Global Post-Crisis Economic Outlook
 
By 
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


Part XII: Financial Globalization and Recurring Financial Crises

This article appeared in AToL on July 29 , 2010
 
 
Recurring financial crises of past decades had clearly exposed the instability of globalized unregulated financial markets and the great danger such instability poses for the economic wellbeing of defenseless developing countries which participate in such markets.
 
In recent decades, the world economy has been repeatedly hit by recurring financial crises: the 1987 crash on Wall Street, the “tequila effects” of the Mexican default in 1994; the contagion effects of the Asian financial crises of 1997, with the Korean sovereign default and its contagion effect on Brazil that, despite US Treasury bailout of exposed US bank creditors, could not prevent the Brazilian crisis of 1999.
 
On August 17, 1998, triggered by contagion from the 1997 Asian financial crisis and the resulting collapse of commodity prices, Russia devalued the ruble from its overvalued fixed exchange rate. The ruble/dollar trading band expanded from 5.3-7.1 RUR/USD to 6.0-9.5 RUR/USD. A 90-day moratorium on 281 billion rubles ($13.5 billion) of Russian sovereign debt was declared. These developments generated a massive “flight to quality” in the debt markets, with investors flooding out of any remotely risky market and into the supposedly most secure instruments within the supposedly “risk-free” government bond market. On September 2, the Central Bank of the Russian Federation decided to abandon the “floating peg within a band” policy and float the ruble freely. By September 21 the exchange rate had reached 21 rubles to a US dollar, losing two thirds of its value of less than a month earlier.
 
Ultimately, these events resulted in a liquidity crisis of enormous proportions, in turn caused the collapse of large US hedge fund Long Term Capital Management (LTCM) which had engaged in convergence plays involving Russian government bonds. LTCM was bailed out by its creditors under an arrangement of the New York Fed, but the contagion effect from the Russian default hit again on Brazil in a circuitous loop around the globe.
 
Less than a decade later, the world economy was hit by the mother of all crises that began in the US in July 2007, first as a collapse of the securitization market of subprime housing mortgages sold worldwide, then quickly leading to a systemic banking and credit market crisis of global dimensions. The financial crisis that first broke out in the US around the summer of 2007 and crested around the autumn of 2008 had destroyed $34.4 trillion of wealth globally by March 2009 when the equity markets hit their lowest points, wiping out half of the world’s market capitalization. (Please see Part I: Crisis of Wealth Destruction)
 
These recurring financial crises have provided conclusive evidence that unregulated financial globalization based on the Washington Consensus is an ill wind that blows no good to rich and poor alike. These recurring financial crises have also provided clear empirical confirmation that globalized free trade is detrimental to domestic economic development.
 
These recurring crises have also shown that it is not viable for any sovereign government to adapt autonomous monetary policies while at the same time maintain a fixed exchange rate pegged to a stronger foreign fiat currency in a global economy that permits free cross-border flow of capital and full currency convertibility at floating exchange rates. The credit crisis that broke out in the US in 2007 was not an unforeseen Black Swan event. It had ample precedents and visible warning signs that were ignored by willful denial on the part of neoliberal idealogues.
 
The Mundell-Flemming Thesis
 
This contradicting limitation of globalized finance liberalization has been summarized in the Mundell-Flemming thesis, for which Robert Mundell won the 1999 Nobel Prize for Economics. The thesis states that in international finance operating under unregulated global financial markets, a government can only have two choices among three options: (1) stable exchange rates, (2) international capital mobility and (3) domestic economic policy autonomy (full employment, interest rate policies, counter-cyclical fiscal spending, etc).
 
China, for example, has opted for capital control and fixed exchange rates, policies that have largely insulated the Chinese economy from much of the turmoil in the globalized unregulated financial markets since 2007, and have allowed China to adopt monetary policies best suited for the internal needs of the Chinese economy.
 
The Masstricht Treasty Conflicts with the Mundell-Flemming Thesis
 
Mundell, who often proudly refers to himself as the conceptual father of the euro, thought his thesis could provide the working basis for a common currency among sovereign states in Europe without a political union, as defined by the terms of the enabling Masstricht Treaty of 1992, on the basis of which the European Monetary Union (EMU) was created. 
 
Mundell’s vision of a common currency for Europe requires sovereign states in the eurozone to give up domestic economic policy autonomy in exchange for cross-border capital mobility and stable exchange rates. Mundell, an economist rather than a political scientist, apparently did not take into account that national politics on economic issues, such as fiscal austerity and associated unemployment, always trump international economic concords such as the Masstricht Treaty.
 
Rebus sic Stantibus
 
This acknowledgment of political reality has been subscribed in international law by the concept of rebus sic stantibus, which states that when the objects of a treaty, or conditions under which it is concluded, no longer exit, the treaty itself becomes null and void per se (by itself). When an EMU member state breaches EMU convergence criteria of the euro, it will conceivably be legally free from all obligations to the terms of the enabling Masstricht Treaty of 1992.     
 
