selective strong dollar policy
Henry C K Liu
This article appeared in AToL
on August 14, 2003
With its current account deficit approaching US$600 billion this year
and the federal deficit running at $450 billion, the United States
needs to attract about a net $5 billion of funding every working day,
much of it from overseas. That is 5 percent of US gross domestic
product (GDP) in nominal value. Assuming money velocity at a
conservative multiple of five, foreign fund inflow supports 25 percent
of the US economy. A weak dollar is supposed to make it easier to meet
this funding requirement, as well as helping to reduce the trade
deficit by making exports cheaper and import more expensive. But a
falling dollar reduces the net yield of foreign-own dollar debts,
generating incentives for foreign holder of US bonds to sell. Therein
sits the rationale behind the US Treasury's selective strong-dollar
policy, designed to reduce any incentive for large foreign holders of
US bonds, such as Japan, to withdraw from the US bond market.
While a strong-dollar policy has officially continued from the
administration of president Bill Clinton to the current administration
of George W Bush, US Treasury Secretary John Snow, at a Group of Seven
(G7) finance ministers' meeting in France in mid-July, defined the
strong-dollar policy in what the market considered weak terms. "What
you want to be strong is that you want people to have confidence in
your currency, you want them to see a currency as a good medium of
exchange," he explained. This describes a sound-dollar policy rather
than a strong-dollar policy. What Snow was really saying is that you
want certain foreigners, such as the Japanese and the Chinese, to
continue to buy US bonds.
Federal Reserve governor Ben S Bernanke remarked before the National
Economists Club in Washington, DC, last November 21: "In the United
States, the Department of the Treasury, not the Federal Reserve, is the
lead agency for making international economic policy, including policy
toward the dollar; and the secretary of the Treasury has expressed the
view that the determination of the value of the US dollar should be
left to free market forces." Less than two weeks later, Paul O'Neill,
the treasury secretary Bernanke referred to as having expressed that
view, was told by the White House to resign on December 5.
In February 2001, O'Neill said publicly: "We are not pursuing, as often
said, a policy of a strong dollar. In my opinion, a strong dollar is
the result of a strong economy." Financial markets reacted with massive
dollar selling, forcing the Treasury Department to issue this
clarification a day later: "The secretary supports a strong dollar.
There is no change in policy."
O'Neill explained on February 18: "I guess I made a mistake in thinking
it was okay to talk beyond simplistic things. So I'll make it very
clear: I believe in a strong dollar, and if I decide to shift that
stance I will hire out the Yankee Stadium and some rousing brass bands,
and announce that change in policy to the whole world."
O'Neill was right that the exchange value of the dollar is not the
stuff of "simplistic things". The US economy has locked on to a
strong-dollar policy for almost a decade. The US government cannot
explicitly abandon it without undermining international market
confidence in the dollar, promoting an exodus from US bonds and pushing
up long-term interest rates.
While since the start of 2002 the dollar has fallen as much as 30
percent from its peak against the euro, it does not add up to an end of
the strong-dollar policy. The United States has been sanguine about the
rapid decline of the dollar only against select currencies. Since its
low for the year in mid-June, the dollar has rebounded by 6 percent
against the euro.
When O'Neill, Snow's predecessor, argued that markets rather than
governments should determine exchange rates, he was asserting that US
government policies would aim at preserving long-term market support
for the dollar. He claimed he had been misunderstood that he meant a
strong-dollar policy was no longer in place. The misunderstanding
actually came not from the market being simplistic, but from the
mismatch of the neo-liberal myth of a free market in foreign exchange,
as espoused by central banks, and the market's view of the fact that
the foreign-exchange market is anything but free.
During the Clinton administration, Robert Rubin, widely regarded as the
father of the strong-dollar policy, declared his aim of a strong dollar
soon after his appointment to the Treasury in January 1995. Rubin
understood that a capital account surplus is the answer for a current
account deficit, based on economics worked out by Martin Fieldstein in
the Ronald Reagan administration. A strong dollar is key to this
capital account surplus/current account deficit strategy, which has
come to be known as dollar hegemony.
