Recurring financial crises of past decades had clearly exposed the instability
of globalized unregulated financial markets and the
great danger that poses for the economic wellbeing of defenseless developing
countries participating in such markets.
In recent decades, the world economy has been repeatedly hit by recurring
financial crises: the 1987 crash on Wall Street, the "tequila effects" of the
Mexican default in 1994; the contagion effects of the Asian financial crises of
1997, with the Korean sovereign default and its contagion effect on Brazil
that, despite US Treasury bailout of exposed US bank creditors, could not
prevent the Brazilian crisis of 1999.
On August 17, 1998, triggered by contagion from the 1997 Asian financial crisis
and the resulting collapse of commodity prices, Russia devalued the rouble from
its overvalued fixed exchange rate. The rouble/dollar trading band expanded
from 5.3-7.1 RUR/USD to 6.0-9.5 RUR/USD. A 90-day moratorium on 281 billion
roubles (US$13.5 billion) of Russian sovereign debt was declared. These
developments generated a massive "flight to quality" in the debt markets, with
investors flooding out of any remotely risky market and into the supposedly
most secure instruments within the supposedly "risk-free" government bond
market.
On September 2 of that year, the Central Bank of the Russian Federation decided
to abandon the "floating peg within a band" policy and float the rouble freely.
By September 21, the exchange rate had reached 21 roubles to a US dollar,
losing two thirds of its value of less than a month earlier.
Ultimately, these events resulted in a liquidity crisis of enormous
proportions, in turn caused the collapse of Long Term Capital Management
(LTCM), a large US hedge fund that had engaged in convergence plays involving
Russian government bonds. LTCM was bailed out by its creditors under an
arrangement of the New York Fed, but the contagion effect from the Russian
default hit again on Brazil in a circuitous loop around the globe.
Less than a decade later, the world economy was hit by the mother of all crises
that began in the US in July 2007, first as a collapse of the securitization
market of subprime housing mortgages sold worldwide, then quickly leading to a
systemic banking and credit market crisis of global dimensions. The crisis,
which crested around the autumn of 2008, destroyed $34.4 trillion of wealth
globally by March 2009 when the equity markets hit their lowest points, wiping
out half of the world’s market capitalization (see Part I:
The crisis of wealth destruction).
These recurring financial crises have provided conclusive evidence that
unregulated financial globalization based on the Washington Consensus is an ill
wind that blows no good to rich and poor alike. They have also provided clear
empirical confirmation that globalized free trade is detrimental to domestic
economic development.
These recurring crises have also shown that it is not viable for any sovereign
government to adapt autonomous monetary policies while at the same time
maintaining a fixed exchange rate pegged to a stronger foreign fiat currency in
a global economy that permits the free cross-border flow of capital and full
currency convertibility at floating exchange rates. The credit crisis that
broke out in the US in 2007 was not an unforeseen Black Swan event. It had
ample precedents and visible warning signs that were ignored by willful denial
on the part of neo-liberal ideologues.
The Mundell-Flemming Thesis
This contradicting limitation of globalized finance liberalization has been
summarized in the Mundell-Flemming thesis, for which Robert Mundell won the
1999 Nobel Prize for Economics. The thesis states that in international finance
operating under unregulated global financial markets, a government can have
only two choices among three options: (1) stable exchange rates, (2)
international capital mobility and (3) domestic economic policy autonomy (full
employment, interest rate policies, counter-cyclical fiscal spending, and so
forth).
China, for example, has opted for capital control and fixed exchange rates,
policies that have largely insulated the Chinese economy from much of the
turmoil in the globalized unregulated financial markets since 2007, and have
allowed China to adopt monetary policies best suited for the internal needs of
the Chinese economy.
Mundell, who often proudly refers to himself as the conceptual father of the
euro, thought his thesis could provide the working basis for a common currency
among sovereign states in Europe without a political union, as defined by the
terms of the enabling Masstricht Treaty of 1992, on the basis of which the
European Monetary Union (EMU) was created.
Mundell's vision of a common currency for Europe requires sovereign states in
the eurozone to give up domestic economic policy autonomy in exchange for
cross-border capital mobility and stable exchange rates. Mundell, an economist
rather than a political scientist, apparently did not take into account that
national politics on economic issues, such as fiscal austerity and associated
unemployment, always trump international economic concords such as the
Masstricht Treaty.
