Page 1 of 2 A new world order and China's key role
By Henry C K Liu This is the first in a series.
The unraveling of the global financial network and trading system since the onset of the global financial crisis that began in New York in mid-2007 has continued for more than five years with no end in sight, despite coordinated, extended monetary easing by many central banks to shore up a seriously impaired neoliberal global financial system that has been disintegrating at the core from its own internal contradictions.
The primary reason for the ineffectiveness of an aggressive monetary response to induce economic recovery is that the large quantity of new money created by central banks has been
channeled into a global banking system terminally infested with a fatal financial virus in the form of a gigantic debt bubble.
The world's central banks all belong to a powerful ideological fraternity that subscribes to the group-think of bankrupt doctrines of monetarism promoted by the US Federal Reserve.
Since the onset of the 2008 credit crisis, central banks have morphed from their original role of being lenders of last resort to prevent cyclical panic bank runs from turning into a systemic crisis of no confidence in the financial system under their separate jurisdiction, to a new controversial role of being market-makers of last resort in a hopelessly dysfunctional economic world order infested with an extreme case of financial moral hazard and an unstable financial market structure flooded with unmarketable troubled assets left by a collapsed giant price bubble created earlier by excessive debt made available by misguided central bank monetary laxative.
The world's under-capitalized, debt-infested, essentially insolvent commercial banks of systemic significance have used the new, basically cost-free money from central banks to avoid insolvency through deleverage - unloading at face value their large holdings of overpriced illiquid troubled asset with fallen market value onto the balance sheets of central banks that have unlimited power to create money out of thin air to drop as if from helicopters, not on the economy at large as needed, but into the under-funded reserve accounts these insolvent banks are required to keep at the electronic vaults of central banks.
Thus central bank quantitative easing (QE) programs have not provided macroeconomic stimulus and liquidity to the needy productive sectors of the economy to kick start and accelerate economic recovery from a debt-induced recession by moving the ailing economy towards full employment with living wages to boost necessary consumer demand to soak up the excess productive capacity that had been financed by excess debt over past decades.
Instead, central bank QE measures have merely bailed out the under-capitalized, insolvent banks from their heavily discounted debt overload, leaving overcapacity in the economy in a worse state by default. This overcapacity is exacerbated by central bank insistence on a balanced government fiscal budget not from revenue growth in a robust economy but by austerity fiscal measures to further dampen demand.
The now more than five-year-old global recession caused by the financial crisis first broke out in earnest in 2008 after an abrupt seizure of credit markets in mid-2007, triggered a new tradition of Group of Twenty (G20) Leaders Summits which was initiated on November 14-15, 2008 by outgoing US President George W Bush (Republican) near the end of his second and final term, 10 days after Barack Obama (Democrat) won the 2008 presidential election to become President Elect, to be inaugurated two-and-a-half months later on January 20, 2009.
The first G20 Leaders Summit on Financial Markets and the World Economy called by the White House tried to forge a coordinated global response by separate sovereign nations to an impending melt-down of the world financial system and to revive the seriously impaired world economy. The financial crisis elevated the G20 from a perfunctory debating society between rich and poor countries to a recognized international institution of real promise, albeit by default.
On the occasion of the First G20 Leaders Summit of 2008, Paul Davidson and I co-authored an Open Letter to World Leaders dated November 7, a week before the White House meeting. The Open Letter was co-signed by a large number of other supportive economists worldwide. The Open Letter recommended a new international financial architecture based on an updated 21st century version of the Keynes Plan originally proposed at Bretton Woods in 1944.
For an economy subject to business cycles, the lower the present rate of interest, the larger, ceteris paribus, would be a future rise, the larger the expected capital loss on securities, and the higher, therefore, the preference for liquid cash balances. As an extreme possibility, Keynes envisaged the case in which even the smallest decline in interest rates would produce a sizable switch into cash balances, which would make the demand curve for cash balances virtually horizontal. This limiting case became known as a liquidity trap.
In his two-asset world of cash and government bonds, Keynes argues that a liquidity trap would arise if market participants believed that interest rates had bottomed out at a “critical” interest rate level, and that rates should subsequently rise, leading to capital losses on bond holdings. The inelasticity of interest rate expectations at a critical rate would imply that the demand for money would become highly or perfectly elastic at this point, implying both a horizontal money-demand function and LM (liquidity preference/money supply) curve.
The monetary authority, then, would not be able to reduce interest rates below the critical rate, as any subsequent monetary expansion would lead investors to increase their demand for liquidity and become net sellers of government bonds. Money-demand growth, then, should accelerate when interest rates reach the critical level. Of course, Keynes did not anticipate that central banks would resort to unconventional measures such as quantitative easing to buy up all the government bonds the market participants would sell.
Keynes argued that there were three reasons why market participants hold money. They hold cash for pending transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes.
The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money market participants would want to hold should be inversely related to the rate of interest. Market participants will want to hold more money (liquidity) when interest rates are low than when they are higher, despite a loss of interest income.
Keynes’ introduction of interest rate into the demand for money has survived in modern finance, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss except under hyperinflation in which there would be a loss of purchasing power; and bonds, which earned interest but which were not as liquid and which has a risk of capital loss.
