Page 1 of 5 MONEY AND COMMODITY MARKETS, Part 1
Integrity deficit has its price
By Henry CK Liu
In a global financial architecture of national fiat currencies, the role of a
reserve currency in international trade is to keep all trading nations
monetarily honest.
This is done by requiring each and every currency issuer to adopt monetary
policies that will protect and maintain the exchange value of their separate
fiat currencies to the reserve currency. Thus for the exchange rate regime to
work, it is imperative for the reserve currency itself to hold constant
purchasing power.
The purchasing power of a fiat currency is dependent on the monetary and fiscal
discipline of the issuing government and the balance of payments discipline of
the underlying economy. Thus
the issuer of a reserve currency cannot itself violate the laws of monetary
integrity to finance recurring fiscal and trade deficits and expects to keep
the reserve status for its fiat currency.
This is the primary reason why the US dollar has been having increasing
difficulty with keeping its role as the prime reserve currency for
international trade as established by the Bretton Woods regime of 1944, which
has been defunct since 1971 when president Richard Nixon de-pegged the dollar
from gold fixed at US$35 per ounce.
The Bretton Woods regime of fixed exchange rates was based on the dollar pegged
to gold as a reserve currency in an international trade regime that disallowed
free flow of funds across national borders outside of transactions between
central banks.
Since 1971, acceptance of the fiat dollar as the preferred reserved currency
for international trade has been essentially and increasingly anchored on US
geopolitical power rather than on sound monetary, fiscal and trade principles.
After the Cold War, with the end of hostility between capitalism and socialism,
the global geopolitical order became increasingly shaped by geo-economics that
have reflected the fluctuating strength of interconnected national economies.
As the US economy declines from persistent loss of monetary, fiscal and balance
of payment discipline, the ability of the US to hold on the dollar's status as
a reserve currency for international trade is directly affected.
The superpower status of the US is also being increasingly eroded by the recent
precipitous decline of its super economy since mid-2007, both in relative terms
and in absolute terms. Still, the US economy remains the largest in the world,
a fact that underlines the residual strength of the dollar, not to mention the
unfair advantage of dollar hegemony.
But the secular decline of the dollar cannot go on indefinitely without causing
fatal harm to even the world's largest economy. The official declarative slogan
that "a strong dollar is in the US national interest" is being modified by
developing events to a normative warning of "a strong dollar is needed to
protect the US national interest". The famous announcement to the world by
former Treasury secretary James Baker III during the 1985 Plaza Accord
negotiations that "the dollar is our currency but your problem" is no longer
operative. The weakening dollar has reverted to being fundamentally a US
problem.
The nature of supply and demand
The global market mechanism is mediated through a price structure denominated
in a designated reserve currency acceptable to all trading nations. Textbook
economics of market fundamentalism assert that market prices are determined by
supply and demand. Theoretically, the law of marginal utility states that price
in a free market at any moment in time is set by the point at which the moving
supply and demand curves intersect, driven by the quest for marginal utility of
all market participants. The theory of marginal utility is anchored with the
calculus of disaggregated arbitrage on changing supply and demand
relationships.
But in addition to supply of and demand for commodities, price when denominated
in money is also determined by the supply of and demand for money.
A controversy exists relating to whether money is a commodity, a medium of
exchange, a store of value or a unit of deferred payment with something of
specific prescribed value. The fact is that money can be all of the above
mentioned, but in varying degrees, depending of the legal-political regime.
Since 1913, supply of money in the US monetary system has been controlled by
the Federal Reserve, the US central bank, through the commercial banking
systems that it regulates. Supply of money is imposed on the economy, not
determined by market forces. Instead, the supply of money drives market forces.
Money creation and financialization of the economy
With "financialization" of the economy, money markets have grown beyond the
regulated banking system to usurp the otherwise exclusive authority of central
banks to control the supply and thus the price of money in relation to demand.
Money now can be created by market participants who are incentivized solely by
the quest for speculative profit in volatile markets. Stability spells
depression for speculators, who thrive on volatility.
With global financial deregulation, money is no longer only created by central
banks to facilitate the financial needs of a healthy economy by maintaining
market stability. Central banks are constantly at war with speculative traders
in a losing struggle to maintain currency and money market stability.
Volatility in markets, particularly involving foreign exchange and interest
rates, gave rise to the need by market participants of financial derivatives
for hedging against market risks. In time, derivatives have morphed from
hedging instruments against risk into profit centers of speculation. A new
financial sector known as structured finance has grown rapidly and extensively.
Money creation through the excess issuance of money by either central banks and
through excess issuance of debt by structured financiers can cause dilapidating
impacts on an economy - as it did in systemic dimensions in the summer of 2007.
Within commodities markets, with free supply of money, the cost of which
declines in proportion to its abundance, both supply and demand are no longer
merely endogenous (within the system) components of the market economy. Both
supply and demand are highly vulnerable to exogenous (external) purposeful
manipulation by five major groups of market participants.
Four of the five groups - end-users, source-producers, traders and speculators
- depend on ready access to money at affordable prices to make profit. They
create money by extending credit to each other for the purpose of making profit
The fifth group, currency issuers, mainly central banks, are not profit
motivated but have the power to control both the supply and price of money to
implement national policy regardless of profitability. Together, the five
groups of market participant created a new capitalism in which capital is
replaced by debt.
While market power is seldom equally distributed among market participants, a
fact that renders the idea of a free market an oxymoron, any one of these five
groups of market participants can manipulate separately or jointly unregulated
markets for unfair advantage through sub-optimization. With globalization,
these groups can also manipulate prices through regulatory arbitrage in
unevenly regulated markets around world.
