Global Post-Crisis Economic Outlook
Henry C.K. Liu

Part I:      Crisis of Wealth Destruction   
Part II:    Two Different Banking Crises - 1929 and 2007
Part III:   The Fed’s No-Exit Strategy
Part IV:   The Fed’s Extraordinary Section 13(3) Programs
Part V:    Public Debt, Fiscal Deficit and Sovereign Insolvency
Part VI:   Public Debt and Other Issues
Part VII:
  Global Sovereign Debt Crisis
Part VIII: Greek Tragedy
Part IX:    Effect of the Greek Crisis on German Domestic Politics
Part X:     The Trillion Dollar Failure

Part XI: Comparing Eurozone Membership to Dollarization of Argentina

This article appeared in AToL on July 16, 2010


For the weaker economies of the eurozone, adopting the euro is comparable to the earlier unhappy dollarization experiment by Argentina, which should have served as a cautionary tale to all national economies of the eurozone.
Commenting at the onset of the sovereign debt crisis in Greece, Argentine President Cristina Fernandez de Kirchner characterized IMF “conditionalities” imposed on Greece as being “unfortunately condemned to failure.” She spoke from experience, as Argentina was hit by one of the world’s biggest sovereign debt defaults in 2001, from which the once prosperous nation still has not fully recovered from IMF “assistance”.
Argentina is blessed with a rich economy by nature in terms of natural resources and by policy in terms of productivity from the high education level of its population. There is no compelling reason why Argentina should become an economic basket case with regard to its sovereign finance, except for falling under the malicious spell of neoliberalism.
Beginning after World War II, Argentina institutionalized a rightist-corporatist welfare state where job-linked social insurance was a policy anchor and social assistance programs were the norm. In the corporatist welfare state, a large population in the so-called informal sector was left out of the corporatist welfare system. A populist movement supported by trade unions and an economic model of import-substituting industrialization were the socio-economic-political background for the formation of this corporatist welfare state.
During the 1990s, with the influence of US economists, neoliberal elements were added to the Argentine welfare state under the liberalization carried out by the Menem Peronist government. Still, social insurance and pro-labor policy survived sweeping financial liberation. Key elements of the corporatist welfare state regime continued. The neoliberal government attempted to carry out more drastic social security and labor reforms, but was unable to do so due to popular support of the political legacy of corporatist welfare of the Peronist era.
In April 1991, Argentina under President Carlos Saúl Menem adopted the neo-liberal programs of the Washington Consensus, which involved wholesale privatization of the public sector, deregulation of financial markets and capital decontrol to attract foreign investment and credit with the aim to infuse the country with easy cash to finance its resultant recurring fiscal deficits. Significantly, it introduced interest rate liberalization and removed all controls on cross border capital and credit flow.
The centerpiece of the new neo-liberal regime was the Convertibility Law of 1991, making the Argentine peso fully convertible and pegged to the dollar at parity. Argentina then employed a parallel dual currencies system in which the peso and the dollar both circulated legally in Argentina and traded at parity maintained by a currency board regime administered by the central bank.
Currency Board Monetary Regime
A currency board is a monetary regime under which the monetary authority commits to maintaining a fixed exchange rate of its currency pegged to a stronger foreign currency as an anchor, such as the dollar, by holding adequate reserve of the anchored currency. It is a rule-based monetary system that requires changes in the monetary base be matched by corresponding changes in foreign reserves in a specified foreign currency at a fixed exchange rate. The monetary base is defined, at the minimum, as the sum of the currency in circulation (banknotes and coins) and the balance of the banking system held with the central bank (the reserve balance or the clearing balance). The monetary rule often takes the operational form of an undertaking by the currency board to convert on demand domestic currency into the reserve foreign currency at the fixed exchange rate.
The classical currency board regime evolved in colonies under British colonialism in mid-19th century to peg local currency of the colonies to the pound sterling. In theory, it relied on three anchors to fix the exchange rate. The first anchor was strict monetary and fiscal discipline backed fully by pound sterling reserves. The second anchor was free currency flow with liberalized interest rates within the British Empire. And the third was full currency convertibility within the British Empire. The currency board was an imperialistic monetary structure to allow the British Crown to control monetary policy in the whole empire. In practice, not all three anchors were operationally maintained in all currency board regimes.
The models of currency board adopted by Argentina (1991), Estonia (1992), and Lithuania (1994), with deposit reserves as liquidity buffers, was an operative choice only for a strong economy with very large foreign reserves, for which ironically none of the three above countries qualified. Pegging a local currency to the US dollar for the purposes of promoting foreign trade and finance requires voluntary submission to dollar hegemony and surrendering monetary sovereignty.
A currency peg to the dollar allows the home economy to gain entrance to the huge US consumer and capital markets while minimizing currency exchange rate risks. At the same time, it requires strict monetary and fiscal discipline that puts stress on a weak local economy.
Fixed Exchange Rates with Full Convertibility Invite Financial Attacks
Still, even for a strong economy with large foreign reserves, the cost of defending the fixed exchange rate from speculative or manipulative market attacks could be huge, if speculators should perceive the fixed exchange rate as out of line with a rapidly changing external market environment or even internal contradictions. Manipulators can then design attack strategies to drain wealth form economies bent on defending their currency pegs as they did in the UK in 1992 and Hong Kong in 1998.
Bank of England Joined European Exchange Rate Mechanism (ERM)
For example, during the 1970s, the Bank of England played a key role during recurring bank crises of stagflation in the United Kingdom and again in the 1980s when monetary policy again became a central part of British government policy. The Bank of England did not become a central bank until May 1997 when the government gave the Bank responsibility for setting interest rates to meet the government's stated inflation target, a good decade after the Big Bang. That was the term given to the financial deregulation on October 27, 1989, of the London-based security market. The Big Bang was comparable to May Day in 1975 in the United States, which ushered in an era of discount brokerage and diversification into a wide range of financial services using computer technology and advanced communication systems, marking a major step toward a single world financial market.