Rebus sic stantibus
This acknowledgment of political reality has been subscribed in international
law by the concept of rebus sic stantibus, which states that when the
objects of a treaty, or conditions under which it is concluded, no longer exit,
the treaty itself becomes null and void per se (by itself). When an EMU member
state breaches EMU convergence criteria of the euro, it will conceivably be
legally free from all obligations to the terms of the enabling Masstricht
Treaty of 1992.
Moreover, when financial globalization is accepted as the most effective way
for the economy of a developing country to achieve growth by attracting foreign
investment and credit, the window for foreign speculative funds to manipulate
its capital markets will be kept wide open.
In any open economy without capital control and with full currency
convertibility, when growth is dependent on free flow of foreign capital and
credit denominated in foreign currency which must be serviced with export
earnings denominated in foreign currency, the only viable monetary options
available to the monetary authority are extreme ones: a floating exchange rate
with autonomy in monetary policy, or a fixed exchange rate without monetary
autonomy. There are no hybrids available.
The worst of both worlds is when a local currency is pegged to the fiat US
dollar, a currency whose issuer follows a monetary policy exclusively designed
only for the needs of the US economy, and not the needs of the economies which
choose to peg the exchange value of their currencies to the dollar.
Both extreme options carry more negative than positive impacts. But these two
extreme options cause different positive and negative impacts on the economy,
with the government helpless in resisting the negative impacts and also in
directing on which segment of the population the negative impacts fall.
Usually, the financial elite, due to their better understanding of the rules of
the game, can protect themselves with high-priced advice at the expense of the
defenseless poor. This makes global trade and finance liberalization domestic
political issues in all trading economies. This fact also applies to the
eurozone.
The case of Argentina
In Argentina, by pegging the Argentine currency to the US dollar, macroeconomic
policymakers opted to surrender monetary autonomy to the US Federal Reserve.
Argentina abandoned floating exchange rates with the hope to achieve following
objectives:
To stabilize interest rates to encourage foreign direct investment;
To restore credibility in the discredited macroeconomic authorities;
To moderate high inflation that renders financial planning inoperative;
To preserve the purchasing power of fixed income consumers and investors;
To moderate the impact of recurring external financial shocks on the local
economy; notwithstanding that a fixed exchange rate carries with it the risk of
sovereign debt default.
However, the currency board regime of pegging the Argentine peso to the dollar
had failed to actually yield the expected benefits. This failure stimulated
discussion of "dollarization" for Argentina as a new monetary solution. But
since Argentina had already given up its monetary autonomy by pegging its
currency to the dollar to try in vain to bring about financial stability, there
was no reason to expect that a more radical currency regime such as
dollarization would work better. Surely, Argentine policymakers had learned
from experience that when the Federal Reserve makes monetary policy decisions
in Washington, the economic well-being of Argentina is never a consideration.
It is obvious that while dollarization eliminates currency exchange rate risks,
it increases default risks in dollar-denominated sovereign debt. In a financial
crisis, both currency exchange rate risk and sovereign debt default risk will
be increased for Argentina.
The same is true for the national economies in the eurozone. The adoption of
the euro is in some ways equivalent to dollarization, since the constituent
nations of eurozone have no control over monetary policy decision-making in the
European Central Bank (ECB) or the European Monetary Union. This is again
demonstrated by actual facts in the eurozone sovereign debt crisis where the
likelihood of sovereign debt default in one nation pushed down the exchange
rate of the euro.
What constitutes sound fiscal policy?
There is an undisputed general law in public finance that sound fiscal policies
must precede a sound currency. What is in dispute is what constitutes a sound
fiscal policy. Neo-liberals deem recurring fiscal deficits as signs of unsound
fiscal policy. Yet over the multi-year duration of most recession phases of
business cycles in market economies, multi-year deficit financing to stimulate
economic activities in a recession can be a very sound fiscal policy.
Under such circumstances, a balanced annual budget would be quite the opposite
of a sound fiscal policy. Still, some recessions may take more than a decade to
recover even with persistent fiscal deficits if the funds are spent on wrong
targets, as in the case of Japan after the Plaza Accord of 1985.
In March 2005, the EU's Economic and Financial Affairs Council (ECOFIN), under
the pressure of France and Germany, relaxed the rules to respond to criticisms
of insufficient flexibility and to make the pact more enforceable.
Permissiveness infested the theoretical regulatory framework.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