The policy exploits the instinctive penchant of other countries to make
export gains from an undervalued currency. The United States would open
its huge market to the exporting economies of the world and force them
to finance the resultant US trade deficit with capital inflows from the
exporting economies. A strong dollar ensures the appeal of US companies
to overseas investors and thus aligning global support for a strong
dollar. Dollar hegemony forces the central banks of US trading partners
to hold their dollar trade surplus in US bonds and assets, if they want
protection from speculative attacks on their currencies. A fall in
domestic currency will cause domestic interest rates to rise, and make
dollar loans more expensive to service and amortize.
As US domestic demand skyrocketed in the late 1990s, the 30 percent
rise in the trade-weighted dollar between 1996 and 2001 helped keep a
lid on domestic inflation and kept dollar interest rates low, even as
the Fed began to hike the Fed Funds rate target to preempt wage-pushed
inflation caused by structural full employment (at 4 percent
unemployment). While US companies managed to attract overseas investors
with low yields that translated into high yields in their own home
currencies by a strong dollar, the inflow also financed the
merger/acquisition mania of US companies that made the resultant
entities fiercely competitive global giants.
The budget surplus of the Clinton years did not slow down inflow of
funds, which readily went to finance mergers and acquisition and
initial public offerings (IPOs). The easy money and credit milked from
the backs of underpaid workers in the exporting economies enabled the
US economy to venture into new technological fields, such as digitized
telecommunication that spurred the dot-com fever, structured finance
that gave birth to the hedge funds industry, and all manners of
financial and accounting acrobatics. Wealth was being created as fast
as the United States could print money, with little penalty of
inflation. The rest of the world was shipping products they themselves
could not afford to consume to US consumers in exchange for papers of
the US financial system that in turn feeds US consumer power with debt.
A new economic sector called financial services came into existence.
This was the true meaning of the slogan "a strong dollar is in the
national interest". Dollar hegemony allowed the United States to levy a
tax on the rest of the world for using the dollar, a fiat currency, as
the reserve currency for world trade. The livelihood of the world's
workers came to depend on US consumers' appetite for debt sustained by
loans from the underpaid workers' own governments. Neo-imperialism
works by making the world's poor finance the high living of the world's
rich. It transcends the Marxist notion of class struggle and surplus
value. In neo-liberal globalization, not just labor but even capital
comes from the exploited.
What the Wall Street Journal calls mass capitalism would not have been
half-bad if it were not for the fact that the hard-earned capital was
squandered through fraud and Ponzi schemes. These new ventures financed
by fund inflows did strengthened the US economy at first. But as the
real economy in the United States did not grow as fast as the inflow of
funds, because fewer and few things were being produced in the US, the
excess funds soon channeled toward manipulation and fraud on a massive
scale, resulting in financial scandals such as LTCM, Enron, WorldCom,
Global Crossing, and thousands of less-known bankruptcies.
Much of the disaster came from the smoke and mirrors of so-called
financial services, based on minute technical quantitative advantages
that seem benign by themselves, but can accumulate into huge profit or
loss in hundreds of billions of dollars on the turn of a penny.
Hundreds of billions of dollars of investment and credit went up in
smoke from fraudulent schemes perpetrated not only by management under
the coaching of ever-enterprising investment banks, but also with the
active, knowing participation of the banks, robbing workers and
retirees the world over of their pensions and life savings.
Domestic jobs in the United States were eliminated by the millions and
shipped overseas, while overseas workers were told to be thankful for
inhuman wages and sweatshop conditions that at least warded off
starvation. Instead of confessing their regulatory failings, US
officials such as Alan Greenspan of the Federal Reserve took comfort in
the role derivatives played in allegedly smoothing over massive
financial shocks in the system, making the damage longer-lasting.
Falling wages and worker benefits were cushioned by the wealth effect
from speculation by people who could not afford the risk. Now that the
US economy is trapped in a prospect of decade-long slow growth with a
pending onslaught of deflation, and the hollowing-out of blue-collar
manufacturing and white-collar high-tech sectors, Greenspan has told
Congress that the threat of deflation remains "remote" and that
thinking jobs are better that doing jobs.
What Greenspan told Congress makes perfect sense in the context of a
new strategy for an American empire. The hollowing out of America's
manufacturing and digital sectors becomes a compelling rationale for US
control of the world to protect its offshore sourcing. After all, wars
have been fought to protect the supply of oil in places where nature
has placed it; why should the United States not fight to protect where
the "free" market puts its manufacturing and data processing? In this
strategy, the US needs only two things: a powerful military with
instant power-projection capability everywhere around the globe, and
dollar hegemony to print dollars that can buy all the things that the
world makes for export to the US. The British Empire was rationalized
by the need of Britain to import food as domestic agriculture became
crowded out by industry. Similarly, the US Empire will be rationalized
by the need of the United States to import manufactured goods as
domestic production is crowded out by financial services.