The Exchange Rate Mechanism (ERM) was a fixed-exchange-rate regime established by the then European Community designed to keep the member countries’ exchange rates within specific bands in relation to one another. The purpose of the ERM was to stabilize exchange rates, control inflation rates (through the link with the strong and stable deutschmark) and nurture intra-Europe trade. It was also designed to enhance European participating in world trade in competition with the US, creating the equivalent of a “United States of Europe” in the form of a European Union (EU) and as a stepping stone to a single-currency regime - the euro.
Britain joined the ERM in October 1990 at a fixed central parity of 2.95 deutsch marks to the pound, an over-valued rate intended to put pressure upon the British economy to reduce inflation rather than institutionalizing international competitiveness. British pride might have played a role in insisting on a strong pound. This chosen rate, or any fixed rate required by ERM membership, proved misguided, because it tried to benefit from the effect of a single currency for separate economies without the reality of a single currency within an integrated economy.
During the 23 months of ERM membership, from October 1990 to September 1992, Britain suffered its worst recession in six decades, with the gross domestic product (GDP) shrinking by 3.86%, unemployment rose by 1.2 million to 2.85 million. The total price to the United Kingdom Treasury for maintaining of ERM fixed exchange rate of the pound sterling had been estimated to be as high as 13.3% of 1992 GDP. The number of residential mortgages with negative equity tripled, reaching a peak of 1.25 million, and company insolvency rose above 25,000 a year.
The British Conservative government of John Major sought to balance political and macroeconomic considerations, only to fail in its effort to “support the insupportable” to prevent a devaluation of a freely traded pound by market forces. If the UK had not lost some £8.2 billion defending the pound’s unsustainable exchange rate, it could have avoided budget deficits, tax hikes, cuts in public spending, and the unpopular value-added tax on fuel. Spending on the National Health Service could have been more than doubled for 12 months.
Britain Withdrew from ERM after Much Economic Pain
Withdrawing from the ERM released the British economy from persistent deflation and provided the foundation for the non-inflationary growth subsequently experienced. It enabled monetary policy to be freed from the sole task of maintaining the exchange rate, thus contributing to economic expansion by a combination of rational monetary measures.
While ERM countries were compelled to maintain relatively high real interest rates to prevent their currencies from falling outside the permitted bands, Britain outside of the ERM enjoyed the freedom to benefit from lower rates.
Hong Kong’s High Cost Currency Peg to the Dollar
Hong Kong has been facing the same problems from the 1997 Asian financial crisis and will not be liberated from recurring global economic crises until its currency peg to the US dollar is lifted. For a small open economy, waiting for an improved economy before de-pegging its currency is like waiting for death to cure an infection.
A Fully Convertible Currency with Fixed Exchange Rates Risks Market Attacks 
For a currency that is fully convertible, the appropriate exchange rate at any particular time is that which enables its economies to combine full employment of productive resources, including labor, with a simultaneous balance-of-payment equilibrium. An excessively high exchange rate causes trade deficits and domestic unemployment, while a low one generates an excessive buildup of foreign-currency reserves and stimulates domestic inflationary pressures that lead to a bubble economy. The rule does not apply to China which does not have a fully convertible currency.
Thus every nation with an open economy must retain the ability to adjust the external values of its currency in this unregulated global financial market and an international financial architecture based on dollar hegemony. To be fixated on a fixed exchange rate within rigid limits is to court economic disaster in the current international finance architecture.

The Exchange Rate Mechanism

The ERM was a transitional regime whose problems were finally removed once the European Monetary Union (EMU) moved toward a single currency in the form of the euro. But the problems, while removed from ERM, did not disappear. The problems merely migrated to member states of the EMU. Still, the anti-inflation bias of the European Central Bank (ECB) continues to create conflict with the separate monetary policy needs of national economies within the eurozone.
In a fast-changing economic environment of unregulated globalized financial markets, the value of the exchange rate that facilitates full employment and a foreign trade balance will frequently fluctuate. Speculative volatility must be countered and the exchange rate must be managed, both by the central bank of sovereign states to prevent disruptions in the domestic economy and in external trade.
However, the separate needs of different sovereign states are not served by the “one-size-fits –all” fixed, unchangeable bands set by the super-national ERM. The optimum strategy for cooperation between sovereign central banks on exchange rates requires a combination of maximum short-term stability with maximum long-term flexibility, the very opposite of the effects of fixed exchange rate regimes.
Since, under the ERM, pound sterling interest rates were pegged to those of the German mark through the fixed exchange rate, the option of interest rates reduction was not available to the British central bank to deal with increasing unemployment and declining growth in the UK. The fact that Britain had no control over pound sterling interest rates, coupled with the questionable political independence of the Bundesbank, Germany’s central bank, was an important factor in Britain’s final decision to withdraw the pound from the ERM fixed-exchange-rate regime.
Inflationary Pressure from the Reunification of Germany
The reunification of Germany cracked open the structural flaw in the ERM because massive capital injection from West to East Germany had produced inflationary pressure in the newly unified in German economy, leading to preemptive increases of interest rates by the Bundesbank.
At the same time other economies in Europe, especially Britain’s, were in recession and not prepared for interest-rate hikes dictated by Germany. This interest-rate disparity magnified the overvaluation of the British pound in the early 1990s.
Along with the European Currency Unit (ECU, the forerunner of the euro), the ERM was one of the foundation stones of economic and monetary union in Europe. It gave member currencies a central exchange rate against the ECU, which in turn gave them central cross-rates against one another. It was hoped that the mechanism would help stabilize exchange rates, encourage trade within Europe and control inflation. The ERM gave national currencies an upper and lower limit on either side of this central rate within which they could fluctuate.
In 1992, the ERM was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Wednesday, September 16, a culmination of factors led Britain to pull out of the ERM and to let the pound float according to market forces.
Black Wednesday became the day on which George Soros, hedge-fund titan, famously broke the Bank of England, pocketing US$1 billion of profit in one day and more than $2 billion eventually. The British pound was forced to leave the ERM after the Bank of England spent $40 billion in an unsuccessful effort to defend the currency’s fixed exchange value against speculative attacks. The Italian lira also left the ERM and the Spanish peseta was devaluated.