Financial Globalization Invites Foreign Manipulation of Domestic Capital Markets
 
Moreover, when financial globalization is accepted as the most effective way for the economy of a developing country to achieve growth by attracting foreign investment and credit, the window for foreign speculative funds to manipulate its capital markets will be kept wide open.
 
In any open economy without capital control and with full currency convertibility, when growth is dependent on free flow of foreign capital and credit denominated in foreign currency which must be serviced with export earnings denominated in foreign currency, the only viable monetary options available to the monetary authority are extreme ones: floating exchange rate with autonomy in monetary policy, or fixed exchange rate without monetary autonomy. There are no hybrids available. The worst of both worlds is when a local currency is pegged to the fiat US dollar, a currency whose issuer follows a monetary policy exclusively designed only for the needs of the US economy, and not the needs of the economies which choose to peg the exchange value of their currencies to the dollar.
 
International Trade and Finance Liberation is a Domestic Political Issue
 
Both extreme options carry more negative than positive impacts. But these two extreme options cause different positive and negative impacts on the economy, with the government helpless in resisting the negative impacts and also in directing on which segment of the population the negative impacts fall. Usually, the financial elite, due to their better understanding of the rules of the game, can protect themselves with high priced advice at the expense of the defenseless poor. This makes global trade and finance liberalization domestic political issues in all trading economies. This fact also applies to the eurozone.
 
The Case of Argentina
 
In Argentina, by pegging the Argentine currency to the US dollar, macroeconomic policymakers opted to surrender monetary autonomy to the US Federal Reserve. Argentina abandoned floating exchange rates with the hope to achieve following objectives:
 
The Dollarization Option
 
However, the currency board regime of pegging the Argentine peso to the dollar had failed to actually yield the expected benefits. This failure stimulated discussion of “dollarization” for Argentina as a new monetary solution. But since Argentina had already given up its monetary autonomy by pegging its currency to the dollar to try in vain to bring about financial stability, there was no reason to expect that a more radical currency regime such as dollarization would work better. Surely, Argentine policymakers had learned from experience that the when Federal Reserve makes monetary policy decisions in Washington, the economic well-being of Argentina was never a consideration.
 
It is obvious that while dollarization eliminates currency exchange rate risks, it increases default risks in dollar-denominated sovereign debt. In a financial crisis, both currency exchange rate risk and sovereign debt default risk will be increased for Argentina. The same is true for the national economies in the eurozone. The adoption of the euro is in some ways equivalent to dollarization, since the constituent nations of eurozone have no control over monetary policy decision-making in the European Central Bank (ECB) or the European Monetary Union. This is again demonstrated by actual facts in the eurozone sovereign debt crisis where the likelihood of sovereign debt default in one nation pushed down the exchange rate of the euro.
 
The Dispute Over What Constitutes Sound Fiscal Policy
 
There is an undisputed general law in public finance that sound fiscal policies must precede a sound currency. What is in dispute is what constitutes a sound fiscal policy. Neoliberals deem recurring fiscal deficits as signs of unsound fiscal policy. Yet over the multi-year duration of most recession phases of business cycles in market economies, multi-year deficit financing to stimulate economic activities in a recession can be a very sound fiscal policy.
 
Under such circumstances, a balanced annual budget would be quite the opposite of a sound fiscal policy. Still, some recessions may take more than a decade to recover even with persistent fiscal deficits if the funds are spent on wrong targets, as in the case of Japan after the Plaza Accord of 1985.
 
In March 2005, the EU’s Economic and Financial Affairs Council (ECOFIN), under the pressure of France and Germany, relaxed the rules to respond to criticisms of insufficient flexibility and to make the pact more enforceable. Permissiveness infested the theoretical regulatory framework at the boom phase of the business cycle.
 
At the urging of Germany and France, the ECONFIN agreed on a reform of the Stability and Growth Pact (SGP).  The euro convergence criteria as spelled out in the SGP are:
1. Inflation rates:
2. Government finance:
3. Exchange rate:
4. Long-term interest rates:
       The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member            states.

The ceilings of 3% of GDP for budget deficit and 60% of GDP for public debt were maintained, but the decision to declare a country in excessive deficit can now rely on certain parameters: the behavior of the cyclically adjusted budget, the level of debt, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures. The pact is part of a set of Council Regulations, decided upon the European Council Summit on March 22-23, 2005. Having adopted unneeded permissiveness at the boom cycle, Germany is now leading the charge to reduce fiscal deficits in eurozone by promoting austerity programs in every eurozone member state in the midst of a severe recession.
 
The Curse of IMF Conditionalities
 
The problem with the IMF “conditionalities” cure in a sovereign debt crisis is its insistence on a balance fiscal budget at the wrong time – during a monetary-induced recession, thus adding to the economic pain unnecessarily and assigning disproportional burden on the most defenseless segment of the population – the working poor, and condemning the impaired economy to an unnecessarily long path toward recovery.
 
