Global Trade Imbalance and Deflation

Global Trade Imbalance and Deflation

By
Henry C.K. Liu

Published in AToL as Of debt, deflation and rotten apples on January 11, 2006

Deflation is a problem that looms over the horizon when the US debt bubble bursts to slow down the economy. Yet investors are motivated to buy US bonds to lock in current high yields if they expect the Federal Reserve, the central bank, to cut short-term rates in the near future to stimulate a slowing economy. When investor demand for bonds is strong, mortgage lenders can offer lower mortgage rates for home buyers because high bond prices lead to lower bond yields. Thus a pending economic slowdown in its incubating phase actually fuels a housing bubble by the abundant availability of cheap money. But there is no escaping the fact that falling interest rates lead eventually to inflation which discourages bond investment. Rising interest rates, on the other hand, while stimulating bond investment, lead to deflation.

Neutral Interest Rate and Income Disparity

The Fed’s below-neutral interest rate policy between 2000 and 2004 produced stealth inflation, by pushing price appreciation to the asset side while prices of consumer goods were kept low by US corporations aggressively exploiting global wage arbitrage. Domestic wages in the US have been kept low with the threat of more offshore outsourcing of jobs. The money that would have gone to domestic wage rise went instead to corporate profits, which have also been magnified by low debt-service cost, leading to widening income disparity between owners of capital and sellers of labor.

Alan Greenspan, chairman of the Federal Reserve Board of Governors, explained this distortion of income parity with the magic of rising US productivity which mathematically could approach infinity when rising corporate profit from imports is divided by stagnant domestic wages and rising unemployment. The lower wages fall and the higher unemployment rises, the more corporate profit rises, and the more Greenspan marvels at the miracle of US productivity. Mounting debt levels have enabled the US to celebrate sky-high productivity increases by simply working less. To keep consumer demand up, the public is taught to trade off wage income for dividend income, which has been boosted by tax cuts and exemptions on dividend, augmented also by one-time cash-out refinancing of ever bigger home mortgages reflective of ballooning price appreciation. Instead of moving to a bigger house made affordable by rising income, the same house is providing consumers with windfall cash to support consumption even as income stagnates. This unsustainable blood-letting cure for a sick economy is celebrated by neo-liberal economists as a happy boom from free trade. The trade apple is kept shining on the outside by sucking nutrient for a slowly depleting, rotting core, eaten away by a growing debt worm, turning a sick economy into a terminal case.

Inverted Yield Curve and Recession

The “term structure” of interest rates defines the relationship between short-term and long-term interest rates. The yield curve is a graphic expression of the interest rate term structure. Historical data suggest that a 100-basis-point increase in Fed Funds rate has been associated with 32-basis-point change in the 10-year bond rate in the same direction. Many convergence trading models based on this ratio are used by hedge funds. Of course what was true in the past is not necessarily true in the future, given that the rules of fixed-income investment game has been altered fundamentally by deregulated globalization of money markets. The recent failure of long-term dollar rates to rise along with the short-term rate since late winter 2003 can be explained by the expectation theory as applied to the term structure of interest rates, as St Louis Fed President William Poole observed in a speech to the Money Marketeers in New York on June 14, 2005. The market simply does not expect the Fed to keep the short-term rate high for extended periods under current conditions. The recent upward trend of short-term rates set by the Fed is expected by the market to moderate or even reverse direction as soon as the economy slows. And reacting to the underlying weakness of deceivingly robust economic indicators, the market apparently expects the economy to slow and perhaps soon.

Greg Ip of the Wall Street Journal reported on December 8, 2005 that Alan Greenspan, outgoing chairman of the Federal Reserve Board of Governors, in a written response to a letter from Rep. Jim Saxton (R- NJ), chairman of Joint Economic Committee of Congress, about the meaning of a “neutral” interest rate, says that definitions of neutral vary, as do methods of calculating them and that neutral levels change with economic conditions. Thus the concept of a neutral rate, one that is neither above nor below normal spreads over inflation rates, is made useless by practical difficulties. This of course is a standard Greenspan position on all economic concepts as the Wizard of Bubbleland always drives by the seat of his pragmatic pants, doing the opposite of his obscure periodic ideological pronouncements. The Fed raised the Fed Funds rate target to 4.25% in its December 13 meeting, continuing its “measured pace” policy of 13 steps of 25 basis points each, up from a low of 1% in June 2004. And with the 10-year yield now at 4.5%, a flat yield curve is imminent and an inversion soon if the Fed, as expected, continues its current upward interest rate policy.