German Inflation Conflicts with British Deflation
In order to curb inflation in Germany, an increase in German interest rates was deemed necessary by monetarist theory, but if the Bundesbank were truly independent of parochial German political-economic pressure, as a dominant regional central bank in the European Union was supposed to be, it would not have adopted this interest rate policy, as there were desperate cries from all over Europe for a decrease in interest rates to combat oncoming recession.
By adopting tight monetary policies in response to domestic inflationary pressures that followed German reunification in 1990, German short-term interest rates, which had been rising since 1988, continued unabated, reaching nearly 10% by the summer of 1992.
Thus at a time when Britain needed a counter-cyclical reduction in interest rates, the Bundesbank sent Deutsch mark interest rates upwards, plunging Britain deeper into recession through the ERM. The ERM required coordinated fiscal policy of its member states to maintain a common monetary policy, when it should have allowed its member states a wider range of monetary policies to support separate fiscal policies for a common economic prosperity.
Failure of the Exchange Rate Mechanism
This was the fundamental problem with the ERM “one-size-fits-all” fixed exchange rates regime conflicting with the separate interest-rate levels needed by different economic conditions in separate member economies within the ERM. British pound sterling interest rates pegged to those set by the Bundesbank was crippling the British economy because the UK was in a recession and required low interest rates, while Germany was facing economic overexpansion in the political reunification that required high interest rates.
Transformation of the Bank of England
In 1997, the British government announced its decision to transfer full operational responsibility for monetary policy from the Treasury to the Bank of England. The Bank thus joined the ranks of the world’s politically “independent” central banks.  This move transformed the role of the Bank of England from a national bank the mandate of which was to support economic development in the entire British Empire, to that of a central bank the mandate of which is to maintain the value of the British currency in an established global financial architecture to fight inflation with unemployment and stagnant wages. 
However, debt management on behalf of the government was transferred to Her Majesty’s Treasury, and the Bank’s regulatory functions passed to a new Financial Services Authority (FSA).
Black Wednesday 1992
On Black Wednesday (September 16, 1992), Soros’s Quantum Fund sold naked short more than $10 billion worth of pound sterling, profiting from the Bank of England’s reluctance to either raise pound sterling interest rates to levels comparable to those of other ERM member countries or to free float the pound sterling. (Germany’s ban on certain kinds of naked shorting during the sovereign debt crisis in EMU member states was more than mere theoretical paranoia.)
Finally, the Bank of England withdrew the currency from the ERM, devaluing the pound sterling, letting Soros’ hedge fund gain US$1.1 billion in the process, crowning him with the awesome title of “the man who broke the Bank of England”. In 1997, the UK Treasury estimated its final loss on Black Wednesday at £3.4 billion.
The Times of Monday, October 26, 1992, quoted Soros as saying: “Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont [then Chancellor of the Exchequer and later Baron Lamont of Lerwick] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell.”
Leveraging to the Hilt
Stanley Druckenmiller, a Soros trader who first saw the vulnerability of the pound, credited Soros with “pushing him to take a gigantic position”. Jack Schwager’s The New Market Wizards recorded an interview with Druckenmiller on his recipe for long-term big-time kills:
“George Soros has a philosophy that I have also adopted: The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30% or 40%, will book their year [i.e., trade very cautiously for the remainder of the year to avoid risking the very good return]. The way to attain truly superior long-term returns is to grind it out until you’re up 30% or 40%, and then if you have the convictions, go for a 100% year.  If you can put together a few near-100% years and avoid down years, then you can achieve really outstanding long-term returns.”
Jim Rogers, another former Soros portfolio manager, was quoted in Market Wizards, an earlier Schwager book: “Until we ran out of money, we were always leveraged to the hilt,” adding, after they ran out of money, they’d sell the weakest positions to fund new ideas.
Sorros’ success was imitated by all other hedge funds. Leveraging to the hilt then became the industry norm and within a decade became the main cause of the credit crisis of 2008. Of course, if an institution is aggressive enough to leverage high enough to qualify as “too big to fail”, it would incfact get itself a free ride with taxpayer money if it should crash from excessive risk.
Trading Models Externalizing Risk to the System
Left invisible, but solidly anchored in all structured finance and derivative models, was the assumption that a systemic collapse would trigger a government bailout. Since each and every derivative trading model derives protection by externalizing risk to the trading system, systemic risk expand automatically to make a systemic meltdown inevitable. This generates incentives for institutions to be deemed “systemic significance” to secure a fail safe advantage in interconnected transactions, even though by themselves they are not “too-big-to fail”. These trading models are operative when they aree marked-to-model, but inoperative when hey are marked-to-market. This is the point when the fail safe strategy by government bailout is activated.
Hong Kong Fought Off Hedge Fund Attacks in 1997
In another example in October 1997, three months after China recovered Hong Kong after a century and a half as a colony under British imperialism, the HK$, which had been pegged to the US$, came under powerful, repeated speculative and manipulative attacks, as a result of the contagion effects of the Asian financial crisis. The automatic monetary adjustment forced interbank interest rates in Hong Kong to shoot up to unprecedented levels (up to an astronomical 300% at one point), reflecting substantial risk premiums on the HK dollar. This generated severe deflationary consequences for the financial and property markets, as well as the entire economy.
The interventionist role the Hong Kong Monetary Authority (HKMA) played in handling violent market turbulence was controversial by the standard of its own free market ideology. HKMA later admitted that as Hong Kong’s link mechanism was on “autopilot” during the attacks, the interest rate adjustments were part and parcel of the working of a currency board regime, and therefore generating an inevitable and painful financial crisis. That such financial and economic pain was avoidable by de-pegging was not officially acknowledged as an option.