Argentina’s Convertibility Law of 1991
 
Without the Convertibility Law of 1991, economic reform in Argentina would not have progressed so far and so fast as to cause the severe debt crisis of 2001. In December 2001, after four years of deepening economic recession and mounting social unrest, the Argentina government collapsed and all sovereign debt payments ceased. Argentina had failed to pay her debt on time before, but this time it registered the largest sovereign default in its history. Argentina’s total public debt grew from a manageable 63% of GDP in late 2001 to a record-breaking and unsustainable 150% of GDP following default and devaluation in early 2002 because while the debt kept growing, the GDP was falling.
 
Argentina had to restructure over $100 billion owed to both foreign and domestic retail bondholders, with about $10 billion held by US investors, all demanding payment only in dollars. With free flow of capital funds, the rich Argentines could convert their pre-tax pesos to dollars to send them abroad and brought them back with leveraged dollar loan as foreign capital to buy Argentine sovereign bonds denominated in dollars that offered higher yields. The rich Argentines were profiting from carry trade with interest rate arbitrage against the peso in their home financial markets.
 
IMF Loans Exacerbated the Argentina Crisis
 
There are important questions related to the role IMF played in contributing to Argentina’s debt crisis. The IMF agrees that it may have hurt more than helped Argentina by lending too much for too long into an untenable situation. The IMF failed to define a clear threshold for identifying insolvency which if available would have helped Argentina avoid its debt crisis.
 
In not cutting off loan to Argentina sooner, the new additional IMF lending exacerbated rather than helped Argentina’s debt problem.  The new IMF loans displaced other older creditor debt for seniority in repayment, and left fewer financial resources to be used in assisting Argentina in post-crisis restructuring. This severely constrained Argentina’s debt workout options.
 
US Policy on Latin American Debt
 
During the Latin American debt crisis of the 1980s, the solvency of US creditors was of paramount concern for the US government and so they had the upper hand in negotiating sovereign restructurings. But the Bush Administration rejected the Clinton Administration policy of large sovereign debt bailouts and followed a policy of allowing market forces to resolve sovereign debt disruptions. This commitment, however, proved easier to articulate than enforce.
 
Although the Bush Administration did not jump to the bilateral rescue of Argentina as the Clinton Administration had with Mexico in 1995, it did make smaller efforts to intervene in Uruguay in 2002. In 2002, Uruguay and the U.S. created a Joint Commission on Trade and Investment (JCTI) to exchange ideas on a variety of economic topics.  
 
The Case of Uruguay
 
The Uruguay banking crisis imploded in July 2002, precipitating a massive run on banks by depositors and causing the government to freeze banking operations. The crisis was caused by a sharp contraction in Uruguay’s economy as a result of over-dependence on neighboring Argentina, which experienced an economic meltdown itself in 2001.
 
In mid-2002 Argentine withdrawals from Uruguayan banks started a bank run that was overcome only by massive borrowing from international financial institutions. This, in turn, led to serious debt sustainability problems. A successful debt swap helped restore confidence and significantly reduced country risk.
 
In total, approximately 33% of the country’s deposits were suddenly withdrawn from financial system and five major financial institutions were left insolvent. Hundreds of thousands of depositors in Uruguay, Argentina and Brazil were left in dire economic conditions after money in their bank accounts literally disappeared.
 
The banking crisis in Uruguay could have been avoided if Uruguayan regulators had properly overseeing the banks. The Uruguay Central Bank had relied on transnational banks to self-regulate and was too lax on financial regulation and too slow in responding to the banking crisis.
 
The early 1900s was Uruguay’s golden era. The country was rich from a very favorable market for beef and wool while much of Europe was out of food production during the war years. The country built up enough surplus wealth that it could support generous social programs and government-run industries that were introduced by President Jose Batlle. However, when the economy weakened in post-war id-1950s, the weight of the country’s social programs and large government payroll contributed to the country’s financial crisis as Europe came back into food production. The advance of synthetic materials cut into the market for hides and other animal products produced by Uruguay.
 
Marxist guerrilla group Tupamaros interpreted the financial crisis as a result of social inequities and mounted began a revolution that was crushed by a US-supported Military government that held power from 1973 to 1985.
 
Following the end of the Cold War, free market fundamentalism and globalization of trade and finance was adopted by many Latin American countries, including Uruguay, implementing free-market reforms to compete in the new globalizing world trade, resulting in income inequities and rising unemployment.
 
As a result, South America experienced a revival of left-leaning politics in Venezuela Bolivia, Brazil, Chile, Peru, and Uruguay. Uruguay first joined the trend of moving to the left with the election of President Tabaré Vázquez in 2004. Before his election to office, Vázquez campaigned for greater regionalism, higher external tariffs, import quotas, and public works projects financed by higher taxes. 
 