There are only two difficulties with this grand strategy: 1) to build
the ideal empire, US workers will have to be retrained for the service
sector and large numbers of both blue- and white-collar workers will
fall through the cracks - and that creates problems in a democracy; and
2) the rest of the world is not stupid and may not take it lying down.
So freedom and democracy at home will have to be modified in the name
of homeland security and foreign resistance will have to be crushed in
the name of freedom and democracy. The "war on terrorism" is
tailor-made for this grand strategy.
There are clear signs that US workers are not taking it lying down.
Representative Bernard Sanders (Independent, Vermont) interrupted
Greenspan during a congressional hearing on July 16: "I think you just
don't know what's going on in the real world. And I would urge you,
come with me to Vermont, meet real people. The country clubs and the
cocktail parties are not real America. The millionaires and
billionaires are the exception to the rule."
In a blistering diatribe, Sanders told Greenspan: "I have long been
concerned that you are way out of touch with the needs of the middle
class and working families of our country, that you see your major
function in your position as the need to represent the wealthy and
"And I must tell you that your testimony today only confirms all of my
suspicions, and I urge you - and I mean this seriously, because you're
an honest person, I think you just don't know what's going on in the
real world - and I would urge you come with me to Vermont, meet real
people. The country club and the cocktail parties are not real America.
The millionaires and billionaires are the exception to the rule.
"You talk about an improving economy while we have lost 3 million
private-sector jobs in the last two years, long-term unemployment is
more than tripled, unemployment is higher than it's been since 1994.
"We have a $4 trillion national debt, 1.4 million Americans have lost
their health insurance, millions of seniors can't afford prescription
drugs, middle-class families can't send their kids to college because
they don't have the money to do that, bankruptcy cases have increased
by a record-breaking 23 percent, business investment is at its lowest
level in more than 50 years, CEOs [chief executive officers] make more
than 500 times of what their workers make, the middle class is
shrinking, we have the greatest gap between the rich and the poor of
any industrialized nation, and this is an economy that is improving.
"I'd hate to see what would happen if our economy was sinking.
"Now, today you may not have known this - I suspect that you don't -
but you have insulted tens of millions of American workers.
"You have defended over the years, among other things, the abolition of
the minimum wage - one of your policies - and giving huge tax breaks to
"But today you have reached a new low, I think, by suggesting that
manufacturing in America doesn't matter. It doesn't matter where the
product is produced. We've lost 2 million manufacturing jobs in the
last two years alone; 10 percent of our workforce. Wal-Mart has
replaced General Motors as the major employer in America, paying people
starvation wages rather than living wages, and all of that does not
matter to you - doesn't matter.
"If it's produced in China where workers are making 30 cents an hour,
or produced in Vermont where workers can make 20 bucks an hour, it
doesn't matter. You have told the American people that you support a
trade policy which is selling them out, only working for the CEOs who
can take our plants to China, Mexico and India.
"You insulted [Representative Michael] Castle. Mr Castle, a few moments
ago - a good Republican - told you that we're seeing not only the
decline of manufacturing jobs, but white-collar information technology
"Forrester Research says that over the next 15 years, 3.3 million US
service industry jobs and $136 billion in wages will move offshore to
India, Russia, China and the Philippines.
"Does any of this matter to you? Do you give one whit of concern for
the middle class and working families of this country? That's my
Then the following exchange took place:
Greenspan: Congressman, we have the highest
standard of living in the world.
Sanders: No, we do not. You go to Scandinavia,
and you will find that people have a much higher standard of living, in
terms of education, health care and decent-paying jobs. Wrong, Mister.
Greenspan: May I answer your question?
Sanders: You sure may.
Greenspan: Thank you. For a major industrial
country, we have created the most advanced technologies, the highest
standard of living for a country of our size. Our economic growth is
crucial to us. The incomes, the purchasing power of our employees, our
workers, our people are, by far, more important than what it is we
produce. The major focus of monetary policy is to create an environment
in this country which enables capital investment and innovation to
advance. We are at the cutting edge of technologies in the world. We
are doing an extraordinary job over the years. And people flock to the
United States. Our immigration rates are very high. And why? Because
they think this is a wonderful country to come to.