Hong Kong was the target of speculative and manipulative attacks four separate and sequential times during the Asian financial crisis of 1997. The first three attacks took the form of garden variety currency dumping, whereas the fourth attack targeted the structural vulnerability of the Hong Kong’s currency board regime after speculators were convinced that HKMA would defend the peg at all cost. And speculators were waiting to be the happy recipients of guaranteed profit from HKMA’s fixation on the peg.
The first attack took place in October 1997, as a result of contagion from the regional financial turbulence that began in Thailand in July 1997. Currency speculators took large naked short positions against the HK dollar, with the expectation of profiting from the breakdown of the Hong Kong linked exchange rate regime. However, interbank interest rate soared in response, forcing speculators to unwind their naked short position as the high cost of borrowing made leveraged naked short trades unprofitable.
Although the automatic defence mechanism inherent in the currency board regime prevented the breakdown of the currency peg, the penalty took the form of unsustainably high interest rates. For example, the overnight interbank interest rate on October 23, 1997 reached as high as 300%. This local interest rate volatility echoed the external market volatility, created psychological shocks to market participants that forced the market to put a risk premium on Hong Kong dollars. Consequently, local banks increased their precautionary demand for liquidity, resulting in continuing high level of interest rates for the HK market. A liquidity crisis developed, further exacerbating already abnormally high interest rates.
This high interest rate anomaly incurred huge adjustment costs in the Hong Kong economy, particularly in the finance, business and property sectors. Labor costs, even though they accounted for only about one-third of the operating expenses of an average corporation in Hong Kong, as compared to the US average of two-thirds, had to be reduced by management through lay-offs and cuts in real wages and benefits in the early 1998.  Asset prices such as land, real property and company shares, together with rental and dividend income, also plummeted sharply and swiftly.
The high cost of defending the currency peg system manifested itself in severe price deflation. It triggered further speculative and manipulative attacks in January and June, 1998, each time draining substantial wealth from Hong Kong companies and residents into offshore hedge fund accounts. The monetary defense mechanism successfully maintained the currency peg in the market at the cost of generating sharp, across-the-board price deflation in the economy.
The Hong Kong dollar continued to trade at the pegged exchange rate to the US dollar, but the same US dollar was buying more assets in Hong Kong than before the crisis. The currency board regime merely deflected currency devaluation toward asset deflation. The exchange value of the HK dollar remained fixed to the US dollar, but Hong Kong asset prices and wages fell. It would be less painful to the local economy if asset prices and wages were remained unchanged while the HK dollar was devalued against the US dollar.
The HKMA was able to defend the fixed exchange rate of its currency because it had large foreign reserves, but it did so by allowing wealth to be drained from the Hong Kong economy through asset deflation, weakening its market fundamentals. The net economic outcome was negative on balance. The monetary operation was successful, but the economic patient was left near dead.
In August 1998, the fourth and near-fatal attack took place, targeting at the automatic adjustment mechanism of the Hong Kong currency board regime. This took the form of simultaneous attacks on money and equity markets, known in hedge fund tactics as a “double play”.
In a double play, before launching attacks, manipulative traders would pre-fund their attacks with highly leveraged positions with HK dollars in the debt market, engaging in big swaps to access large sums in HK dollars that multilateral entities had raised through their bond issuance. Speculative and manipulative traders then spread rumors about imminent Chinese yuan devaluation and a pending collapse of the Hong Kong equity and property markets. At the same time, they made large naked short positions in the stock futures index market. Then, they induced an interest rate hike by dumping their pre-funded HK dollars in the spot and forward market to force the HKMA to buy HK dollar with US dollars from its reserves. All these actions induced the Hang Seng index to plummet sharply and abruptly, from 16802 in June 1997 to 6708 in August 1998. Within three days beginning October 20, 1997, the Hang Seng index dropped 23%.  
As the Hong Kong stock market started to plunge, other speculators saw opportunities for profit through massive naked shorting. The Hong Kong financial markets fell into chaos, as further naked short selling created panic selling of shares in free fall.
The Damage by Naked-Short Attacks
The current ban against naked short selling by Germany during the 2010 EU sovereign debt crisis is driven by more than mere phantom fears. The German defensive measure has the 1992 experience of the British pound and the 1998 experience of Hong Kong dollar with naked short selling as cautionary guides.
During the Asian financial crisis of 1997, speculators and manipulators exploited the automatic interest rate adjustment mechanism of the currency board regime, turning speculation into manipulation for certain profit. Hedge funds took naked short positions simultaneously in the Hong Kong stock and futures markets. Simultaneously, they sold yet-to-be-borrowed Hong Kong dollars against the US dollar. Under the currency board regime, the HKMA must stand ready to buy back HK dollars released into the market to maintain the peg.
This was the structural dilemma inherent with the currency board regime. On the one hand, continuing buybacks of HK dollars by the HKMA automatically shrank the Hong Kong monetary base and drove HK dollar short-term interest rate up sharply. On the other hand, the overnight interest rate having risen sharply to 500% at one point in October 1997, triggered precipitous drops in stock and stock futures prices and produced hefty profits for short-sellers. After every attack, market confidence plummeted further by the hour, creating an imbalance of sellers over buyers to push share prices further down.
The HKMA feared Hong Kong’s economy could very well bleed to death if the downward vicious cycle was permitted to continue. If the economy should die from hemorrhage of wealth, no further purpose would be served by preserving the currency board. And if the downward asset price spiral was allowed to continue, the currency board would eventually also collapse after the large foreign reserves was exhausted, because wealth was draining from Hong Kong with no stop loss limits.
It soon became clear that the option was not even to choose between letting the economy collapse and letting the currency board regime collapse. The two are linked so that as one sinks, the other would be dragged down with it. The economy must be saved along with the fixed exchange rate. Yet few acceptable options were available to reverse the trend of depleting foreign currency reserves while bleeding the equity market dry. Among all the unpalatable options available, only two stood out with some uncertain promise: 1) outright capital control and 2) direct market intervention. Both were not cost-free silver bullets.