There was concern among the world financial community that if Uruguay adopted protectionist policies, while carrying the debt resulting from the 2002 financial crisis, the economy would collapse. However, rather than making a hard lurch to the radical left, Vázquez named pragmatic Dean of the Uruguayan University of Economics, Danilo Astori, a social democrat, as Finance Minister. Astori is a leader of the Asamblea Uruguay party, which is part of the ruling centre-left Broad Front party. Astori adopted an economic plan that aggressively courted foreign investment and increased trade opportunities to keep the Uruguayan economy growing. Social spending was increased, but within the framework of a balanced fiscal budget.
 
Vázquez’s populist politics and ideology flexibility in achieving his economic objectives, combined with Astori’s relatively pragmatic social democratic view of how the capitalist world operates, resulted in five straight years of economic growth despite the global financial crisis of 2008 and 2009. During the Vázquez administration, poverty was reduced from 37% to 26%, and a free internet-ready laptop computer was provided to every child in Uruguay.
 
Vázquez was praised for his administration’s fiscal discipline which enabled Uruguay to pay off a huge debt to the IMF made after the 2002 regional financial crisis. But then, near the end of his term, spending accelerated and the government went deep into debt despite the strong economy and new tax revenues.
 
Uruguay has strong political culture that favors substantial state involvement in the economy, and privatization is still widely opposed by voters. Recent governments have carried out cautious programs of economic liberalization similar to those in many other Latin American countries. They included lowering tariffs, controlling deficit spending, reducing inflation, and cutting the size of government. In spite of some de-monopolization and privatization over the past 10 years, the state continues to play a major role in the economy, owning either fully or partially companies in insurance, water supply, electricity, telephone service, petroleum refining, airlines, postal service, railways, and banking. The global financial crisis that began in the US in 2007 has caused Uruguay politics to be cautious about the wisdom of the neoliberal trends of the past decade.
 
The current president of Uruguay is José Alberto Mujica, (known as Pepe) who was elected in November 2009 and took office March 1, 2010. Mujica was a former Marxist Tupamaro guerrilla who participated in assault and kidnapping in the 1960’s and spent 13 years in prison. Mujica’s image as a leftist radical was softened during the campaign when he acknowledged that the economy was doing well and he would not make fundamental changes and would continue the direction set by Danilo Astori who had resigned from his ministry on September 18, 2008, and was succeeded by Álvaro García, a member of the Uruguay Socialist Party.
 
In February 2010, President Mujica and Astori as Vice President, jointly met with a group of mostly Argentine businesspeople in Punta del Este, where they promised that their administration would set clear rules, reasonable taxes, and respect private property rights. The message was that Uruguay plans to follow the path of South America’s “Responsible Left”.
 
US Support of IMF Loans to Argentina
 
More to the case in point, when Argentina repeatedly sought help from the IMF, the United States proved to be one of the strongest voices of support. Therefore, any criticism of the IMF’s costly response to Argentina cannot be divorced from US policy, which when faced with a serious developing country financial crisis, was unable to deviate significantly from the course taken by the previous administration. A proposal for an international bankruptcy agency, such as the Sovereign Debt Restructuring Mechanism (SDRM) promoted by the IMF, failed to take hold.
 
Argentina’s Debt Restructure
 
Argentina made a final offer to restructure its sovereign debt in June 2004, amounting to a haircut of 75% reduction in the net present value of its foreign debt. Although a better offer was expected by year-end, it was still the largest proposed write-down in the Post-WWII history of sovereign restructuring. Both foreign and domestic holders of Argentine government bonds rejected the workout proposal. Spooked by trouble brewing in Argentina, emerging-market investors stampeded out of Turkey on November 22, 2000, before the long US Thanksgiving holiday weekend, causing a financial crisis by contagion. (Please see my September 16, 2003 article: How Turkey’s Goose was Cooked)
 
Large-scale drastic sovereign debt restructuring for Argentina was needed urgently, since the debt had risen mathematically beyond the ability of Argentina to pay. The aim of debt restructuring is not to help the debtor, but to help the debtor to maximize its ability to pay back the creditors at the lowest possible discount, in preference over not paying at all. The principle is that a haircut is preferable to decapitation. But the haircut to foreign lenders was financed by scalping the working poor in Argentina.
 
However, the Argentine government still faced high barriers trying to refinance its sovereign debt by a work-out with creditors. Creditors (many of them private citizens in Spain, Italy, Germany, Japan and other countries, even Argentines whose money came back as foreign loans, who had invested their savings and retirement pensions in supposedly safe government bonds) denounced Argentina’s default by appealing for help from their respective governments. The Italian government lobbied against Argentina in international forums. Vulture funds which had acquired sovereign bonds at prices way below face value, demanded repayment in full immediately after default.
 