The Fed’s statement accompanying the December 13 meeting on interest rate did not include any reference to “accommodative” rates that had described earlier hikes. The market appeared to interpret this omission as the Fed acknowledging that short-term rate is now at neutral; that is, on par with historical spread above inflation rate.

Historically, a flat yield curve signals future slow growth and an inverted yield curve signals future recession. But Greenspan dismissed the historical pattern by arguing that lenders are now likely to accept low long-term rates because of their expectation of future low inflation, and this would stimulate future economic activities. So stop worrying about the inverted yield curve and learn to love a global “savings glut”.

The Fed also dropped its usual reference to a “measured pace”, an omission which immediately encouraged speculation that it would hereafter raise rates only intermittently instead of at a gradual steady pace of small steps of 25 basis points at every FOMC meeting. Yet the market remains nervous about the Fed’s acknowledgement of the need for “further measured policy firming” that suggests more rate increases. Greenspan will chair his last meeting in January 2006. Ben Bernanke, the incoming Fed chairman, will chair his first rate meeting in March, as the Fed does not hold rate meetings in February.

Yet there is no denying that the debt-driven US economy is afflicted with overcapacity. And if low inflation, as defined by the Fed, is the result of stagnant wages, where in the world is the future expansion of demand going to come from without inflation? The answer is from more debt collateralized by a further expanding asset price bubble.

Lower interest rates also lower the exchange value of the dollar, allowing non-dollar investors to bid up dollar asset prices. Asset price appreciation is not registered by economic indicators as inflation, thus the Fed could continue its below-neutral interest rate policy to fuel an expanding bubble without penalty. The economy has been delirious for some 4 years with run-away debt that no one feels any need to pay back as long as real interest rates remain negative or below neutral, while no one seems to worry that debtors can ill afford to pay back debts as soon as real interest rates rise about neutral. With short-term rate at 1% and real estate prices rising over 30% annually, a full price mortgage can be amortized in a little over three years by market trends.

Off-shore Dollars Not Necessarily Owned by Foreigners

Non-dollar investors in dollar assets are not necessarily foreigners. They are anyone with non-dollar revenue, such as US transnational companies that sell overseas or mutual funds that invest in non-dollar economies. The New York Fed estimates that, at year-end 2003, foreign central banks held $2.1 trillion in dollar-denominated securities, “equivalent to more than half of marketable Treasury debt outstanding.” Yet foreign central banks do not own these dollars free and clear. They acquired export-earned dollars in their economies by the governments issuing sovereign debt denominated in domestic currencies. Much of dollars reserves held by foreign central banks come from dollar profits of the export sector. Such profits are earned mostly by off-shore joint-venture or wholly-owned operations of US and other foreign transnational companies and financial institutions. These US subsidiaries do not repatriate their off-source earning to avoid high US taxes. They convert their dollars to domestic sovereign debt instruments that pay high yields to profit from inter-currency interest rate arbitrage. Some 60% of Chinese export is traded by non-Chinese companies and the ratio is expected to increase as China further privatizes its state-owned enterprises. The exporting economies exchange high-yield domestic sovereign debt instruments for dollars to buy low-yield US bonds.

Unlike investors, hedge funds do not buy bonds to hold, but to speculate on the effect of interest rate trends on bond prices by going long or short on bonds of different maturity with denomination in different currencies. They finance their transactions with loans from the repo market which trades collateralized short-term loans at rates that closely tracks Fed Funds rates. An inverted dollar yield curve will cause distress for repo borrowers who borrow dollars short-term to invest in longer-term instruments. While hedge funds do not set the direction of the market, they do exacerbate market volatility. The proliferation of hedge funds and the continuing rise in the amount of money they command through astronomical leverage allow market trends to be excessively affected by short-term speculation. Hedging, instead of a strategy for protection, has come to mean taking on ever higher risk for higher returns. The inverted dollar yield curve can be read as a signal that market speculation is betting on a coming global recession by betting against high short-term dollar rates. Thus traditional term structure is being made to stand on its head. Instead of an inverted yield curve forecasting a future recession, market expectation of a future recession is producing an inverted yield curve, which reinforces the likelihood of a future recession.