Malaysia’s Capital Control Not Operative for Hong Kong
While earlier in the 1997 Asian financial crisis, Malaysia had adopted capital control with positive results, Hong Kong would not benefit from similar measures because, unlike Malaysia, the Hong Kong economy was primarily an outward-oriented trading economy with no sizable domestic market of its own. Hong Kong therefore chose direct market intervention with its huge foreign reserves. When manipulative and speculative attacks intensified again in August 1998, the HKMA intervened with its reserves of US dollars simultaneously in the money, stock and futures markets, in addition to buying back Hong Kong dollars in the foreign exchange market.
During the last two weeks of August, 1998, the HKMA imposed temporary penalty charges on targeted lenders that served as settlement banks for the manipulators and speculators to make speculative funds more expensive while HKMA itself bought US$15 billion worth of Hang Seng Index constituent stocks (8% of the index’s capitalization). In addition, it took naked long positions that pushed the stock futures 20% higher to squeeze the naked short sellers. After the massive market intervention by the HKMA, the exchange rate of the HK dollar quickly stabilized, and currency futures and short-term interest rates returned to sustainable levels. Manipulator and speculators were left licking their wounds but not until substantial damage had been done to the Hong Kong economy. To soften anticipated neo-liberal criticism, the HKMA labeled its market intervention as “market incursion”.
Still, for this unprecedented “market incursion”, the HKMA received harsh criticism for deviating from its long-standing “positive nonintervention” policy. In defense, the HKMA argued that the “incursion” was justified by Hong Kong’s strong economic fundamentals as well as the severity of the regional financial turmoil. The HKMA contended that without forceful incursion to foil market manipulation, not only would the currency board have collapsed but there would also have been serious regional and global ripple effects. It was a “too-big-to-fail” argument that was summarily dismissed by US neo-liberals who quietly did the same on a much larger scale in 2008.
The 1998 market incursion was a deviation from Hong Kong’s economic policy of “Positive Non-Interventionism” adopted under British imperialism after WWII to appease US free market ideology. The policy was first officially implemented in 1971 by John James Cowperthwaite, a Scottish civil servant in the British Colonial Office who worked to remove all colonial government interventionist preference toward trade with Britain in order to facilate more trade with the US, the world’s biggest market with semmingly inexhaustible purchasing power.
Friedman Condemned Hong Kong for Market Intervention
Milton Friedman’s opinion in the Octeber 6, 2006 Wall Street Journal, less than a year before the credit crisis that imploded in New York July 2007, criticizing Hong Kong for abandoning Positive Non-Interventionism, praising instead Cowpertheaits  as having been “so famously “laissez-faire” [in ideology] that he refused to collect economic statistics for fear this would only give government officials an excuse for more meddling. This is an amazing praise from Friedman who was known for his 1953 propositions for a positivist methodology in economics which stresses the important of economic data.
Cowperthwaite’s policy greatly enhanced the profit of traditional British trading firms such as Jardine Matheson which had first prospered in Hong Kong for a century and a half starting from illicit opium trade in early 19th century. Upon retirement from the British Colonial Office, Cowperthwaite served as international advisor to Jardine Fleming, the Hong Kong-based British investment bank.
Cowperthwaite’s policy had been continued by all subsequent Financial Secretaries, including Sir Philip Haddon-Cave. Milton Friedman cited Postitive Non-Interventionism as a fairly comprehensive implementation of laissez-faire policy, although Haddon-Cave referred to the description of Hong Kong as a “laissez-faire” society as “frequent but inadequate”.
Hong Kong’s Sin Repeated by the US
Notwithstanding their stern criticism of the HKMA in 1998, the Federal Reserve and the US Treasury also engaged in direct market intervention in US markets a decade later in 2008. This was done under the rationalization of saving “systemically significant” private institutions that were deemed “too big to fail”. At least the HKMA bought all the listed shares in the Hang Seng index, rather than toxic assets from only selected distressed firms as the Fed and Treasury did, which was decidedly less evenhanded or market neutral.
In retrospect, the HKMA “market incursion” could not have had a lasting stabilizing effect on the market without the coincidental favorable policy-induced developments that followed: a coincidental lowering of US dollar interest rates, the rapid recovery of the economies in the region from the effects of an acceleration of the decade-old loose money monetary policy by the Federal Reserve under Alan Greenspan since 1987, the quick rebound of low-price Chinese export to the US under dollar hegemony to help contain US inflation even with low dollar interest rates, and finally and particularly, China’s firm pledge not to devalue its currency against the US dollar amid a wave of other currency devaluations by other governments in the region.
The Report on Financial Market Review released by the Hong Kong government in April 1998, four months after the crisis events, promised a firm commitment going forward to the currency board principle of free currency flow, namely, letting the flows of funds determine interest rate movements and refraining from manipulating the monetary base, other than necessary sterilization measures to offset exceptional domestic events. At the same time, though, the HKMA reserved the option of intervening in the foreign exchange market at unspecified levels close to the target rate of 7.80 Hong Kong dollars to one US dollar. Hong Kong’s total amount of foreign currency reserves was US$256.2 billion in May 2010. The amount of foreign reserves continues to represent over nine times its currency in circulation, or about 53% of Hong Kong dollar M3. However, it is dwarfed by China’s massive foreign reserve of $2.5 trillion. 
The currency board regime in Hong Kong uses the first two of the three anchors of the classical currency board, i.e., (i) fiscal discipline backed by ample reserves, and (ii) free cross border currency flow. Missing is the fixed exchange rate regime as it was within the British Empire. The global currency markets since the collapse of the Bretton Woods regime are a mixture of fixed exchange rates and floating rates. No effective mechanism to deal with global currency arbitrage was put in place by HKMA. Instead, HKMA has opted for discretionary foreign exchange market intervention, playing on what it described as “constructive ambiguity” or “the surprise element”. This type of non-rule-based, “driving by the seat of the Monetary Authority’s pants” currency board regime is unique in the world.