Argentina had depleted its dollar reserves. The Argentine central bank needed to hang on to what small amount of foreign exchange that it still held to maintain the availability of dollars in the local financial market, in order to prevent further devaluation of the peso. For four years following, Argentina was a credit pariah, effectively shut out of the international financial markets.
 
Even if the Argentine economy were to stabilize and improve with temporary emergency bailout, Argentine sovereign debt was still the largest defaulted debt up to that time in history (about $93 billion), and Argentina was in no position to pay its massive sovereign debt without turning into a failed state fiscally – by abdicating the normal financial responsibilities of government.
 
Yet the Argentine government kept a firm stance, and finally got a workout deal by which 76% of the defaulted bonds were exchanged by others, of a much lower nominal value (25–35% of the original) and at longer terms. Among these bonds, some were indexed based on the future economic growth of Argentina.
 
The terms of the debt exchange were not accepted by some of the private debt holders (amounting to a quarter of the debt). The IMF had lobbied for holdouts, but its position was greatly weakened by the anticipated payment made in January 2006.  
 
In the June 2005 report by the Argentine Ministry of Economy, the total acknowledged debt of the Argentine state amounted to $126.5 billion, down by $63.5 billion from the first semester as a result of the restructuring process. Of this, 46% was denominated in dollars, 36% in pesos, and 11% in euros and other currencies. Due to the full payment of the IMF debt and several other adjustments, by January 2006 the total figure decreased to $124.3 billion.
 
Debt bonds not exchanged in 2005 accounted for $23.381 billion, of which $12.7 billion were already overdue. Because no payments were made on these to creditors, Argentina was the only member of the G-20 unable to raise capital in the international financial markets.
 
Individual creditors worldwide, who represent about one third of this group, have mobilized to seek repayment from the Argentine state. Among the most prominent are The Task Force Argentina, an Italian retail bondholder association, and Mark Botsford, a private US citizen retail bondholder. The American Task Force Argentina, sponsored by a New York sovereign debt fund, stated their ultimate aim was to bolster the stability of global credit markets; work towards an equitable outcome for remaining creditors; ensure the integrity of US law (the long arm of which the group wanted to extend to sovereign Argentina); and strengthen crucial bilateral relations between the United States and Argentina. The group essentially wanted to turn Argentina into a US financial colony.
 
During the restructuring process of Argentine sovereign debt, the International Monetary Fund (IMF) was considered a “privileged creditor”, that is, all its debt was recognized and paid in full. In 2005, Argentina shifted from a policy of constant negotiation and refinancing with the IMF to a policy of payment in full, taking advantage of a large and growing fiscal surplus due to rising commodity prices, with the acknowledged intention of gaining financial independence from the IMF.
 
The Issue of Disindebtment
 
Joseph Stiglitz, Nobel laureate (2001) and former Chairman of the President Clinton’s Council of Economic Advisors (1995-97) and former Senior Vice President and Chief Economists of the World Bank (1997-2000), from which he was fired at the behest of then Treasury Under Secretary Larry Summers, criticized the IMF and supported the Argentine strategies on the debt restructuring, but opposed the “disindebtment” policy, suggesting instead that the IMF should be denied of its seniority and should receive the same treatment as other creditors.
 
The main points of criticism of disindebtment were, in the first place, that the large amounts of money used to pay off IMF debt were siphoned off from productive purposes within Argentina to speed up the recovery or from being used to come to terms with other outstanding creditors; and second, that the government traded comparatively low interest IMF credits for new issuance of public debt at much higher interest rates.
 
On December 15, 2005, President Kirchner announced his intention of liquidating all the remaining debt to the IMF, in a single payment of $9.810 billion, initially planned to take place before the end of the year (a similar move had been announced by Brazil two days before, and it was understood that the two measures were to be coordinated).
 
Argentina made some minor payments beforehand, but the main one, for about $9.5 billion, was delayed for accounting reasons and paperwork, and was finally made on January 3, 2006. The debt was in fact denominated in Special Drawing Rights (SDR - a unit used by the IMF and calculated over a basket of currencies). The Argentine Central Bank called on the Bank for International Settlements (BIS) based in Basel, Switzerland, where a part of its currency reserves were deposited, to act as its agent. The BIS bought 3.78 billion SDR (equivalent to about $5.417 billion) from 16 central banks and ordered their transfer to the IMF. The rest (2.87 billion SDR or $4.12 billion) was transferred from Argentina’s account in the IMF, deposited in the US Federal Reserve Bank in New York.
 
The payment served to cancel the debt installments that were to be paid in 2006 ($5.1 billion), 2007 ($4.6 billion), and 2008 ($432 million). This disbursement represented 8.8% of the total Argentine public debt and decreased the Argentine central bank’s reserves by one third (from $28.1 to $18.6 billion). According to the official announcement, it also saved about $1 billion in interest, though the actual savings amounted to only $842 million (since the reserves that were in the BIS were until then receiving interest payments).
 