Global Savings Glut is only a Dollar Glut

There is another factor that distorts the historical term structure of interest rate, the denial of which has caused Greenspan to describe a flat yield curve as a conundrum. Fed chairman-designate Ben Bernanke argued in a speech on March 29, 2005 while still a Fed governor, that a “global savings glut” has depressed US interest rates since 2000. Echoing this view, Greenspan testified before Congress on July 20 that this glut is one of the factors behind the so-called interest rate conundrum, i.e., declining long-term rates despite rising short-term rates. Bernanke noted that in 2004, US external deficit stood at $666 billion, or about 5.75% of US gross domestic product (GDP). Corresponding to that deficit, US citizens, businesses, and governments on net had to raise $666 billion from international capital markets. As US capital outflows in 2004 totaled $818 billion, gross financing needs exceeded $1.4 trillion.

Yet this shows only the flow of funds without identifying the ownership of such funds. With deregulated global money markets, money can change location without changing ownership as funds move electronically around the globe in search of highest returns. What Bernanke did not say was that sizable amount of this money belongs to US entities. Bernanke argued that over the past decade a combination of diverse forces has created a significant increase in the global supply of savings, in fact a global savings glut, which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today. He asserted that an important source of the global savings glut has been a remarkable reversal in the previous flows of credit to developing and emerging-market economies, a shift that has transformed those economies from borrowers on international capital markets to large net lenders.

Eruo-dollar Owners Not Necessarily Foreigners

In the US, domestic saving is currently dangerously low and falls considerably short of US capital investment. Of necessity, this shortfall is made up by net borrowing from foreign sources, essentially by making use of foreigners’ savings to finance part of domestic investment. The word foreign is misleading; it is more accurate to refer to off-shore sources, including euro-dollars owned by US corporations, institutions and individuals. The US current account deficit equals the net amount that the US borrows abroad, and US net off-shore borrowing equals the excess of US capital investment over US domestic savings, but not necessarily national savings because many US corporations, institutions and individuals own substantial off-shore-, or euro-dollars. Still, Bernanke reasoned that the country’s current account deficit equals the excess of its investment over saving. In 1985, US gross national saving was 18% of GDP; in 1995, 16%; and in 2004, less than 14%. It seems obvious that despite Bernanke’s predisposed observation, the current account deficit equals the excess of US consumption, not investment, over domestic savings. In a globalized money market, national saving is composed of both domestic and off-shore savings.

Theoretically, investment cannot, as a matter of definition, exceed savings, a concept aptly expressed by the formula I = S (total investment equals total savings) framed by economist Irving Fischer (Nature of Capital and Income - 1906) that every economist learns in the first day of class in neoclassical macroeconomics. For total investment to be equal to total savings, the demand for loan-able funds must equal the supply for loan-able funds and this is only possible if the rate of interest is appropriately defined. If the interest rate was such that the demand for loan-able funds was not equal to the supply of it, then we would also not have investment equal to savings. Thus Fed interest rate policy is responsible for over- or under-investment in the economy.

Foreign countries with dollar trade surpluses from the US increased reserves by issuing local currency sovereign debts to withdraw the trade surplus dollars in their economies, thereby, according to Bernanke, mobilizing domestic saving, and then using the dollar proceeds to buy US Treasury securities and other dollar assets. Effectively, foreign governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets. What Bernanke neglected to say was the much of this money belong to off-source subsidiaries of US corporate parents. These US corporations achieve profitability by cross-border wage and benefit arbitrage through outsourcing. The net effect of lowering dollar interest rates by outsourcing also reduces interest income for US pension funds, dealing a double blow to US workers.