Currency Board is an Implementation Device, not a Policy Instrument
Generally, all monetary measures under a currency board regime are subordinated to meeting the target fixed exchange rate. This reduces the local monetary authority from being an independent sovereign monetary authority serving the monetary needs of the local economy, to the role of a local agent of the foreign monetary authority that issues the anchor foreign reserve currency. A currency board regime denies the monetary authority its fundamental mandate to issue local fiat money to meet the needs of the local economy, leaving it the only option of issuing local currency up to the amount equivalent to its foreign currency reserve at the fixed exchange rate. This makes a currency board as device to fix the exchange rate. It is not a monetary policy instrument.
The currency board must hold sufficient foreign reserve or more to ensure that all holders of its domestic notes and coins, and all banks reserves deposited at the currency board can exchange their holdings of local currency to the anchored foreign currency on demand. At least 110% of the monetary base, generally identified as M-0, must be backed by the reserve foreign currency held at the currency board. Some well-reserved current boards, such as that of Hong Kong, maintain several folds of the monetary base of its domestic currency in the reserve foreign currency.
Parallel Currency Arrangement in Argentina
During the second half of 2001, Argentina’s parallel currencies arrangement under which the market increasingly preferred dollars over pesos put reserve adequacy pressure on the Argentine currency board, but Argentina was trapped with no plausible exit. Notwithstanding a parallel currencies arrangement, most of the country’s debt was denominated in dollars not pesos, thus there would be a huge cost in local currency terms to breaking the peg by devaluating the peso, not to mention the long-term damage to Argentina’s credit rating in world capital markets, as government-owned assets had been largely privatized, leaving the nation with reduced collateral to support its large and rising debt.
The Dollarization Option
The loss of exchange value from currency devaluation could not be made up by the improved trade competitive advantages from a devalued peso to reduce, let alone eliminate, the large and rising current account deficit along with the need to borrow more foreign currency to finance it. Many monetary solutions were considered, including modifying the peg to a currency basket of dollars and euros and yen which would have entailed a de facto and controlled devaluation of the peso, and finally, even dollarization.
The Convertibility Law of 1991
Neoliberal economist Domingo Cavallo was the ideologue behind the Argentine Convertibility Law, which created a currency board that fixed the dollar-peso exchange rate at parity. After President Fernando de la Rúa signed the Convertibility Law in April 1991, Economic Minister Cavallo managed to halt hyperinflation, which had averaged over 220% a year from 1975 to 1988 and had leapt to 5000% in 1989, and remained at 1300% in 1990. But the cure was worse than the disease. Argentina was hit by a cycle of bank crises of illiquidity and insolvency.
Argentine Bank Crisis of 2001
On December 3, 2001, in response to a new bank crisis that threatened to destroy the entire domestic financial system, Cavallo restricted withdrawals of bank deposit to a maximum of 1,000 pesos/dollars per month up to March 3, 2002. The restriction led to depositor riots in the streets and brought down the government of President Fernando de la Rúa.
The interim government immediately suspended payments on all external debt. In January 2002, the new president, Eduardo Duhalde, repealed the Convertibility Law of 1991 and adopted a new, provisional fixed exchange rate of 1.4 pesos to the dollar (amounting to 29% devaluation) and the conversion of all bank accounts denominated in dollars into pesos at the new exchange rate and its transformation in bonds. Soon afterward, Duhalde completely abandoned the peg and allowed the peso to float freely, resulting in a swift depreciation of the peso, which lost 75% of its value with respect to the dollar in a matter of months.
The reason of this drastic depreciation of the peso was the “pesification” of bank accounts under which the 100 billion dollars in bank accounts were changed to 100 billion pesos. This caused a sudden, enormous demand for dollars in the market as every peso holder wanted to exchange pesos for dollars before pesos devalue further and forced the market exchange rate down to 4 pesos per dollar in 5 months.
Currency Convertibility Not Supported by Viable Monetary Regime
The Argentine economy suffered financial setbacks repeatedly because currency convertibility was never supported by a viable monetary regime that the Argentine central bank could control to respond to the need of the Argentine economy. Argentina experimented with all monetary approaches advocated by neoliberal economic theory, yet each monetary experiment was followed by a dilapidating financial crisis. The experiment with a flexible exchange rate regime led to hyperinflation that stagnant wages could not keep pace. The experiment with a currency board regime to peg the local currency to the dollar at parity led to a severe recession that forced down wages in a downward spiral.
Nonetheless, inappropriate currency mechanisms were not the only causes behind these failed experiments of financial tribulations. Misguided economic restructuring towards market fundamentalism through inappropriate policies advocated by the Washington Consensus had been a more critical cause. The currency board only robbed the central bank of any chance of a monetary response to the crisis.
In all these experiments, wages were the variable outcome rather than the policy anchor for economic calculations. In other words, wage levels were prevented to rise alongside price levels, rather than price levels remaining stable while wage levels rose to create real growth. Inflation amid stagnant wages was a formula for economic decay rather than economic development. Under such conditions, the entire economy was co-opted to serve maximization of return on capital at the expense of labor.
In desperation, some neoliberals sought new corrective solutions to make the fundamentally wrong approaches work better. They advocated “dollarization” as an optimal solution to deny the government the easy option of increasing the peso money supply to stimulate the economy in recessions. They claimed that dollarization is an effective way to avoid the financial instability that is destructive to economic growth. To put off mass revolt against defending the value of the currency at the expense of a living wage, neoliberal policymakers resort to sovereign debt to finance social expenditure.
Dollarization – A Failed State Monetary Policy
Dollarization for a developing economy is essentially a monetary regime of a failed state, by surrendering the sovereign responsibility of conducting monetary policy to support the monetary needs of the national economy to the issuer of the dollar, which is the Federal Reserve, the US central bank, whose mandate is to protect the value of the dollar at all expense. Dollarizaon is a non-dollar government’s policy of no confidence in the government’s ability to manage its own monetary policy.