The initial announcement was made in a surprise press conference that quickly became crowded with reporters. President Kirchner said that, with this payment, “we bury an ignominious past of eternal, infinite indebtment.” Many present later called the decision “historic”.
 
The head of the IMF at the time, Rodrigo Rato, saluted it, though remarking that Argentina still “faces important challenges ahead”. United States Secretary of the Treasury at the time, John Snow, said that this move “shows good faith” on the part of the Argentine government.
 
The day after the announcement of payment to the IMF, the price of the dollar in pesos jumped and then stabilized on 3.07 pesos (a 1.3% devaluation) after the Argentine central bank was forced to sell $270 million for pesos in the open market to withdraw pesos from circulation. The peso-denominated Argentine debt bonds declined by 3% in price, pushing the interest rate up to reflect a higher risk premium and the Buenos Aires Stock Exchange lost 1.9% in capitalized value.
 
After the initial surprise, reactions to the move were mixed, and the markets returned to quiet trading in a few days. Both President Kirchner and Economic Minister Felisa Miceli assured the public that the measure to pay the IMF would have a “neutral effect” in the economy, since the Argentine central bank’s dollar reserves were still enough to buy the whole monetary base in pesos.
 
Some analysts pointed out that the payment to the IMF was more a political move than a thought-out economic strategy. But there were disagreement on its long-term consequences. Minister Miceli said that the policy of accumulation of foreign currency reserves would continue and that the Argentine central bank would attempt to buy with pesos all the dollars that entered the market through foreign trade in 2006.
 
The central bank’s reserves surpassed their pre-IMF-payment levels on 27 September 2006. As a result of its aggressive dollar buying strategy, the exchange rate of the peso increased 8% in one year, reaching 3.12 pesos per dollar.
 
Merkel of Germany can learn from Chávez of Venezuela
 
Germany can learn from Venezuela’s effort in promoting Latin America regionalism. In August 2007, the President of Venezuela Hugo Chávez bought $500 million Argentine bonds which were due to the IMF. This was decided by Chavez two years earlier during the inauguration of Tabaré Vázquez as President of Uruguay.
 
This trade of bonds would be the Argentine third emission of Bono del Sur by Venezuela under Chávez, as a proposal for an alternative financing mechanism for Latin America. It aims at supporting regional integration via financing cross-border projects. The bonds purchases are funded by borrowing states: Argentina, Brazil, Venezuela, Ecuador, Bolivia, Uruguay and Paraguay.
 
The program was dismissed out of hand by neoliberals as a pipe dream that would end in disaster. Yet there have been three successful tranches of debt issued at $3 billion value. The bonds, purchased by local and international investors have performed rather conventionally.
 
The project was consistent with Venezuelan foreign policy aims to reduce Latin American dependence on Washington by assisting friendly governments to promote regional integration, The $5.5 billion aid programme came as subsidized loans and below market gasoline to Central and South American governments. The $3.4 billion purchase of Argentine bonds plus the purchase of Ecuadorian bonds were announced the day that Venezuelan joined the South American customs union, Mercosur. Financing program was linked to a new institution, the Banco del Sur, that Venezuela was constructing with South American partners.
 
From 2005 to 2006, Venezuela had already bought more than $3 billion bonds from Argentina, issued by the Argentine government following the debt restructuring. In total, Venezuela bought more than $5 billion bonds from Argentina since 2005.
 
If Germany is really interested in keeping the EU together and keeping the euro going, she should follow Venezuela’s example on Argentina and buy Greek government bonds as well as sovereign bonds of other PIIGS states in the eurozone.
 
Argentina in Better Shape than the US
 
In 2009, the Argentine economy grew at a rate of 0.9% compared to a growth rate of 6.8% in 2008 and 9.2% in 2005. Inflation in 2009 was 11.7% and unemployment at 8.7%.  Argentina's economy increased 9.7% during May 2010 year-on-year. During the first five months of the year it accumulates a 6.5% increase. The currency (ARS) traded at 3.9205 peso to the dollar on June 4, 2010.
 
By comparison, the US economy grew only 0.18% in 2009 and contracted by -1.83% in 2008. The dollar itself is not in great shape. It has risen against the euro by default, not because the US economy is on a recovery path or that the dollar is immune to massive Fed quantitative easing.
 
US Unemployment Worse than Argentina
 
Unemployment in Argentina was 7.9% in 2009. By comparison, notwithstanding President Obama’s upbeat portrayal, the US jobs report for May and June 2010 showed an economy in deep depression. The private sector in which neoliberal market fundamentalists place exclusive hope for providing gainful employment, created only 41,000 jobs in May, most of which were temporary positions, for an economy of 310 million people. The 2010 decennial census employed 411,000 temporary minimum pay workers kept the unemployment rate artificially low.
 