Sanders: That is an incredible answer.
Payrolls outside the agricultural sector fell by another 44,000 in
July, the sixth consecutive monthly fall. The unemployment rate fell to
6.2 percent from 6.4 percent - because an estimated 556,000 US
residents dropped out of the labor force through discouragement.
While Greenspan is losing his infallible image, Congress is
nevertheless making only helpless noises about the need for a weaker
dollar to revive struggling US manufacturers without sparking
inflation. The logic is to increase export through a weak dollar and to
retain jobs at home by making imports more expensive. Under these
conditions, it seems only natural that the United States should not
object to a weaker currency.
The reality is that while a weak dollar makes imports more expensive,
it might only reduce import volume but not necessarily the total import
value, and while US export may become more price-competitive, a drop in
US import may also reduce foreign purchasing power for US exports. Thus
the US may increase export volume but not necessarily increase total
export value. The only beneficiary is likely to be US transnational
corporations with foreign revenue whose dollar profit from non-dollar
operations will be boosted by a weak dollar, thus neutralizing any
incentive for overseas investors to sell US equity. The fact is that
once jobs are being done for 30 cents an hour overseas as a result of
"free" trade, the only way these jobs will return to the United States
is if employers can find workers in the US who will work for 30 cents
an hour. The solution has to be a rapid rise of wages outside the G7
economies that rapidly increase the purchasing power of non-G7 workers.
So far, even with the US dollar at four-year lows against the euro and
six-year lows against the Canadian dollar, overseas investors have
chosen simply to hedge their currency risks instead of abandoning US
assets. Yet today's unregulated financial markets can turn suddenly. If
an accelerated fall in the dollar starts to disrupt asset markets and
pushes up interest rates, the United States may need to reactivate
fully the half-dormant strong-dollar policy. Recent concerns for the
budget and trade deficits appear to be undermining already shaky market
sentiment further and risk sparking a spiral of dollar selling. The
twin deficits imply that the US needs strong inflows into the dollar
daily to maintain its value, and if foreign investors become fearful
that the currency could fall sharply, those inflows could drop off.
There are signs that this fall-off is happening in the US equity
market. Recent trading data showed a net outflow from US stocks - the
sixth in seven weeks. The dollar is in a fix in which a falling dollar
makes the dollar fall more.
The US dollar has fallen by more than 10 percent this year against the
euro and nearly 15 percent against the Canadian dollar. These are hefty
falls in currency-market terms, where the sheer levels of liquidity
available in the leading currencies often limit the size and pace of
moves. The speed of the dollar's recent slide has largely caught
currency strategists by surprise. Many had previously thought that the
main phase of dollar weakness would come to a halt around the middle of
2003, but now expect that weakness to persist for at least through the
end of the year, citing deflation fears and the twin deficits.
Dollar-based investors take comfort from the fact that few strategists
are yet predicting the sort of disorderly market that would precipitate
a dollar crash, and that domestic deflation increases the purchasing
power of the dollar.
The Bank of Japan (BOJ) is thought to have intervened covertly in the
foreign exchange market in July, selling massive amounts of yen for
dollars in a bid to stem the yen's rise and support its struggling
exporters. There is speculation that BOJ spent at least 1 trillion yen
($8.5 billion) on one Monday alone as the dollar fell to two-year lows
against the yen. It bought $34 billion in May to stop the yen from
appreciating against the dollar.
Yet even if market participants are scared off by BOJ intervention,
market sentiment toward the dollar remains overwhelmingly bearish.
Speculators can still find other currencies, such as the euro, where
there is less official resistance, to short against the greenback. The
European Central Bank (ECB) is institutionally structured to prevent
the euro from falling, but it possesses little authority or tools to
prevent the euro from rising. It was a worry that seemed unnecessary at
the time of the ECB's formation. When the euro was launched in 1999,
most observers hoped the euro would strengthen against the dollar.