Two year after the 1997 Asian financial crisis, then Treasury Secretary Robert E. Rubin gave a talk on April 21, 1999 on Reform of the International Financial Architecture at The School of Advance International Studies in which he said:
Some countries have recently considered making another country’s currency their own: in particular, adopting the dollar. This is a highly consequential step for any country, one that has to be considered very carefully and, in our view, should not be done without consultation with United States authorities. On one hand, dollarization offers the attractive promise of enhancing stability. On the other hand, the country also must be prepared to accept the potentially significant consequences of doing without the capacity independently to adjust the exchange rate or the direction of domestic interest rates. The implications for the United States are also consequential. We do not have an a priori view as to our reaction to the concept of dollarization. We would also observe that there are a variety of possible ways for a country to dollarize. But it would not, in our judgment, be appropriate for United States authorities to extend the net of bank supervision, to provide access to the Federal Reserve discount window, or to adjust bank supervisory responsibilities or the procedures or orientation of U.S. monetary policy in light of another country’s decision to dollarize its monetary system.
Foreign Direct Investment vs Hot Money Capital
It is only an IMF sponsored myth that global capital will not directly invest in developing economies with macro policies of low interest rates and with inflation under control by cross-border wage arbitrage in the name of free trade. With the growth of globalized structured finance, inflation and currency risks had been managed by hedging to disappear as a hindrance for “hot money” capital for Asia until July 1997 and for Europe not until 2010.
In theory, these conditions are retardants for foreign direct investment (FDI).  And FDI had grown at a much slower rate than opportunistic speculative hot money investment in the equity markets in past decades.
The IMF, in order to attract global capital to return to Asia, had to eat its hat and revert to emergency low interest rate policies, after the failure of initially high interest rate conditionalities of IMF rescue packages designed to fight inflation and to protect the local currency’s ability to service outstanding foreign debt.
IMF Aversion to Inflation
The IMF lives in constant fear of debtor nations copying the German post-WWI solution of repudiating foreign debt with domestic hyperinflation. But Post-WWI German foreign debt was denominated in German currency, while debtor nations in the post-WWII era had debts denominated in foreign currency, specifically in dollars. In fact, it is now clear that initial IMF conditionalities exacerbated the crises in Asia, Russia and Brazil.
The 1997 Asian Financial Crisis Not Caused by Inflation
In July 1997, when the Asian financial crises began in Thailand, the meltdowns had not been triggered by hyperinflation.  They were triggered by a collapse of an over-valued Thai currency peg to the US dollar which drained foreign exchange reserves from the Thai central bank defending the peg.  Generally, in hindsight, it is indisputable that the conditions leading to the Asian financial crises were: unregulated global foreign exchange markets and the widespread international arbitrage on the principle of open interest parity (in banking parlance, this type of activity is known as “carry trade”) made possible by the free cross border flow of funds and credit; short term debts to finance long-term projects; hard currency loans for project with only local soft currency revenue; overvalued currencies unable to adjust to changing market values because of fixed pegs.
Under these conditions, when there is a threat of currency devaluation caused by a dwindling of reserves, the whole financial house of cards collapsed in connected economies globally in a chain-reaction called contagion. The Asian financial crisis of 1997 that started in Thailand in July quickly blossomed through contagion into regional economic crises and beyond within a few month weeks to New York by October that eventually hit Russia a year later in 1998 and then Brazil in January 1999, despite coordinated efforts of the G7 to contain the contagion.
Brazil Hit by Contagion
In Brazil, the government was forced to allow a short, 2-day period of 9% devaluation before it threw in the towel on January 15, 1999 and suspended foreign exchange control and abandon the peg to allow the Brazilian real to free float.
During the first 2 days of the crisis, the Brazilian government tried to do a stock purchase, copying Hong Kong’s example in August 1998.  But it was a non-starter. Hong Kong had to use US$18 billion in 2 days to crush the manipulation by hedge funds of its stock and futures markets in August 29, 1998. Brazil had only US$30 billion of reserves left by January 14, 1999 as compared to HK’s US$100 billion in 1998. So, the Brazilian government decided that it was futile to even try, after some fake moves to try in vain to spook speculators in the market.
For many years, many economists have touted the myth of the indispensability of fixed exchange rates for small economies heavily dependent on external trade, like Hong Kong, or large free-trade economies facing high inflation, like Brazil. The inertia of the status quo and the lack of hard data on the uncertain effects of de-pegging have permitted this myth to assume the characteristics of indisputable truth.
Hyperinflation in Brazil
Brazil pegged its currency to the dollar as a means of fighting chronic and severe inflation. When the Real Plan was introduced in 1994, inflation was 3,000%.
Hong Kong pegged its currency to the dollar in 1983 to instill confidence in the uncertain political climate following the announcement in 1982 of its return to Chinese sovereignty in 1997.
As Hong Kong knows from first-hand experience, the penalties of an overvalued fixed exchange rate currency monetary regime in an open market of full convertibility are injuriously high interest rates and runaway asset deflation, resulting in economic contraction that produces business failures and high unemployment, not to mention credit crunches and illiquidity that threaten potential systemic bank crises and recurring attacks on currency through manipulation of markets.
Brazil, burdened historically with costly social programs that had become politically untouchable, the overvalued currency peg inflicted much pain on the economy, particularly the export sector.  Both industry and labor had wanted for a long time a lower exchange rate to relieve Brazil from high (70%) interest rate and to stimulate export, even if the concurrent low inflation of 3% would rise as a result.
The crisis in Brazil was triggered by a moratorium on state debt payments imposed by the large and wealthy state of Minas Gerais on January 12, 1999. On January 13, Brazil devalued the real by 9%, having seen its foreign reserves dropped by more than half in the last 5 months to $31 billion. A drain of $1.8 billion from the Brazilian central bank was recorded the following day.
Brazilian Monetary Crisis of 1999
On the morning of January 15 1999, to stop the financial hemorrhage, Brazil lifted exchange rate control entirely and allowed the Brazilian real to float freely in the foreign exchange markets. Within minutes, the Brazilian real fell to 1.60 to the dollar from its previous 1.32, but by day’s end, settled around 1.43 to the dollar. By the end of the trading day on January 15, Brazil had managed to halt the flight of the dollar, with the Brazilian real down 10.4% for the day and 18% from the pegged rate, even though the market had estimated the Brazilian real to be overvalued by 30%.
