free markets are free only to the extent within the rules of the game set by government. When governmental rules stay for long periods, they become invisible tradition and are accepted by market participants as natural conditions.  Generally accepted accounting principles (GAAP) have a large measure of government-defined concepts and measures in them. Most governmental rules that can be changed easily without political difficulty are changed rather forthrightly.  What are left are rules that for all kinds of political reasons cannot be changed easily by government.  War provides opportunities for governments to change these undesirable, obsolete or dysfunctional rules that are politically difficult to change in peace time. The private sector cannot launch wars to bring about preferred rules for enhancing profitability, but it can co-opt government policy toward war.  This is the economic basis for all wars.


Trade Related Aspects of Intellectual Property Rights (TRIPS) 

This article appeared in 
AToL on August 5, 2005


Intellectual property rights has been blown up to be the wide open virtue empire building arena by TRIPS

Property rights are a social institution, not a natural phenomenon.  Intellectual property is an invention of the knowledge-based economy. Both free traders and protectionists in the US agree on the need to protect US intellectual property (IP) rights globally in general and in China especially. Of course a protectionist regime has less, if any, leverage at its disposal for combating the violation of intellectual property rights outside its borders. The Uruguay Round in 1986 produced the WTO Trade Related Aspects of Intellectual Property Rights (TRIPS) agreement.  It is supposed to be an attempt to narrow the discrepancy in ways these rights are protected in different countries around the world, and to bring them under common international rules. It establishes minimum levels of protection that each government has to give to the intellectual property of fellow WTO members. In doing so, it attempts to strike a balance between the long term benefits and inevitable short term costs to global society at large. Society benefits in the long term when IP protection encourages creation and invention, especially after the limited period of protection expires and the creations and inventions enter the public domain. National governments are allowed to reduce any short term costs through various exceptions, for example to tackle critical time-sensitive public health problems. The WTO dispute settlement system is designed to settle international trade disputes over IP rights before such disputes translate into political tension.

Yet ideas and knowledge are increasingly important, even dominant, parts of trade. Because technological underdevelopment in many countries is traceable to the historical legacy of Western imperialism, TRIPS can be viewed as condoning hidden trade-restricting tariffs imposed on the world by the technologically-advanced economies to perpetuate cultural imperialism. Prices of goods that carry IP rights invariably enjoy astronomical margins of profit over production cost. This high margin is rationalized by the claim that most of the cost of new medicines and other high technology products lie in the amount of invention, innovation, research, design and testing involved, not production cost.

The current high margin is designed to not only repay past research and development costs, but to finance on-going such costs to sustain an uninterrupted future stream of inventions. This means the technology gap between rich and poor economies will be widened with time under TRIPS. Only established mega drug companies operating with a de facto economic monopoly through astronomical price mark-ups can afford to develop new drugs. With all the talk about the need for competition policy, IP rights protection is shaping up to be the most anti-competitive regime in world trade. Further, in many advanced economies, such research and development costs are subsidized by government funding or tax deductions, paid for by the general public. Yet patent earnings seldom, if ever, flow back into private bank accounts of individual taxpayers in the form of tax rebates.

Films, music recordings, books, computer software and on-line services are bought because of the information and creativity they contain, not because of the plastic, metal or paper used to make them. The cost of material and printing is a miniscule part of the price of these products.  The bulk of the price goes to pay for advertising, distribution and only finally fees for licensing IP rights of the creators. Much of the revenue from IP rights goes to middleman organizations rather than original creators, weakening the argument that its protection encourages invention.

Many products that used to be traded as low-tech goods or basic commodities now contain a higher proportion of invention and design in their value - for example brand-name clothing or genetically-modified new varieties of plants and produce. Creators are given the right to prevent others from using their inventions, designs or other creations - and to demand payment in return for others using them. These “intellectual property rights” take a number of forms. For example, books, paintings and films come under copyright; inventions can be patented; brand names and product logos can be registered as trademarks; and so on. Governments have given creators these rights as incentives for producing ideas that will benefit society as a whole.

But often, intellectual property rights are abused to protect trade-restraining monopolies. In such cases, both the definition of intellectual property and the enforcement of its protection can be unjust and oppressive. When copies of Louis Vuitton bags of same quality can be sold at a fraction of the price of the original at a profit, it is empirical evidence that the profit margin of the original is excessive. If the copies are of inferior quality, then they are caricatures and arguably not a violation of intellectual property rights. Fakes that are sold as fakes do not qualify as theft of the original. It is not illegal in any country to sell copies of the Mona Lisa as copies. The reason behind widespread intellectual property rights violation is because unjust and oppressive laws invite popular resistance.