According to conventional wisdom, a weaker dollar is supposed to
provide just the relief that corporate America needs as companies
confront the threat of deflation and continued weakness in the domestic
economy. But US companies are unlikely to change their investment and
sourcing plans unless they can be sure that the dollar will not spring
back soon. Most US transnationals, such as General Electric and
Citigroup, routinely hedge against currency risks, or their revenue is
so well spread across the globe that the overall exchange-rate impact
is almost neutral. In fact, currency hedges have become one of their
major sources of corporate profit. If the dollar stays low for long
periods, companies may decide to source more expensive raw materials
from new, cheaper plants - possibly even in the United States, but this
is unlikely to make high US wages competitive with wages in Asia or
Latin America. Even an illegal immigrant worker in the lowest-paying
job in the US commands a higher wage than does a floor manager in a
Third World sweatshop. Certainly, no re-sourcing decisions will be made
by short-term currency fluctuations.
The 2003 first-quarter earnings from the immediate impact of a weaker
dollar on the translation of international sales into US currency
benefited many US companies. United Technologies (UT), the US
industrial group that owns Otis, the elevator company, and Pratt &
Whitney, the aircraft-engine maker, recorded $1 in earnings per share
for the first quarter, of which 5 cents was from favorable
foreign-currency translation. UT receives 60 percent of its revenue
from outside the United States and 20 percent alone from Asia, where
growth is expected to remain strong. The currency effect helped offset
weakness in some other major markets such as the EU, Latin America and
The stronger pound sterling, euro and Canadian dollar contributed $219
million to the $10.3 billion of revenues that Wal-Mart, the retailer,
recorded in its international operations in the first quarter. But most
big US companies' trading relationships are founded on multilateral
rather than bilateral exchange rates. Walt-Mart's positive currency
effect was offset by the weaker Mexican peso. The change in the
euro-dollar exchange rate has also allowed some companies - such as
Dell, the computer maker - to raise market share outside the United
States by cutting prices.
Experience has shown that it will take a lag of at least four or
sometimes eight quarters for the realignment of the dollar to feed
through into US exports. Trade economists have claimed that each
percentage-point drop in the trade-weighted dollar index (TWDI), if
sustained over at least eight quarters, is worth a $10 billion annual
increase in exports, measured in constant dollars. Imports are quicker
to respond, with a fall normally detected within one quarter of a
change in the value of the currency. The US trade deficit in May 2003
was $41.84 billion. The TWDI in April 2003 was 109 and was 88.5 on June
13, still above the 1990s average of 87.8. The TWDI was 178.9 in August
1998 at the height of the Asian financial crisis.
Speculators appear to be gearing up to bid the euro even higher,
creating fresh challenges for global companies as they navigate
volatile currency markets amid difficult economic conditions. After
rising more than 10 percent against the dollar so far in 2003, the euro
in mid-July matched its 1999 launch level, above $1.1742. Against
sterling, the euro has gained 9 percent, peaking in July above its
launch level Stg0.706. More than half of the fund managers recently
surveyed believed for the first time that the euro to be overvalued
rather than undervalued. Yet more than half said the euro was their
favorite currency, with long-euro, short-dollar trades the most
popular. This indicates that herd instinct is alive and well.
G7 finance ministers, in concert with US Treasury Secretary John Snow,
raised doubt about Washington's strong-dollar policy. As usual, the
sole dissent came from Japan. Eurozone finance ministers reiterated
support for a "strong and stable" euro. They echoed Wim Duisenberg,
outgoing president of the European Central Bank, who recently said the
euro was trading at fair value.
Recent surveys showed that average forecast projects the euro to trade
up toward $1.20 from the $1.13-$1.14 level by year-end. Policymakers'
comments could extend those forecasts further still to $1.25 or even
The dollar's gains in the late 1990s were based partly on dollar-buying
by eurozone groups, such as Vivendi and Daimler, which bought US
companies. These companies and their eurozone investors are now nursing
heavy losses after three years of falling equity prices in the United
States and worldwide. The result is a drying up of capital flows to the
US from the eurozone. In deficit until 2002, the eurozone current
account now runs a surplus that gives confidence to investors assessing
the currency risk of eurozone assets.
The US twin deficits by contrast are seen as a risk for the dollar's
value, leading greater numbers of investors to hedge against the risk
by buying forward contracts - sending the dollar lower still. The
eurozone's economy is likely to fall into deflation if the euro returns
to its equivalent peak levels of the mid-1990s and stays there for long
periods. Simulations models suggest that if the euro rises by about
another 20 percent, there is a roughly two in three chance that
deflation will hit the eurozone.
