No economy, whether modern
or ancient, monarchist or democratic, capitalist
or socialist, can rely solely on market
forces to meet all the needs
of society or to direct the development of the
nation toward a desired destiny.
A
properly regulated market performs many important
economic functions that are necessary for any
economy, feudal, capitalist or socialist. However,
market forces, when unregulated or undirected by
government, as neoliberals advocate for capitalist
market economies, naturally allocate resources
most efficiently toward efforts and investments
with the highest potential return on capital
rather than where it is needed most by the nation
and its people.
The Washington Consensus
has been largely discredited since the Asian
Financial Crisis of 1997 as an effective strategy
for economic development for developing economies.
Its 10 propositions are: 1) Fiscal discipline;
2) Redirection of public-expenditure
priorities toward fields offering high economic
returns; 3) Tax reform to lower marginal rates
and broaden the tax base; 4) Interest-rate
liberalization; 5) Competitive exchange rates;
6) Trade liberalization; 7)
Liberalization of foreign direct investment (FDI)
inflows; 8) Privatization; 9)
Deregulation; and 10) Secure private-property
rights.
These propositions add up to a
wholesale reduction of the central role of
government in the economy and its primary
obligation to protect the weak from the strong,
both foreign and domestic. (See the World
Order, Failed States and Terrorism series of
reports Asia Times Online, February 3, 2005.)
Generally, highly efficient markets,
particularly modern financial markets, aside from
their fault of misallocating financial resources
based on maximum return on capital, do not produce
sustainable or balanced financial or economic
outcomes if left unregulated by government.
Minsky's Financial Instability
Hypothesis Hyman P Minsky (1919-1996),
American economist and professor of economics at
Washington University in St Louis, developed the
Financial Instability Hypothesis (FIH) in the
1960s, linking financial market fragility in
business cycles with speculative investment
bubbles endogenous to financial markets, in a
direct challenge to the Efficient Market
Hypothesis (EMH), which had been developed by
Eugene Fama at the University of Chicago Booth
School of Business.
A basic rule in EMH in
the field of behavioral finance says that trading
profit has always and will always come from
reducing financial market inefficiencies. EMH
states that prices of stocks reflect the market's
aggregate response to information. Any one market
participant can be wrong about price levels; even
every market participant can be wrong. But the
market as a whole is always right. After the
dot-com bubble burst in 2000, apologists for the
EMH defended it by arguing that the dot-com bubble
operated within the EMH; only the information
behind the rational expectation was false. It was
an argument that the operation was a success but
the patient died.
By 2008, the EMH has
been largely discredited by real data on the
credit market crisis that had started in mid-2007
when the financial market was spectacularly wrong
about the sustainability of the housing price
bubble. But the market's glaring error in defiance
of common sense was not detected by most
mainstream free-market economists until credit
markets around the world began to melt down in the
short period of a few trading days in mid-2007. In
EMH's place, mainstream economists, including
those in central banks, have since rediscovered
Minsky, after having ignored his insightful
warnings for almost five decades.
Minsky's
FIH is based on his model of credit market cycles,
which he identified as consisting of five
sequential stages: displacement, boom, euphoria,
profit taking and panic.
In the current
credit and financial crisis, the displacement
stage began in the early 2000s when the Federal
Reserve under chairman Alan Greenspan kept
short-term interest rate (the fed funds rate
target) dangerously low to first allow the dot com
bubble to form and then lowered the fed funds rate
to 1% in July 23, 2003, the lowest in 45 years,
and kept it there for a whole year to feed a
housing price bubble after the dot com bubble
burst. The housing bubble eventually burst in mid
2007.
The
fed funds rate target has been set at 0 to 0.25%
since December 16, 2008 by the Ben Bernanke Fed to
try in vain to revive the gravely impaired economy
on its third year of recession. The Greenspan debt
bubble On Greenspan's 18-year watch (August
11, 1987 - January 31, 2006) as chairman of the
Fed under four presidents (Ronald Reagan, George H
W Bush, Bill Clinton, George W Bush), assets of
government-sponsored enterprises (GSEs) ballooned
830%, from $346 billion to $2.872 trillion. GSEs
are financing entities created by the US Congress
to fund subsidized loans to certain groups of
borrowers such as middle- and low-income
homeowners, farmers and students. Agency
mortgage-backed securities surged 670% to $3.55
trillion. Outstanding asset-backed securities
exploded from $75 billion to more than $2.7
trillion.