The extent of protection and enforcement of intellectual property rights varies widely around the world according to varying stages of economic development in different countries.  As intellectual property became more important in trade, these differences became a source of tension in international economic relations. New internationally-agreed trade rules for intellectual property rights are supposed to be a way to introduce more order and predictability, and for disputes to be settled more systematically before they translate into political tensions. But they can also be viewed as a new form of rule-based knowledge imperialism.  There exist an inherent inconsistency and conflict of interest for an industrial standard to claim protection of intellectual property rights because the condition for being accepted as industry standard is that all in the industry can use it freely. An industry standard that demands payment of fees for its use is a monopoly.

The argument that protection of intellectual property rights is indispensable for economic growth has no basis in history. The socio-economic and political history of the US was shaped by the widespread piracy of a simple pattern held by Eli Whitney (1765-1825) on the cotton gin, the widespread use of which had immense socio-economic and political repercussions. Little cotton had been produced in America prior to 1793. During the colonial period, the main crop was tobacco, but tobacco farming had ceased to be profitable as a result of soil exhaustion. The tedious process of separating short cotton fiber from the seeds had to be done by hand and took too much time to be profitable even in a slave economy. A few planters grew a long-staple strain called Sea Island cotton that was easier to separate, but this only grows in coastal areas, not inland, where only short-staple cotton can be grown. Whitney’s cotton gin made it possible to grow short-staple cotton inland for profit. The cotton kingdom then stretched quickly over a vast area from Georgia and South Carolina westward as far as Texas. With the growth of the British textile industry, cotton growers in the US were assured of a market for all they could produce. But cotton growing was labor-intensive, which perpetuated the south's slavery economy, which until the arrival of the cotton gin was fading as an economic institution because of a dwindling need for cheap labor. Also, cotton, unlike rice and sugar, was a more democratic crop, being equally profitable for large landowners with hundreds of slaves and for small farmers with a couple of hundred acres and two or three slaves. Right up to the Civil War, half of the cotton was grown by small farmers with fewer than six slaves each. The widespread piracy of the cotton gin pattern created a socio-economic condition that became one of the key causes of the Civil War.  Thus for the South, the civil war was in essence a people’s war against the big business interests of the North.

In recent years, the US judiciary and some highly-placed US government economists have been claiming that in the knowledge-based economy, antitrust laws may threaten economic liberty, turning antitrust on its head. The US Appeals Court’s decision (District of Columbia circuit) on Microsoft in July 2001 raised the issue with timely urgency. The justices acknowledged that tying browsers (Internet Explorer) or other add-on programs to computer operating systems (DOS-based Windows) may not be bad for economic freedom. The court, while upholding a lower court’s finding that Microsoft had engaged in unlawful monopolistic acts, said broadly that it is unclear how the “current monopolization doctrine should be amended to account for competition in technologically dynamic markets.” And given these conditions of uncertainty, courts must demand “considerable experience with certain business relationships,” such as software packages that bundle services together, before jumping to the conclusion that they are unlawful. The court said that in the future, all cases of tying involving platform software (upon which other computer programmers build) should be judged by a higher standard of proof.

Existing antitrust law requires only the "per se" test, which merely requires proof of the existence of a tie involving a dominant producer. But the court now says that platform-software cases must be judged by the “rule of reason,” which requires courts to balance the pro-competitive aspects of the tie against the anti-competitive ones. The new standard will almost certainly make it harder for government regulators to prove illegal tying in platform-software cases. This may make it easier for software firms to defend themselves when they bundle services together and offer them as one product. Thus whichever firm manages to establish an “industry standard” in one module can force the market to accept its bundling in a clearly anti-competitive manner.

The court defended its deliberate indecisiveness at least partly on the grounds that no one else had yet decided how the monopolization doctrines of the old economy should apply to the new. It feared that a ban on bundling, unless carefully considered, might “stunt valuable innovation.” And in general, the court noted, “we decide this case against a backdrop of significant debate among academics and practitioners over the extent to which ‘old economy’ monopolization doctrines should apply to firms competing in dynamic technological markets characterized by network effects.”

While the market has decidedly punctured the myth of the new economy being exempt from laws of financial gravity, the court appears to be still a willing victim of self-delusion. Microsoft's operating system, the cumbersome and memory-gluttonous DOS, aside being a long way from the most innovative, became the industry standard by its dubious grafting on to Windows, which was not an original Microsoft innovation but somehow became Microsoft’s legal intellectual property. Moreover, the fee charged by Microsoft for Windows is outrageously excessive compared with typical pattern fees. Microsoft does not merely demand a copyright fee for the use of its pattern, it forbids all others from manufacturing Windows, which must be bought from Microsoft as a product, additional copies of which Microsoft can produce with no significant additional cost.