If one thinks not in terms of a two-asset world, but in terms of the range of assets which actually exist in the current financial world, there is no reason to hold cash balances for either precautionary or speculative purposes. These are assets that are both very liquid and interest bearing, such as money market accounts and Treasury bills, plus all forms of options in structured finance.
Though Keynes' two-asset-class explanation of why interest rates influence the demand for money is outdated by developments, his other explanations are still sound. Money held for transactions purposes is much like inventory which businesses hold. A rise in interest rates will decrease the optimal amount of money as inventory, and a rise in the cost of re-monetizing will increase the optimal amount. Modern management has introduced just-in-time inventory which renders this argument mute. Most chief financial officers have also perfected just-in-time cash management schemes. The exception is that holders of money can live on it, which is not true for holders of most other inventories.
This new international financial architecture proposed in the Open Letter will aim to create:
1) a new global monetary regime that operates without national currency hegemony,
2) global trade relationships that support rather than retard domestic development and
3) a global economic environment that provides incentives for each and every nation to promote full employment and rising wages for its labor force.
At that first G20 Leaders Summit hosted by out-going US president George Bush in 2008, leaders of member sovereign states agreed to a hastily drafted action plan based on orthodox macroeconomic doctrines to try to stabilize the precarious global market economy and to prevent recurrent crises in the future, resulting in the premier international forum that acquired its current name and significance.
G20 leaders in 2008 reached general agreement on cooperation in key areas to strengthen sustainable economic growth, and to deal with the on-going global financial crisis that had first broken out in New York in mid 2007. with focus on three key objectives:
1) Restoring global economic growth through globalized free trade;
2) Strengthening the international financial system of global market capitalism;
3) Reforming supranational financial institutions to give more voice to the emerging economy countries.
Objectives 1 and 2 were emergency Band-Aid solutions to deal with the painful symptoms but not the dilapidating disease of dysfunctional economic interactions that had caused the current financial crisis.
Neoliberal globalization has promoted the myth that the current terms of international trade lead to win-win transactions for all participating nations, based on a panglossian distortion of the Ricardian notion of comparative advantage. In recent decades, international trade has been conducted primarily through cross-border wage arbitrage, driving down wages in both advanced and developing economies. Around the world, unemployment has been the weapon of choice with which to fight inflation induced by continuous central bank monetary easing.
Yet without global full employment with rising wages, Ricardian comparative advantage is merely Say's Law internationalized. Say's Law states that "supply creates its own demand", but only under full employment, a pre-condition supply-siders conveniently ignore.
After two decades of substituting wage increases with consumer debt in order to maximize return on capital by tilting the distributional balance between capital and labor against labor to the benefit of capital, and the detriment of demand, overlooking the structural wage-price dynamics of Fordism that built the US middle class, this win-win illusion of comparative advantage in international trade without the prerequisite of global full employment with rising wages has been shattered by concrete data: relative poverty has increased worldwide and global wages, already low to begin with, have declined since the Asian financial crisis of 1997, and by 45% in some emerging market economies, such as that of Indonesia. As wages failed to grow, demand was kept high by debt unsustainable by low wages.
Under dollar hegemony, export to US markets is merely an arrangement in which the exporting economies, in order to earn dollars to buy needed commodities denominated in dollars and to service dollar loans and direct investments, are forced to finance the US consumption beyond the level supported by US wages, and by the need to invest their trade surplus dollars in dollar assets as foreign-exchange reserves, giving the US a rising capital account surplus to finance its rising current account deficit.
Furthermore, the trade surpluses are achieved not by any advantage in the terms of trade, but by sheer self-denial of basic domestic needs and critical imports necessary for domestic development. Not only are the exporting nations debasing the market value of their labor and the exchange value of their currencies, degrading their environment and depleting their natural resources for the privilege of running on the poverty treadmill, they are enriching the dollar economy and strengthening dollar hegemony in the process, and causing harm also to the US economy.
Thus the exporting nations allow themselves to be robbed of needed capital for critical domestic development in such vital areas as education, health and other social infrastructure, by assuming heavy debt denominated in foreign currencies to finance export, while they beg for even more foreign investment in the export sector by offering still more exorbitant returns, lower wages and generous tax exemptions, putting increased social burden on the underdeveloped domestic economy. Yet many small economies around the world have no option but to continue to serve dollar hegemony like a drug addiction by hoping to develop their domestic economies through export.
Japan provides clear evidence that even a dynamic, successful export machine does not by itself produce a healthy economy. Japan is aware that it needs to restructure its domestic economy, away from its export fixation, and upgrade the living standard of its overworked population and to reorder its domestic consumption patterns. But Japan has been and will continue to be trapped in helplessness by dollar hegemony.
Japan has seen its sovereign credit rating lowered by international rating agencies while it remains the world's biggest creditor nation, unless China overtakes it in that dubious honor in a few more years. Moody's Investor Service downgraded Japanese government bonds (JGB) by two notches in 2004 to A2, or one grade below Botswana's, not to mention Chile and Hungary. Japan in 2004 had the world's largest foreign-exchange reserves: $819 billion in July 2004; the world's biggest domestic savings: $11.4 trillion (US gross domestic product was $11 trillion in 2003); and $1 trillion in overseas investment. And 95% of its sovereign debt is held by Japanese nationals, which rules out risk of default similar to Argentina, or any eurozone country. Japan has given Botswana, where half of the population is infected with the AIDS virus, $12 million in grants and $102 million in loans.