The dollar has fallen 30 percent against the euro since its peak in
2000. In 1985-87, it fell by 54 percent against the deutschmark. The
dollar rose by a trade-weighted average of 35-50 percent (depending on
which index is used) from early 1995 until February 2002. Since trade
economists claim that every 1 percent increase in the dollar produces
an increase of $10 billion in the annual US current account deficit
after a phase-in period of two to three years, this appreciation
accounts for the bulk of the total deficit that now approaches $600
billion (about 6 percent of GDP) per year. These deficits have risen by
almost one full percentage point of GDP in each of four of the last
five years. The exception occurred during the recession year of 2001.
As a result of the current account deficits of the past 20 years, the
negative net international investment position (NIIP) of the United
States now exceeds $3 trillion (30 percent of its GDP) and is climbing
by about 20 percent per year. This has been sustained by dollar
hegemony in which the role of the dollar as the reserve currency for
trade keeps the trade surplus in dollars earned by countries exporting
to the US as captured investment or loans in the dollar economy. It is
a phenomenon in which the US produces dollars and the rest of the world
produces things dollars can buy, making the US trade deficit tolerable
and its impact on the exchange value of the dollar negligible.
The dollar has been declining in a gradual and orderly manner since
early 2002 by 10-20 percent as measured by various indices. So far it
has reversed one-third to one-half of the run-up of the previous
six-and-one-half years, since 1996. The sharp rise of the dollar that
began in 1996 in an unregulated global financial market detonated the
Asian financial crisis of 1997. If the dollar stays down, which is
likely as long as the Fed maintains its near-zero interest-rate policy,
the US annual current account deficit may decline by $100 billion to
$200 billion over the coming two to three years from where it would
otherwise have been. The impact on imports on the fall of the dollar up
to this point would translate into a drop of more than half from its
$600 billion peak. This means the economies exporting to the United
States will not be in any position to absorb more US exports, even if
prices are lowered by the lower dollar exchange rates, unless they
incur massive trade deficits. But because of dollar hegemony, no
country can sustained a dollar trade deficit without the penalty of a
collapse of its currency, except the United States.
Adverse effects of the dollar's decline on the US economy are just
beginning to show up in the bond market and in the US capital account.
The Bush administration has accepted the correction, frequently
reiterating that the exchange rate should be left to market forces and
discouraging any thought that it might intervene directly to interrupt
the decline. But the market knows that the Fed, unlike other central
banks, can intervene in the foreign-currency market indirectly because
of dollar hegemony. The Fed has unlimited dollar resources, through
what Bernanke called "the printing press", to keep dollar interest
rates low and the dollar exchange rate high. Other central banks cannot
Some economists suggest that the United States can sustain a current
account deficit at about half the current level, or $250 billion to
$300 billion per year (2.5-3 percent of present GDP). At this level,
the ratio of the US NIIP to GDP could level off at 30-35 percent, below
the conventional "danger zone" of 40 percent. Given that every 1
percent decline in the dollar will produce a reduction of $10 billion
in the external imbalance, the US trade-weighted exchange rate needed
to fall by 25-30 percent from its recent peak. Hence the depreciation
of the dollar to date has probably gone only about half the needed
distance to date. But the conventional 40 percent danger zone may not
apply to the United States because of dollar hegemony.
The dollar decline to date, however, has been selective among the major
trading partners of the United States. The dollar has fallen by about
30 percent against the euro but only about 15 percent against the yen.
The dollar rose against the Chinese yuan in 1994 to 8.278 to a dollar
when it had been pegged in a very narrow range around 5.8 per dollar.
But since the yuan is not freely convertible, its effect on the
foreign-exchange market is immaterial. To sell dollars, the Chinese
central bank would have to accept other foreign currencies rather than
The concentration on euro appreciation against the dollar is
paradoxical, since Japan is by far the world's largest surplus and
creditor country, while China is the second-largest holder of
foreign-exchange reserves. As for Chinese exports, many economists have
pointed out that China's share of world trade is still small for the
size of its population. A World Bank report estimates that China's
share of world trade will be 9.8 percent by the year 2020, with 20
percent of the world's population. The Plaza Accord in 1985 forced the
Japanese to push the yen up to reduce its trade surplus, but it did not
help the US economy, nor did it help the Japanese economy. Chinese
exports rose by one-third in the six months to June, to $190 billion,
while imports jumped 46 percent to $186 billion. On a global basis,
Chinese foreign trade has been balanced. The Chinese economy has been
holding up the anemic global economy.
