The Coming Trade War

Henry C.K. Liu

Part I: Coming Trade War and Global  Depression

Part II:  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, as eminent post-Keynesian economist Paul Davidson has pointed out. Say’s Law ignores a critical time lag between supply and demand that can be fatal to a fast-moving modern economy without demand management. Savings require interest payments, the compounding of which will regressively make any financial system unsustainable by tilting it toward overcapacity caused by overinvestment. 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

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
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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.”

Next: Trade in the Age of Overcapacity