The anti-labor bias of free trade
Since trade globalization endorses the free cross-border movement of capital
while it restricts free cross-border movement of workers, the structural
anti-labor pitfall is blatantly obvious. In disconnected labor markets under
trade globalization, demand for workers internationally is determined by
cross-border wage arbitrage while demand for workers domestically is governed
by uneven market power between capital and labor as dictated by traditional
market conditions generated from capitalist ideological fixations.
Capital can cross national borders to where cost and wages are lowest, but
workers cannot go where wages are highest because of immigration restrictions.
The net effect is global wage stagnation in the midst of spectacular
multinational corporate profits that results in global overcapacity. To the
chagrin of supply-siders, supply outraced demand even when demand was held up
with a debt bubble.
End-users can manipulate short-term prices by drawing on inventory to affect
demand temporarily or manipulate long-term prices by using substitutes to
affect demand permanently. Source-producers can manipulate short-term prices by
reducing production rate or manipulating inventory levels temporarily to affect
supply. They can also manipulate long-term prices through below-threshold
pricing to deny profitable development of competing substitutes.
Traders can manipulate prices by market timing and speculators can manipulate
prices by hoarding or flooding the market. Cartels can be formed in unregulated
markets by agreement among market-participating groups to create monopolies
with unfair market power. Currency issuers can manipulate exchange rates by
central bank adjustment of monetary policy measures such as interest rate
policies to manage quantitative easing or tightening. Money market participants
can manipulate prices by interest rate arbitrage.
Thus free markets require sophisticated, complex and dynamic regulations to
restrict the ability of market participants to manipulate prices through
monopolistic practices, rendering highly problematic the literal meaning of an
unregulated free market. Totally free markets tend to end in market failures.
This is particularly true in money markets as finance is infinitely more pliant
that physical goods.
Market fundamentalism
Market fundamentalism is the belief that the optimum common interest is only
achievable through a free-market equilibrium created by the effect of countless
individual decisions of all market participants, each freely seeking to
maximize his/her own private gain, and that such market equilibrium should not
be distorted by any collective measures in the name of the common good.
Yet market participants seldom act with equal information or full understanding
of the effects of their actions. Market fundamentalism is a theory that
suggests the right path to a watering hole can best be found by blind men
pulling at different directions for uncoordinated reasons. The fundamental
problem with market fundamentalism is the ability of market participants to
maximize advantage by externalizing cost or penalties outside of the market
onto the real economy. Free markets require regulation to remain free.
Increasingly, it has become obvious that what is good for Goldman Sachs, a
highly profitable global investment bank headquartered in New York, is not
necessarily good for the United States or for that matter the world. Thousands
of Goldman Sachs do not add up to a healthy world economy, solid evidence that
market fundamentalism does not work.
Price stability
Generally, end-users desire low and stable prices; source producers desire
sustainably high and stable prices. Both end users and source producers want
stable markets. Traders desire price volatility to profit by buying low and
selling high. Speculators desire cyclical price divergence and convergence so
that they can go long on technical price depressions or go short on price
bubbles. Speculators also perform a role of reducing risk exposure for other
market participants by betting on uncertain outcomes. Each group of market
participants separately plays a needed role to keep markets functioning with
winners and losers. Ideally, a regulated market aims at producing only winners
with no losers, or at least more winners than losers.
Yet many modern large industrial enterprises are vertically integrated, so that
they are simultaneously end-users, producers, traders and speculators. These
large, vertically integrated enterprises are forced to seek optimum resolution
of conflicting price objectives in commodities and financial markets. Large
financial institutions are all globalized to the degree that their
profitability is increasingly derived from predatory manipulation to exploit
weak points in all national economies through under-regulated financial
markets.
Evolution of money markets
Until the late 1950s, a currency's money market was based only in the issuing
nation's financial center: US dollars in New York, sterling in London, yen in
Tokyo, Swiss francs in Zurich, etc. The Bretton Woods monetary regime of fixed
exchange rates built around a gold-backed dollar did not consider unrestricted
cross-border flow of funds desirable or necessary for facilitating
international trade.
At the height of the Cold War, the Soviet Union became concerned that its
dollar deposits in New York needed for arms-related procurement might be frozen
by a hostile US government, as happened to the funds held in the US by the
People's Republic of China after the Korean War broke out. The USSR opened
dollar accounts with European banks as a remedy.
The impact of Regulation Q In 1963, the US introduced the populist
Regulation Q, which for subsequent decades imposed limits and ceilings on bank
and savings-and-loan (S&L) interest rates. Regulation Q created incentives
for US banks to do business outside the reach of US law in quest of high
interest rates, and London came to dominate this offshore dollar business.
Bank accounts in London are subject only to British laws, so US sanctions,
restrictions and taxes cannot apply to the dollars deposited in them. British
law on international finance is well developed on account of the financial
hegemony of the British Empire after the fall in 1815 of Napoleon. In time,
banks in London, often branches of US banks, started actively trading deposits
in other currencies besides dollars as well, as it became possible for them to
accept deposits in one currency in one country and lend profitably in another
currency in another country.
Up to the financial crisis that broke out in mid-2007, financial regulation had
become increasingly lighter, so money could and still can be moved to and from
London with little cost; therefore the price of London money generally tracks
very closely that of domestic money in many countries. But there have been
differences between domestic and London interest rates. These differences have
had different causes at different times: monetary policy, tax laws, bank
regulations, the possibility that a country might introduce exchange controls,
and the differences between the creditworthiness of the banks in London and
those in the domestic market. The London money and foreign-exchange markets are
dominant for trading currencies, raising capital and selling debt.
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