The International Monetary Fund has thrown its weight behind the
Chinese exchange-rate policy and rejected mounting global pressure for
China to revalue its currency. IMF chief economist Kenneth Rogoff,
speaking at a Washington conference on the US dollar and the world
economy recently, said currency appreciation was risky for some
countries. The IMF's support of China is at odds with US Treasury
Secretary Snow and Fed chairman Greenspan, both having suggested that
China should liberalize its exchange-rate system so that its currency
can gain in value. The EU and Japan have also made calls on China to
abandon the peg for the yuan.
Hugo Restall, editorial-page editor of The Asian Wall Street Journal,
wrote on July 31: "Asians seem to have realized that not only is the
China threat overrated, but the country is an engine of growth that
"In fact, US and Chinese economic interests are quite closely aligned,
because the two economies are so complementary. You might even say that
China is an economic colony of the US, with its currency so tightly
pegged to the dollar and American companies using it as a base for
their low-cost manufacturing.
"That might seem like a strange idea given how nationalistic the
Beijing regime is. But consider the government's actual behavior, and
it's not hard to imagine that if Paul Bremer were running China instead
of Hu Jintao, he'd be accused of exploiting the country's economy to
benefit the US and other Western countries.
"First of all, the most productive sector of the economy is largely run
by foreigners, for the benefit of foreigners. China may boast of being
the largest recipient of foreign direct investment in the world, but it
got that way in part by offering preferential tax treatment and other
incentives to multinational companies. Those ventures in turn export
not only their products, but also their profits, often hidden by
manipulating the prices used for transactions within the companies.
"There's still time for China to get wise. But the point here is that
Americans should be sanguine about China's development model. Thanks to
Beijing's own policies, China is giving them cheap capital, cheap
manufactured goods sold below their true cost and a market for
sophisticated, high-value-added goods. At the end of the day, China
will be left with uncompetitive companies, depleted savings and a
balance-sheet recession. It will have to sell off the distressed assets
of its failed banking system, at which point Western companies can buy
up even more of the economy at fire-sale prices.
"One more thought about China: Since the two economies are
complementary, it's ultimately not in the US interest for Beijing to
continue with its self-defeating policies. A sudden collapse would hurt
the US because the market for US Treasurys might be disrupted, social
unrest could damage American-owned factories and the market for US
goods could dry up. In short, Americans should be somewhat concerned
about China, but not for the reason they think. The good deal they're
getting now can't last forever."
Though the article's focus on inefficient state-own enterprises is not
directly on target, truer words have seldom been said about the
stupidity of an export policy that depresses domestic wages to earn
dollar trade surpluses within the context of dollar hegemony.
Mercantilist policies are rendered inoperative by dollar hegemony. The
aim of China's planners to build the domestic economy through export
earnings is fundamentally flawed. Trade can only supplement domestic
development, never replace it. With a non-convertible currency, a large
economy such as China's can finance its domestic development through
state credits based of the State Theory of Money, with no need for
foreign loans or capital. The value of the Chinese currency is a
function of the strength of the Chinese economy, from which the
government has the authority to levy taxes, and not by the
foreign-currency reserves held by its central bank. Central banks can
affect the supply of money through monetary policy, but they cannot
affect, except in very indirect ways, the demand for money in the
economy. James A Baker, treasury secretary under Reagan, has a score to
settle with Greenspan, whom both George Bush Sr and Baker blamed for
Bush's one-term presidency. Baker's record of outsmarting Fed chairmen
was nevertheless impressive.
Baker's aim of pushing down the dollar in 1985 was to cure the anemic
US economy, not to cause it. Baker became Reagan's White House chief of
staff in 1980, with Don Regan of Merrill Lynch as treasury secretary.
Paul Volcker was a holdover Fed chairman appointed by Jimmy Carter,
whose supporters justifiably thought Volcker's monetary policies were
the reasons for Carter's one-term presidency.