A related strategy has focused on reducing the burden of external debt by paying them down with the funds from a combination of reduced fiscal deficits and increased domestic debt issuance. Of necessity, this also pushed emerging-market economies toward current account surpluses. The shifts in current accounts in East Asia and Latin America are evident in the data for the regions and for individual countries.

Bernanke also asserted that the sharp rise in oil prices has contributed to the swing toward current-account surplus among the non-industrialized nations in the past few years. The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria, Indonesia and Venezuela, have risen as oil revenues have surged. The aggregate current account surplus of the Middle East and Africa rose more than $115 billion between 1996 and 2004. In short, events since the mid-1990s have led to a large change in the aggregate current account position of the developing economies, implying that many developing and emerging-market countries are now large net lenders rather than net borrowers on international financial markets. In practice, these countries increased foreign exchange reserves through the expedient of issuing sovereign debt to domestic money markets, and then using the dollar proceeds to buy US Treasury securities and other dollar assets. Bernanke calls this mobilizing domestic savings.

While Bernanke accurately describes the conditions, he obscures the causal dynamics. There is little data on the ownership of international capital and the prospect of hot money that zaps around the globe electronically being most US-owned is very real. When dollars are moved from Singapore to New York, its carries no information on who owns those dollars. The so-called global savings glut is hardly the result of voluntary behavior on the part of foreign central banks. It is the coercive effect of dollar hegemony which has left the trading partners of the US without a choice. The US trade deficit is denominated in dollars which can only be recycled into dollar assets. Local currency sovereign debts are issued by foreign treasuries to soak up the current account surplus dollars so that foreign central banks end up holding larger dollar reserves can hardly be viewed as national savings. Foreign central banks merely exchange domestic sovereign debt for dollars which are US sovereign credit instruments.

Further, Bernanke ignored the obvious fact that rising dollar asset value has distorted the aggregate debt-equity ratio in the global credit market. As US assets appreciate while Japanese assets depreciate, US borrowers can carry more debt with the same debt-equity ratio than Japanese borrowers. This has in fact reduced margin requirements for all sorts of leverage financing in the US. Banks give not only full-market-value loans, but full-expected-future-market-value loans in an ever-rising bull market. History is very clear on the accelerating damage that margin calls did in the 1929 crash, a fact that apparently escapes Bernanke, despite his image as a dedicated student of the 1929 crash.

Rising Foreign Exchange Reserves breeds Domestic Deflation

The exporting economies ship real wealth to the US in exchange for fiat dollars which cannot be spend in their own economies without first being converted into local currencies. If the local central banks exchange the trade surplus dollars in their economy with local currencies, local inflation will result from an expansion of the money supply while the wealth behind the new money has been shipped to the US. Thus most foreign governments issue sovereign debt in local currencies to soak up the dollars in their economies, little of which are owned by their own citizens and much owned by foreign investors and traders, and turn them over to their central banks as foreign exchange reserves. The net effect is deflationary for the exporting economies because sovereign debt reduces the local currency money supply. Local sovereign debt is used to cover the loss of real wealth by export to the US for dollars. Thus the true financial health of any economy is measured not by the amount of foreign exchange reserves held by its central bank, but the net foreign exchange reserves after deducting the outstanding sovereign debt, the dollar equivalent of which is determined by the exchange rate between the currencies. This is why exchange rate re-valuation affects not only trade competitiveness, but also capital account balance between economies of different currencies.

The glut Bernanke refers to is only a dollar glut that in fact impoverishes the exporting economies. There is no global savings glut at all. While the exporting economies continue to suffer from shortage of capital, having shipped real wealth to the US in exchange for paper that cannot be used at home, their central banks are creditors holding huge amounts of dollar-denominated debt instruments. It is not a global savings glut. It is a global dollar glut caused by the Fed printing money freely to feed the gargantuan US appetite for debt.