In some markets, customers might in fact want one company to dominate because if it does, it will set a standard everyone can follow and that will make the product more valuable to all. The court's difficulty was that no one knew how to apply antitrust principles to such markets. But an industry-standard operating system for computers is very similar to an industry-standard gauge of railways. Should the company that adopted a gauge that became the industry standard be permitted to prevent other firms from manufacturing rolling stock of the gauge without paying the company a fee?

The court cited the overused example of the traditional telephone system. The more people who subscribe to it, the more calls all consumers may make or receive. Each individual phone user thus benefits from the network in proportion to the number of other people who use it. Once a product like that, or a standard, achieves such wide acceptance, consumers definitely want the supplier of that product to be bigger rather than smaller. Under those circumstances, antitrust laws should intervene only cautiously, to avoid making matters worse for the consumer. But this is a confused argument. The issue is not that industry standards are themselves anti-competitive. The issue is that a single firm’s ownership of industry standards is anti-competitive. The law should recognize that the benefits of being an industry standard must be balanced by responsibilities and obligations to the industry and the community at large.

For example, the Queen’s English has become the international language of finance. Should all bankers and financiers pay a fee to the Queen of England for the use of her language in loan documents? Industry standards imply socialization. It is a very sound principle that if a standard is adopted industry-wide, that standard is owned by all users and must be freely available to all. Microsoft can bundle all it wants to serve the public better, but it should then make Windows free to all users and charge only for its new add-ons to compete with those offered by other firms.

The court concluded, amazingly, that in the end, the goal of US competition law is not to promote competition for its own sake but to promote efficiency. This is a very peculiar attitude for an US court, for the whole US argument against monopolistic planned economy is its alleged inefficiency. Larry Summers, former US Treasury secretary and now president of Harvard University, when he spoke to antitrust lawyers at a 2001 meeting of the American Bar Association was at pain to stress the point that monopolies may be good. “First, do no harm,” he advised, borrowing from the Hippocratic Oath. Where the need for common standards naturally leads to monopoly power, he argued, antitrust enforcement actions may divide those markets in ways that will harm efficiency and the consumer. “We shouldn’t jump too quickly to the conclusion that because something increases competition it is necessarily good,” he said. But that is a socialist argument against a competitive society versus a cooperative society. Funny he did not say anything against the deregulation of airlines and energy. “The nature of competition is going to shift in the knowledge-based economy. The real question is whether there will be an enduring monopoly in something that is inferior,” he said, adding that the history of the software market made that seem unlikely. Unlikely? The DOS-based Windows software is universally considered by programmers as a grossly inferior product; the only advantage in using it is that it is an industry standard.

For neo-liberals, the only time a monopoly is good for the consuming public is when the entire industry has become uneconomic by deregulation, such the rail industry. Unfortunately, this is becoming commonplace in energy, air transportation, health services, telecommunications and the entire new economy. There is no data to support the contention that Microsoft bundling has been good for consumers. It has been good only for Microsoft.  Microsoft has spent more than $3 billion in recent years settling lawsuits by rivals, including a $1.6 billion deal with Sun Microsystems Inc. in 2004 and a $750 million truce with America Online, now part of Time Warner Inc., in 2003.  In a settlement announced on June 30, 2005, IBM will get $775 million in cash and $75 million worth of software from Microsoft to settle claims still lingering from the federal government’s antitrust case against Microsoft.

The Agreement on TRIPS, the subject of Annex 1C of the agreement establishing the World Trade Organization, is the latest translation of cultural imperialism into economic imperialism on a global scale. The Schumpetrean "creative destruction" that US Fed Chairman Alan Greenspan tirelessly celebrates, is increasing distorted from the specific idea of a better mouse trap, to the systemic appropriation of the broad notion linking mice to traps. In the US, the self-proclaimed bastion of democracy, the creative destruction of economic democracy through the rule of law is in full force. Not only do the poor economies not have a fighting chance under TRIPS, even the people in the advanced economies are quietly put in technological servitude by the new patent regime.  The notion that an individual should be granted permission to stake a personal claim on a nation’s natural resource (such as gold, oil and other mineral rights) is undemocratic enough, but now intellectual property rights are defined way beyond any reasonable personal efforts, such as writing a book or a symphony (covered under copyrights), to thoughts while shaving that really amount to wholesale robbery from the public domain. On a corporate level, intellectual property rights has become an economic weapon of mass destruction, preventing creativity from ever seeing sunlight. US annual revenue from patent licenses now exceeds $100 billion, which is larger than the foreign exchange reserves of most countries.  Through TRIPS, US patents gain global status without the burden of sharing patent fees with other governments.