Volcker on September 29, 1979, presented the Fed's "new operating
system" to combat hyper-inflation on board the Treasury secretary's
official plane on the way to an IMF meeting in Belgrade to secretary G
William Miller and Charles Schultz, chairman of the Council of Economic
Advisers (CEA). While agreeing that the Fed must do more to tighten
money supply and credit, both immediately opposed the idea that would
set the Fed on a course of target money supply, a pure monetarist
Miller, the businessman, objected that if the Fed targeted reserves
directly, it would result in more volatility in interest rates that
would exacerbate both inflation and market instability. Schultz, the
economist, objected to fundamental issues of locking the Fed on a
course toward recession it could not reverse. Volcker listened politely
but held on to his belief that the technical decision was the Fed's
"independent" prerogative. The new operating system caused the Fed to
lose control of US interest rates and cost Carter a second term.
The economic disorder that had helped to elect Reagan reached a new
height as he took office. Price inflation remained in double digits.
Interest rates were driven to double digits by inflation and the Fed's
tight money supply policy. Bank prime rate hit 21 percent. Unemployment
hit 7.4 percent. Both were rising with no end in sight. Reagan declared
that government was the problem, not the solution, reversing the failed
Carter approach of relying on government policy to halt inflation. The
Reagan cure was a 30 percent, three-year tax cut and a balanced budget,
cutting $100 billion a year from government revenue over the next five
years and a $41 billion budget reduction in the first year. Voodoo
economics was in full swing.
Reagan wanted "sound money", a fixation of his half-baked monetarist
preoccupation. Optimism was relied upon to defy economic logic. Volcker
made obscure speeches on the unavoidable clashes between monetary
restraint and economic growth, but the White House was not listening.
The United States was ignoring an economic truth about inflation: that
the economy must always decline first, before prices will decline.
Sound money means capping the money supply, which means either price
inflation or that real output would fall. Historical data have always
sided with real output falling first, before prices will fall. Thus
sound money is a recipe for negative growth: recession, way before any
benefit can appear. Moreover, despite slogans, Reagan's policies of
slowing the economy and tax cuts were heading for increased deficits,
the opposite direction of sound money. Reagan rehabilitated classical
economics, which had been discredited since 1930, and its four main
strands of conservative economic thinking: monetarism, tricking down
growth, balanced government budgets and unregulated markets.
Baker was uneducated about monetary policy and did not claim to be
otherwise. Ironically, Reagan, who was a passive president on most
other issues, was forceful on monetary policy on account of decades of
ideological incubation. He was a diehard anti-inflation monetarist and
an apt student of Milton Friedman as superficially presented by the
popular press. Now Baker and the two Bushes, being all Texans, have a
genetic hostility toward big money center banks in the eastern US, and
despite being financial elites themselves, are imbedded with Texan
populism. Bush Sr even proposed, when he was still Reagan's vice
president, an excess profit tax on banks if prime rates remained high.
But Ronald the king had spoken, and everyone worked to give the king
what he wanted. The economy plunged from the frying pan to the fire.
Penn Square Bank failed from bad loans due to falling oil prices and a
Third World debt crisis developed due to a fall in inflation engineered
by the Fed, most dangerously in Mexico, which was about to default on
$80 billion of debt owed to US banks, placing the US banking system
under threat of collapse.
Predictably with US domestic politics, what severe pain suffered by US
citizens could not accomplish, the threat to the banking system
produced immediate government action. A deal was made between the Fed
and the White House to cut the interest rate and to raise taxes to cut
the deficit. A Mexican bailout with $3.5 billion from the Fed and the
Treasury, plus a $1 billion advance payment oil purchase from Mexico by
the Department of Energy, another $1 billion line of credit from
Department of Agriculture for future purchase of US grain and a
Fed-orchestrated $1.85 billion from other central banks, half from the
Fed. This was the beginning of the international debt crisis that still
remains unresolved. It set the basic formula for protecting the banks
while the price is paid by the world's poor in hunger and deaths.
Alan Greenspan has in essence followed this policy since he took over
from Volcker. The Fed has since shifted its role from regulator to that
of a cleanup crew, and the biggest cleanup job is yet to come.
But Snow and Greenspan in 2003 have less room to maneuver than Baker
and Volcker did in 1985. The odds are that Snow will still push down
the dollar at least by another 10 percent and the Fed will keep Fed
Funds rate target near zero. But while these moves may deflect some
political heat, they are not likely to save the US economy from a long
period of stagnation