At first glance, the US has become the world's biggest debtor nation. Japan and China have become the world's biggest creditor nations. The US owes Japan over US$2 trillion. At the end of third quarter 1998, 33% of US Treasury securities were held by foreigners, up from just 10% in 1991. Some 30% of foreign-held assets were US government bonds ($1.5 trillion), and 12% corporate bonds. Again, the word foreign is misleading. It is more accurate to use the term odd-shore, for much of these securities are owned by off-shore US entities. By June 30, 2005, over 50% of outstanding US Treasuries ($2 trillion) were held by foreign central banks. But the foreign governments have liabilities to off-shore US entities who own their sovereign debt instruments. Total US Federal debt exceeds $7.6 trillion. Yet Japan desperately needs US investment and credit. The US economy has been booming for more than a decade with only two brief recessions, each bailed out by the Fed injecting massive liquidity into the banking system, while during the same time the Japanese economy have been sliding downhill in a deflationary spiral, with its sovereign debt receiving junk ratings. The same happened to Korea and will soon happen to China where the initial euphoria of dollar addiction will eventually turn to pain.

While there are many well-known factors behind this strange inversion of basic economic logic, one factor that seems to have escaped the attention of neo-liberal economists is the US private sector’s ability to use debt to generates returns that not only can comfortably carry the cost of debt service but also to conflate asset values with astronomical p/e ratios. Japan has been cursed with an opposite problem. Japan’s long-term national debt exceeded its GDP in 2004, and the ratio of its long-term national debt to GDP was double that of the US in 2004. Japan has been unable to further utilize sovereign credit to back the investment needs of its private sector. As a result, Japan looks to international capital (mostly from the US), money (over $2 trillion) that really belongs to Japan. Japan has been selling increasingly larger stakes in its supposedly successful industrial enterprises to US trans-nationals. But the foreign capital injection comes in the form of dollars, which are converted by the BOJ into Japanese government bonds, adding to the already excessive national debt. Substantial amount of Japanese government bonds (JGB) are owned by non-Japanese investors, though it is difficult to know exactly how much. The moves towards zero yen interest rates temporarily helped the Tokyo equity market but whether it represents a sustainable recovery is still very much in doubt.

Central Banks Fear Deflation more than Inflation

Although Greenspan never openly acknowledges it, his great fear is not inflation, but deflation, which is toxic in a debt-driven economy. Price stability is a term that increasingly refers to anti-deflationary objectives, to keep prices up rather than down. What has happened to Japan for the past decade is a terrifying warning to Greenspan. The fundamental problems separating the US and the Japanese economies are structurally different, yet the financial symptoms of economic imbalance are strikingly similar. Japan, with its huge trade surplus denominated mostly in dollars, is the world's greatest creditor nation externally, but the world's greatest debtor nation internally. The US, the world's greatest debtor nation externally, is the world's greatest sovereign creditor through dollar hegemony. What happened to Japan was that even with the world's largest holding of dollar reserve, Japan was unable to ward off a protracted deflationary financial crisis caused structurally by exporting wealth for paper that is useless in Japan. The more dollars Japan earns, the more its domestic sovereign debt expands, along with the expansion of its foreign exchange reserves, causing more sever domestic deflation.

For the US, even when the Fed can print dollars at will, it would be unable to ward off a debt crisis, because the more dollars the Fed prints, the more seriously it adds to the debt crisis. At some point, even paper debts cannot be repaid by printing more paper due to the exponential ballooning interest spiral. Paying interest on unpaid interest will soon accelerate the debt crisis. Debt, if not repaid by gold, must be repaid by work; and the Fed, by printing more paper money, actually destroys what little real productive work still available in the US economy. In fact, the financial services sector, a euphemism for the debt manipulation sector, is producing most of the new jobs in the US. Such jobs create financial value by pushing paper around at increasing speed.

A look at the Japanese debt economy in the last decade will give some idea of what awaits the US debt economy when deflation hits. The Japanese government is in an inescapable debt-death spiral by virtue of the fact that nominal GDP is falling at an annual rate of about 5%. Stabilizing the Japanese government's debt-to-GDP ratio would require that nominal GDP rises at a rate equal to the interest rate on its outstanding debt, or about 1%. The fact that nominal GDP is falling at a 5% rate means that Japan's debt-to-GDP ratio will rise at least 6% a year, even without a sudden need to recapitalize insolvent banks. That debt-GDP ratio is now 130%, and at 6% a year it will double in just over a decade. That fact will itself accelerate the collapse of Japanese government bonds (JGB) market unless deflation is reversed. The current US debt-GDP ratio is only 76%, but the trend is not different from the Japanese debt spiral. The Japanese crisis was caused by export while the US crisis is being caused by import.