Greenspan presided over the
greatest expansion of speculative finance in
history, including a trillion-dollar hedge-fund
industry, bloated Wall Street firm balance sheets
approaching $2 trillion, a $3.3 trillion
repurchase agreement (repo) market, and a global
derivatives market with notional values surpassing
an unfathomable $220 trillion.
Granted,
notional values are not true risk exposures. But a
swing of 1% in interest rate on a notional value
of $220 trillion is $2.2 trillion, approximately
20% of US gross domestic product (GDP). (See Greenspan:
The Wizard of Bubbleland, Asia Times Online,
September 14, 2005).
The Federal Reserve's
extended loose monetary policy stance enabled
serial debt bubbles to sustain the protracted US
trade deficit, which was circularly financed by an
influx of trade-surplus dollars from countries
exporting to the US, such as China, Japan, the
European Union and oil exporting countries. These
countries could not spend their trade-surplus
dollars earnings in their local economies because
to do so they must first convert the dollars to
their domestic currencies, which would immediately
create inflation because the goods behind the new
domestic currencies had already been shipped to US
market to earn dollars.
The exporting
nations must then buy US government debt with the
dollars they earned as trade surplus from the US
because of dollar hegemony. (See US
dollar hegemony has got to go, Asia Times
Online, April 11, 2002.)
The boom stage of
Minsky's FIH was set off by the easy availability
of low interest rate subprime mortgages, which
drove up house prices to unrealistic levels.
Securitization of mortgage debt allowed banks to
sell huge amounts of risky loans to the credit
markets in the form of structured finance
instruments of varying degrees of risk with
commensurate returns to investors with varying
risk appetite that allow banks to take the toxic
subprime mortgage debt off their balance sheets,
so that banks could lend more loans without having
to increase the reserves or capital. This housing
bubble boom led to the euphoria phase and the
smart money began to take profit by selling at the
height of the price cycle and caused the debt
bubble to burst. The selling panic caused credit
markets to fail from the absence of buyers at any
price. Suddenly, all market participants were
driven to on the sell side by panic. Markets fail
when there are no buyers at any price. (See Why
the US subprime mortgage bust will spread to the
global finance system, Asia Times Online,
March 16, 2007 - posted four months before the
crisis broke out in July 2007.)
FIH states
that in the boom phase of the business cycle when
cash flow rises beyond what is needed to pay off
debt, a speculative euphoria naturally emerges to
take on debts in excess of what borrowers can pay
off with their normal income. This excess debt in
turn leads inevitably to a financial crisis, a
"Minsky Moment", when the debt bubble bursts and
liquidity dries up to cause a systemic chain
reaction of credit defaults, causing credit market
failure in which even financially healthy
borrowers are forced into default as a result of a
severe general liquidity drought in the market.
The role of
government Government regulatory
intervention is needed to prevent the emergence of
recurring Minsky Moments in financial markets
before they occur, and massive central bank
monetary easing, which is not without long-term
negative consequences, will be needed to provide a
failed market with liquidity should a Minsky
Moment develop despite regulatory constraint.
In addition to state regulation to prevent
financial market failure, state subsidy must be
available to support and nourish needed economic
activities and financial transactions that are
important to long-term growth of the economy both
quantitatively and qualitatively when such
economic activities and financial transactions are
not supported by private investment responding to
market forces.
The most egregious
deficiency of financial markets, and the most
ignored, is its structural tendency to depress
wages as the necessary condition for generating
high return on capital. This tendency naturally
prevents adequate consumer demand, which leads to
excess productive capacity, which in turn causes
nations to seek new markets through export.
Lenin's theory of imperialism being the final
stage of capitalism is based on the failure of
capitalistic markets to raise wages along with
rising productive capacity.
World trade
through globalization in its current form is an
unsustainable game of cross-border wage arbitrage
to depress wages world wide in order produce at
low wage locations to export to economies with
higher wages. This global trade is denominated in
dollars that the US can produce at will, not
because the US has sufficient assets of intrinsic
value to back up her dollars, but because US
geopolitical prowess has compelled the world's
trading of basic commodities, such as oil, or
other basic commodities, to be denominated in
dollars.
When trading of oil is
denominated in dollars, the US essentially owns
all the oil in the world, regardless of who
happens to be the intermediate holder of oil at
any particular moment.
Debt bubbles
caused by low wages The single most
damaging outcome of globalized trade and finance
in the past three decades had been increasingly
low wages compared with asset prices in every
economy that participated in cross-border wage
arbitrage.
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