Total non-farm payroll employment declined by 125,000 in June, 2010 and the unemployment rate edged down to 9.5%, according to the U.S. Bureau of Labor Statistics. The decline in payroll employment reflected a decrease (-225,000) in the number of temporary employees working on Census 2010.
 
Private-sector payroll employment edged up by 83,000 in June. Among the major worker groups, the unemployment rate for adult women (7.8%) declined, while the rates for adult men (9.9%), teenagers (25.7%), whites (8.6%), blacks (15.4%), and Hispanics (12.4%) showed little or no change. The jobless rate for Asians was 7.7%, not seasonally adjusted.
 
In June, the number of long-term unemployed (those jobless for 27 weeks and over) was unchanged at 6.8 million. These individuals made up 45.5% of unemployed persons. The civilian labor force participation rate fell by 0.3% point in June to 64.7%. The
employment-population ratio, at 58.5%, edged down over the month. The number of persons employed part time for economic reasons (sometimes referred to as involuntary
part-time workers), at 8.6 million, was little changed over the month but was down by 525,000 over the past 2 months. These individuals were working part time because their hours had been cut back or because they were unable to find a full-time job.
 
In June, about 2.6 million persons were marginally attached to the labor force, an increase of 415,000 from a year earlier. (The data are not seasonally adjusted.) These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.
 
This is dismal performance on the job market even after a stimulus package of some two trillion dollar: the $787 billion American Recovery and Reinvestment Act of 2009 (ARRA), the $152 billion Economic Stimulus Act of 2008 by the previous Bush Administration, the $700 billion Emergency Economic Stabilization Act of 2008, commonly referred to as a bailout package for the U.S. financial system, and the $356 billion Troubled Asset Relief Program (TARP) to purchase assets and equity from financial institutions to strengthen its financial sector.
 
More than 15 million workers are officially unemployed, half of whom had been out of work for more than six month or longer, with millions more too discouraged to continue to try to look for work. Those who are still working are mostly under-employed in relation to their education and experience and past income. Teachers are also hard hit by unemployment while the student population continues to rise. Public sector workers, particularly in state and local government are facing massive layoffs, many in the social services sectors. The official unemployment rate for May 2010 was 9.7% and for June was 9.5%, but in many disadvantaged segments of the population in the most distressed regions in the country, the unemployment rate reaches over 50%.
 
US Public Debt Higher than Argentina
 
US public debt as of July 8, 2010 was $ 13.192 trillion against a projected 2010 GDP of $14.743 trillion. As of April 2010, China held $900.2 billion of US Treasuries, ranking top surpassing Japan’s holding of $795.5 billion.  As of 2007, outstanding GSE debt securities (non-mortgage and those backed by mortgages) summed up to $7.37 trillion.
 
Former Treasury Secretary Hank Paulson revealed in his recently published memoir that in August 2008 while attending the Olympics in Beijing, he was informed by Chinese officials that “Russian officials had [earlier] made a top-level approach to the Chinese suggesting that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies.” GSE debts are issued by Government-Sponsored Enterprises Fannie Mae and Freddie Mac.  Paulson said while “the Chinese declined to cooperate”, the report was nonetheless “deeply troubling,” as “heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets.”
 
In an Op-Ed article in the June 14, 2010 edition of Foreign Affairs by Ben Steil, Senior Fellow and Director of International Economics, and Paul Swartz, Analyst, Center for Geoeconomic Studies, the authors suggests that “with the U.S. needing to sell another $1.3 trillion in debt in 2009, the risk Paulson describes is certainly real.” 
 
They point out that over the past decade, foreign ownership of US debt has increased dramatically.  Foreign holdings of Treasurys have risen from 29% to 48% of the outstanding stock, while foreign holdings of U.S. government agency and GSE backed debt have increased from 6% to 16%.  Virtually the entire increase in both has been accounted for by foreign governments, as opposed to private investors.  And one government dominates: China.  By the authors’ estimates, China has accumulated an astounding $850 billion in Treasuries and $430 billion in agency debt over the decade - almost half the total foreign government accumulation. (As of April 2010, China held $900.2 billion of US Treasuries, ranking top surpassing Japan’s holding of $795.5 billion.)
 
The authors report that to some, the fear that the Chinese might dump U.S. debt is misguided. “It would be very much against their own interest to do so,” Federal Reserve chairman Ben Bernanke said back in 2006.  Heavy selling would precipitate precisely the fall in the dollar's local and global purchasing power that the Chinese fear.  So the Chinese would not cut off their noses to spite their faces.
 
But the same faulty argument can be made about anyone caught in a Ponzi scheme, the authors warn.  No one who finds himself in a Ponzi scheme wants to see it collapse, yet he will still sell because he knows he will be worse off if others sell first.
 