The Japanese trade surplus, coupled with a capital account deficit, the opposite of the US, has been leaking yen into dollars faster than the Bank of Japan (BOJ), the central bank, can inject more yen into the yen money supply because of the so-called liquidity trap. In fact, the Japnease Treasury has been withdrawing yen from the Japanese money supply by selling JGBs at a rate faster than the BOJ can inject new yen into the banking system. Similarly, the US trade deficit, coupled with its capital account surplus, has been leaking dollars into the global dollar economy faster than the Fed can inject dollars into the US domestic economy. This has happened because sometime in the last decade, the global dollar economy has outstripped the US domestic economy through globalized trade financed by dollar hegemony, as more and more dollars stayed off-shore even if they were owned by US entities rather than foreigners. The notion that a strong dollar is in the US national interest no matter who owns it is at best controversial and increasingly foolhardy. It is where the dollars are based that determines if a strong dollar is good for US national interest. A strong dollar in a global dollar economy is only good for off-shore dollar owners, not US residents.

Foreign Trade Restrains Domestic Growth

Going forward in the current deregulated global trade regime, every one of the Group of Seven (G7) economies can only grow by making sure that the rest of the world grows at a faster pace. There was a period during the Cold War when the more advanced US economy grew at a slower pace than those of its allies in the Western block, much to the benefit of the whole bloc. The future of the world economy depends on more economic equality, not by shrinking the size of the G7 economies, but by expanding the economies outside of the G7 at a faster pace. It is clear that this needed shift toward economic equality cannot be achieved through neo-liberal globalized trade. This is because trade without global full employment does not yield comparative advantage to the poorer trading partners. Say's Law, which asserts that supply creates its own demand, is only true under conditions of full employment. Comparative advantage in free trade is Say's Law internationalized, true only under conditions of global full employment and shrinking cross-border disparity of wages.

Dollar hegemony makes trade surplus denominated in dollars a mechanism to drain wealth from the trade-surplus economies to the global dollar economy which is not congruent or limited to US political territories. This is caused by more than the fact that the dollar has been a fiat currency since 1971, a paper instrument detached from any specie of intrinsic value. The real factor is that dollars are not spend-able outside of the global dollar economy, thus are useless for domestic development in non-dollar economies. The dollar is not even fully useful in the US domestic economy due to low yields in the domestic US market. In the 1980s, there were serious talks about the merits of global dollarization, but the idea went nowhere as long as dollars were controlled by the US Fed to response only to US needs. And US needs were not indentical to US benefits. Besides, the dollar issue is mainly a technical-issue of international trade. The real issue for the world economy is that economic development needs to replace international trade as the dominant driving force of the world economy, making the dollar issue a mechanical rather than a fundamental issue. With global wage arbitrage and dollar hegemony, globalized trade tends to be deflationary until cross-border wage arbitrage works to push wages up rather than down.

Neo-classic economics requires all central banks to view their key mission as fighting inflation. As a central bank, BOJ allegiance is to the value of its currency, the yen, rather than the health of the Japanese economy. In this respect the BOJ is at odds with MITI, Japan’s powerful Ministry of International Trade and Industry, which wants to preserve a cheap yen, which is inflationary. This split is known as central bank political independence. Central banks take this view because they believe that the health of the economy depends on the soundness of money. They reject the notion that the health of the economy is the basis of a sound currency. The BOJ wants to resist international market forces for a rising yen while the BOJ wants to resist domestic market forces for a falling yen. Central bankers are not above arguing that the monetary operation is a success, though the economic patient died.