With a free floating currency, Brazil’s short term interest rate fell from 71.65% to 36.11% and the stock market jumped 34% on January 15 from its previous low, with lifting effects worldwide on other markets.  The DJIA rose 219.62 points, or 2.4% to 9,340.55.  US Treasuries dropped sharply, reversing the flight to quality, pushing yield on 30-year bonds to 5.12% from 5.05%. By 7 pm on January 15, only $173 million had left Brazil’s foreign reserves coffer.
For recovery, Brazil still had to put its economic fundamentals in order, to cut government deficits within its political realities and to reduce its $270 billion foreign debt.
But its self-imposed penalty of an overvalued peg had now been removed, gaining improved conditions for export and stimulus effects for domestic demand. With Brazil's currency free floating, it was highly unlikely that Argentina's currency board regime can hold.  Argentina either had to free float its currency or to go the dollarization route.
According to Paul Krugman: the Brazilian free float “started out with good news. When Brazil floated the real on a Friday, the initial drop in the currency was moderate, and the stock market soared on hopes that the grim austerity program would soon be loosened up. Then Brazilian officials went to Washington; and over the weekend they were persuaded - bullied, according to rumor - into announcing that interest rates would be raised, not lowered. The result was despondency, and a collapse in the currency.”
Brazil’s decision to abandon the peg was significant because it was the last large economy that follows free trade, market deregulation, fixed currency and privatization, the fundamental components of globalization promoted by neo-liberal economic theories.  The decision represented a de facto declaration that market valuation of currencies is a more realistic option than placing faint hope of an international regulatory regime on capital movement or control down the road.
Hong Kong's situation was not congruent to Brazil's.  Yet Hong Kong had incurred much unnecessary pain in holding onto the myth of an indispensable peg as Brazil did.
The reality in Brazil in 1999 punctured the myth of the magic of the currency peg. That lesson deserves to be taken seriously by Hong Kong in reviewing the role of its own monetary policy in its strategy for recovery.
Currency Board and the Monetary Base
To put it a one sentence, a currency board system is a linked exchange rate system which theoretically requires the monetary base to be backed by a foreign currency at a fixed exchange rate.
The monetary base is normally defined as the sum of the amount of bank notes issued and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves and between the currency board and the banks.
The monetary base would increase when the foreign currency to which the domestic currency is linked, is sold to the currency board for the domestic currency (capital outflow). The expansion or contraction in the monetary base would lead to interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital inflow or outflow respectively, ensuring stability of the exchange rate throughout the process.
A currency board system effectively removes the power of the central bank to set monetary policies, such as interest rates, liquidity, money supply, etc.  It assigns that power to the market and the monetary policy of the target currency.
When the local currency is pegged at below market value, local interest rates will fall, at time to negatives levels as in Hong Kong in the 80s. When the local currency is pegged at above market value, local interest rates will rise. When the underlying exchange rate set by a currency board is not supported by economic fundamental, speculative and manipulative attack on the local currency will occur, as it did repeatedly in Hong Kong during the past 18 months. There are very few, if any, pure currency boards operating in today’s unregulated global economy.  This is because, in real life, the linkages between asset prices, interest rates, and liquidity are affected dynamically by interlinked financial derivatives.
The direct penalties of a fixed exchange rate pegged at an overvaluation level are: high interest rate and deflation of asset denominated in local currency, not to mention the need to tie up foreign reserves to support the overvalued currency, instead of using it for stimulus fiscal packages.
When the peg is released after a long period, both interest rate and asset price will bound back from peg-induced lows and settled according to economic fundamentals.
For Brazil this is the best option, if it does not set off a round of competitive devaluation from around the region and the globe.  Free float, nevertheless, will reduce the impact of competitive devaluations, because each currency will have to seek its proper value in trade terms according to fundamentals.
Currency Board and Economic Pain
Both a currency board and dollarization come with a great deal of economic pain. Usually smaller economies are not in phase with the US economy, so when Greenspan lowers interest rates and easy monetary policy, it would exacerbate economic problem for the pegged currency economies.
HK got itself into a bubble economy with its 7.8 to 1 linkage through a currency board adopted in 1983 when the dollar was undervalued during the 80s and HK experience negative interest rates. Now with the dollar overvalued, HK suffers from repeated attacks on its currency by hedge funds, causing recurring high interest rate (300% at its worst), deflated assets by 60%, contracting consumer demands and falling exports, and pending banking crisis, not to mention unemployment and corporate bankruptcies.
For Brazil, the real plunged when it was allowed to trade freely in January, 1999 and 4 months later the real was recovering from its low (below US$0.50 to one real), stabilizing around US$0.60 to one real and rising.  Export was up due to more competitive prices. The stock market was up, the Bovespa index rose from its low of below 5000 in January to over 11,000 by year end.  Ten years later, on July 1, 2010, it was 61,430. Inflation in March, 1999 was 3.9% from 20% in 1996. Interest rates dropped: the interbank rate for loans longer than one day fell to 30% from 55% in January, 1999. 
On April 22, Brazil sold US$2 billion of 5-year notes at 11.88%, only 6.75 percentage points above 5-year US Treasuries.  About two-thirds of the notes went to US investors and the rest to Europe.  The second part of the Brazilian debt sale closed on April 23, involving a swap of previously issued Brazilian Brady bonds for the new 5-year notes. 
Aminio Farga, Brazilian central banker and former aid to Soros, announced that “we are putting a program together to better manage our yield curve,” referring to efforts to sell debt with longer maturities. The strong demand caused George Soros to declare in an investor conference in New York that “the global financial crisis is now officially over.... So now we can look for the next one.”
Rubin, Summers and Greenspan made policy statements on the question of the future global financial architecture and dollarization. While these positions have been well known for some time, the fact that these issues were now being openly debated in the American public opinion arena was significant.
July 7, 2010
Next: Financial Globalization and Recurring Financial Crises