Patents originally were intended to protect the lone inventor, the pioneering genius in a garage, against the predatory exploitation of big companies. In today’s reality, the opposite is usually the case. As basic industries such as electricity, telecommunication and broadcasting developed in the 20th century, the great corporations learned to create arsenals of interrelated patents to use as sword and shield by systemic patent. The recent advertisement campaign of Mercedes-Benz in the Wall Street Journal is built around a theme that there is only one Mercedes, the car with 10,000 plus patents.  Patent battles have become a strong catalyst for mergers, reducing competition in many domains. The largest corporations, with gigantic patent portfolios, routinely enter into cross-licensing agreements with their largest competitors.   Companies without portfolios of their own have to pay cash, representing a hidden tax within the high-tech economy.  And the costs are skyrocketing.  Revenues in the United States for patent licenses were about $15 billion in 1990; eight years later they had soared to more than $100 billion. In 1999, IBM alone took in well over $1 billion from licensing and received a record 2,756 new patents. MSFT’s revenue would dwindle by 80% if its patent and copyrights are suddenly invalidated. A Boeing software engineer has patented a basic method of correcting the century in dates stored in databases and sent a threatening form letter to 700 of the nation's largest corporations (including The New York Times), demanding one-fourth of a percent of their total revenues, on the assumption that they probably have used the same method.

The four key elements in the issue of fair value in global trade are IP, technology, information and pricing.  In classical exchange theory, price is determined by cost and demand which under free trade conditions will reach equilibrium to provide the optimum price and the largest sales. But free trade is a myth, and the US is the leading opponent of it in practice while being the leading proponent of it in rhetoric. 

The rationale for IP protection is that it is needed to subsidize the coming stream of new technology.  But as the Microsoft anti-trust case demonstrates, IP inhibits new technology more than it is generally recognized.  The same is evident in medical drugs.  The only arena this inhibition does not exist is in military technology where the technological imperative still governs at the expense of price sensitivity. The fundamental criterion for a free market is the equal availability of information to all participants.  When information is packaged and sold as commodities, free market becomes the casualty. When two economies of uneven stages of technological development trade bilaterally, the concept of countervailing trade surplus in favor of the less advanced economy is simple justice.  Otherwise it would be structural economical imperialism.  More and more developing nations are finally taking this view in their trade negotiations with more advanced countries.

As for intellectual pirating, this is a serious and controversial issue. The reason it is so widely practiced by most less-advanced economies is that there is a widespread view that the current intellectual property rights regime is not fair toward late comers. China is only the latest to join the club. The US as a young nation participated fearlessly in intellectual piracy until it became technologically matured. The same is true with Japan, Korea and Taiwan.  Europe was notorious for its brazen theft of early technology from other cultures. To be fair, China should be entitled to claim retroactive IP rights on the compass, gunpowder, paper making, silk production, printing, etc., for a period of 50 years starting now, to compensate for her loss due to the absence of an international IP regime during her epoch of high inventiveness. The Arabs should be compensated for Arabian numerals without which modern mathematics would not develop. When a law is unjust, it invites widespread violation. How about an international affirmative action program for IP or IP amnesty for the underdeveloped Third World for 50 years? It will speed up global development and the advanced economies will also benefit more than they will lose as a result. 

Michael Hardt and Antonio Negri demonstrate in their book that empire can be the new political order of globalization. This is a problematic position. It is possible to recognize the contemporary economic, cultural, financial and legal transformations taking place across the globe in the form of empire building. Hardt and Negri contend that these development should be seen in line with historical understanding of Empire as a universal order that accepts no boundaries or limits. Their book shows how this emerging Empire is fundamentally different from the imperialism of European dominance and capitalist expansion in previous eras.

Yet empire is a institutional structure based on power. Its growth draws on the containment of national sovereignty in the Westphalian world order of sovereign states based on the principle that nations inherently possess sovereign rights. Westphalian sovereignty is the principle of international law that each nation state has sovereignty over its territory and domestic affairs, to the exclusion of all external powers, on the principle of non-interference in another country's domestic affairs, and that each state (no matter how large or small) is equal in international law. The doctrine is named after the Peace of Westphalia, signed in 1648, which ended the Thirty Years' War, in which the major continental European states – the Holy Roman Empire, Spain, France, Sweden and the Dutch Republic – agreed to respect one another's territorial integrity. As European influence spread across the globe, the Westphalian principles, especially the concept of sovereign states, became central to international law and to the prevailing world order. The Westphalia principle gave legitimacy to colonies of European Empires around the world to exercise self determination based of United Nation charter of human rights at the end of WWII.

National sovereignty is today a progressive mechanism for small and weak countries to oppose big power encroachment of national sovereignty in the name of globalization and regional integration. It is the veto power of the world’s weak to protect indigenous culture and independence. The most important characteristic of positive regional integration is the voluntary participation of nation states. It is this voluntary characteristic that makes possible regional integration without empire.