Yet there are good reasons why central banks fear deflation more than inflation. The Fed, due to its unlimited power to print dollars since 1971, a major reserve currency for international trade since the end of WWII, a privilege which no other central bank enjoys, can fight deflation in the dollar economy by simply printing more dollars with short-term immunity, as Bernanke suggested. In a deflationary environment, currency buys more with the passage of time and transactions are delayed in hope of better prices. Deflation leads consumers and corporations to postpone spending in anticipation for still lower prices, and it wreaks havoc with business balance sheets and discourages new productive investment. For Japan, with the yen consumer price index falling at about 1% per year, and the broader gross domestic product (GDP) deflator falling at about 2% per year, deflation has become persistent in Japan in recent years as the country continues to enjoy a substantial trade surplus. Aside from a temporary increase in 1997 when the consumption tax was raised, prices have been falling in Japan for the past decade. But the BOJ, unlike the Fed, has been powerless to resist deflation in the yen economy.

As shown by the Japanese example, deflation is damaging to the financial health of the banking system. An operative central banking regime depends on functioning links between monetary policy and banking policy. With deflation, interest rates are forced to become very low - close to zero, or even negative - below neutral. Yet near-zero interest rates only postpone, not eliminate, the need for banks to deal with problem loans, because, notwithstanding Milton Friedman's famous pronouncement that inflation is everywhere and anywhere a monetary phenomenon, deflation, the reverse of inflation, is not everywhere and anywhere just a monetary phenomenon. Deflation is a problem that cannot be cured by monetary measures alone, as Japan has found out and as the United States is about to. Global deflation can only be cured by reforming the international finance architecture to allow international trade to be replaced by domestic development as the engine for growth. Global trade under dollar hegemony drains domestic currency in the exporting economies with domestic currency sovereign debs to enable the central banks to accumulate dollar reserves. This causes domestic deflation.

The Perils of Zero Interest Rates

With near-zero interest rates, borrowers find it easier to meet their interest payments to banks and the credit market, allowing loans to remain performing even if the borrowing firms are structurally unprofitable. A clear example of this is the financial arms of the US auto giants and its use of the commercial paper market. General Motors Acceptance Corporation (GMAC), the financial arm, now contributes over 90% of the distressed auto maker's earnings. GMAC is a financial services unit that finances more than car; its main market is now home mortgages. GM is considering selling part of GMAC, its profitable finance arm. Being detached from GM might allow GMAC to improve its credit rating kept down by astronomical GM losses of over $1 billion each quarter and thereby cutting its borrowing costs and boosting its profits from interest rate spreads. The sale of a big stake would also strengthen GM’s balance sheet but would also reduce the profit contribution from the unit that has kept the parent firm afloat. Already, GM's profit from financing has been tightening as rising interest rates cut consumer loan demand. Total US mortgage volume dropped 30% in 2004, to $2.7 trillion, as interest rates jumped close to 100 basis points last summer. This was particularly bad news for GMAC, which had benefited from a boom in home refinancing. Its mortgage profits fell 10% in 2004, to $1.1 billion. Still, GMAC earnings are expected to hit $2.5 billion in 2005, guaranteeing a dividend to GM in excess of $2 billion. But that is down from $2.9 billion in 2004. There are all kinds of talk in the Street about the problem GE has been facing in its commercial paper positions and about pending GE sale of low-return assets.

And deflation makes it harder for borrowers to repay loan principal. Deflation weakens debt to equity ratios. High nominal interest rate in an inflationary environment can be a negative real interest rate after inflation adjustment, in which case banks are actually paying their borrowers. Conversely, a zero nominal interest rate can be a high real rate in a deflationary environment. Under a national banking regime, banks are performing their duty as long as they support the national purpose. In Japan's case, the banks' role was to support export. Even if the banks did not make a profit or their corporate borrowers could not meet debt service temporarily with current cash flow, the banks were serving the national purpose as long as the borrowing corporations were gaining market share in the global market.

Rational Expectation and Irrational Exuberance

The BOJ, as a central bank since the Japanese Central Bank Law came into effect in April 1998, has been struggling to revive the country's economy, stagnant for more than a decade. By comparison, the US Central Bank Law came into being in 1913 and within 2 decades led the US economy to its greatest collapse. At its Monetary Policy Meetings (MPMs), the BOJ decides the guidelines for market operations that cover the inter-meeting period of about half a month or a month ahead. Market participants, on the other hand, often engage in funds transactions that become due in three or six months. This requires them to forecast movements in the overnight call rate during the period between the next MPM and the maturity date of their transactions. Consequently, when the outlook for interest rates is uncertain, market forces will set interest rates on term instruments, such as three- or six-month instruments, substantially higher than the prevailing overnight rate, defeating BOJ’s purpose of low interest rate policy.

Nobel economist (1995) Robert E Lucas’s theory of “rational expectations” postulates that expectations about the future can influence the economic decisions independently made by individuals, households and companies. Using mathematical models, Lucas showed statistically that the average individual market participant would anticipate - and thus could easily neutralize - the impact of government economic policy. Rational expectation theory was embraced by President Ronald Reagan’s White House during his first term, but the theory worked against Reagan's “voodoo economics” instead of with it. The Fed’s allegedly more transparent posture under Greenspan reinforces rational expectation by the market, which coupled with a “measured pace”, can neutralize the impact of Fed interest rate policy to correct what Greenspan calls “irrational exuberance.”

The BOJ zero-interest-rate policy in effect stopped the toxic interaction between economic activity and the financial markets by removing concerns among market participants that they might face difficulties in getting funding due to a liquidity squeeze in the market. In the meantime, the Japanese Financial Function Early Strengthening Law and other legislation enacted in the autumn of 1998 attempted to provide a framework for the stabilization of the financial system. In March 1999, about a month after the adoption of the zero-interest-rate policy, major banks were recapitalized by injection of public funds. But the "convoy system" of bank mergers shelters the weakest banks at the expense of the strong. Moreover, fiscal spending was increased significantly to stimulate economic activity. But the yen money supply did not expand because of a recurring trade surplus denominated in dollars. The zero-interest-rate policy masked the symptoms, but it did not address the disease. There is visible evidence that something similar will happen to the US when deflation hits next year. Many US companies would in fact be walking deads in a deflationary environment even if interest rates were set at zero. The recent trend of mega merger reflects a drastic consolidation in key sectors. Deregulated markets favor size as a means to achieve market efficiency. Yet size has repeated demonstrated itself as a disadvantage in times of distress, as LTCM, Enron, GM, GE have demonstrated.

Zero Interest Rate Powerless to Stop Deflation

Interest-rate policy can be a stimulant or a depressant in an inflationary environment. But a zero-interest-rate policy can have unintended adverse effects in a deflationary environment. Since the cost of money is near zero, there is no compelling reason for banks to lend money, except for earning fees to refinance loans made earlier at higher interest rates. This creates problems for banks down the road by reducing future interest income for the same loan amount. The narrow spread in interest rates will also reduce bank profitability and force banks to raise credit thresholds, shrinking the pool of qualified borrowers. It can also cause a distortion in income distribution in the household sector by denying interest income it would have otherwise earned by savers and pensioners. It can create problems for pension funds and insurance companies.

Structural economic and financial reforms can be delayed by too much easing of otherwise necessary cash-flow pains. Market participants’ risk perception can be dulled. Institutional investors, such as life-insurance companies and pension funds, can then face difficulty in finding good investment opportunities to pay for long-term commitments made previously at high interest rates. In the US, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization. Credit-default swaps, a relatively novel form of derivative contract, allow investors to hedge against securitized mortgage pools. This type of contract, known as asset-back securities, has been limited to the corporate bond market, conventional home mortgages, auto and credit card loans. In June, a new standard contract began trading by hedge funds that bets on home equity securities backed by adjustable-rate loan to sub-prime borrowers, not as a hedge strategy but as a profit center. When bearish trades are profitable, their bets can easily become self-fulfilling prophesies by kick-starting a downward vicious cycle.

Total outstanding home mortgages in the US in 1999 were US$4.45 trillion and by the end of 2004 this amount grew to $8.13 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgages stood only at $1.82 trillion. On his 18-year watch, outstanding home mortgages quadrupled to $8.821 trillion by the end of third quarter 2005. Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt. Given that new housing units have