So, the authors ask, how serious is the risk of strategic, coordinated foreign selling, of the type that could destabilize financial markets?  They answer that “Here is where Paulson drops the ball.  He tells us only that China rejected the Russian scheme to coordinate the mass dumping of GSE debt.  Yet large-scale near-simultaneous selling is precisely what happened.  By our calculations, Russia sold $160 billion worth, virtually all of its holdings, over the course of 2008, while China sold nearly $70 billion worth between June 2008, when its holdings peaked, and the end of that year.”
 
And while the fire sale went on the yield spread between GSE debt and U.S. Treasury debt soared.  From 2003 to 2007 it averaged 34 basis points.  When Russia started selling GSE debt in January 2008, it stood at 57 basis points.  When China started selling in July, it hit 86 basis points.  As GSE debt was widely used as collateral in the U.S. repo market, the rising spread forced U.S. financial institutions to pony up more and more securities to support their borrowing.  The government put the GSEs into conservatorship in September.  Yet Chinese and Russian dumping of GSE debt accelerated into the fourth quarter of 2008, as did spreads, which peaked in November at over 150 basis points.

This episode highlights the clear risks to the US, and indeed the wider world, of growing American dependence on foreign government lending, the authors conclude.
 
US Owes No Foreign Debt Denominated in Foreign Currencies
 
The question the authors of the Op-Ed piece did not ask was why the US, while vulnerable, is not critically over a barrel by massive foreign holdings of US sovereign debt.  The reason is because US sovereign debts are all denominated in dollars, a fiat currency that the Federal Reserve can issue at will. The US has no foreign debt in the strict sense of the term.  It has domestic debt denominated in its own fiat currency held in large quantities by foreign governments. The US is never in danger of defaulting on its sovereign debt because it can print all the dollars necessary to pay off foreign holders of its debt. There is also no incentive for the foreign holders of US sovereign debt to push for repayment, as that will only cause the US to print more dollars to cause the dollar to fall in exchange rates.
 
Dollar Hegemony Allows the US to Borrow Without Repayment
 
In this situation, the borrower enjoys market power over the lender. This advantage that the US enjoys comes from dollar hegemony, a peculiar condition in global finance in which the dollar, a fiat currency that the US can issue at will, is recognized worldwide as a reserve currency for international trade because of US geopolitical power with which to force the trading of critical basic commodities to be denominated in dollars. Everyone accepts dollars because dollars can buy oil and every economy needs oil. Granted, one can buy oil also with euros and yen, but only because these currencies are freely convertible to dollars, and therefore they are really derivative currencies of the dollar.

But this is not quite a free ride. Although the US is getting low-price imports paid for with paper dollars that it will never have to buy back with gold, this type of trade comes with is a penalty of losing low-paying manufacturing jobs overseas, mainly to China. In recent months, as the Chinese government realizes that a low-wage economy is an underdeveloped economy, it has encouraged Chinese workers to demand higher wages through collective bargaining and strikes. Low-wage jobs then will move by transnational corporations to other underdeveloped low-wage economies such as Vietnam, Indonesia and some countries in Central and Latin American. But this type of trade globalization through cross-border wage arbitrage also pushes down wages in the US and other advanced economies, causing insufficient  consumer income to absorb rising global production. The result is global overcapacity. This is the main cause of the current financial crises which have made more severe by financial deregulation. But the root cause is global overcapacity due to low wages of workers who cannot afford to buy what they produce. It is not enough to merely focus on job creation. Jobs must pay wages high enough to eliminate overcapacity. In stead of a G20 coordination on fiscal austerity, there needs to be a G20 commitment to raise wages globally. 
 
Argentina in the Current Global Financial Crisis
 
Unlike the US, Argentina has been shunned from the international capital markets for eight years since a default of nearly $100 billion in 2002. The country is now trying to regain investor confidence as it faces tight financing in 2010.
 
Economy Minister Amado Boudou was quoted as saying in a local paper Argentina’s economy could grow up to 7% in 2010 as the worst of the global financial crisis eases. Critics note that the Argentine government has a record of being too optimistic with its economic expectations. Most market analysts had forecasted the economy to contract in 2009. The actual data showed Argentina growing at 0.9% in 2009.
 
In December 2009, Argentina filed a shelf offering with the US Securities and Exchange Commission for the sale of debt instruments in the United States. Argentina launched an offer in January 2010 to swap some $20 billion in defaulted debt that is still in the hands of "holdout" investors who did not accept a controversial debt restructuring in 2005. The government announced it could allow retail “holdout” creditors not to subscribe to fresh capital in a swap of defaulted debt that aims to allow Argentina to return to the international debt markets. A deal with those investors is essential for Argentina to be able to issue new international bonds. Argentina plans to swap defaulted sovereign bonds for new issues.
 
Argentine center-left President Cristina Fernandez’s approval ratings fell to a low of 20%. She took over from her husband and predecessor, former President Nestor Kirchner in late 2007, but their hopes that he could return to power seemed dim as the economy stagnated and their popularity ratings languished. Fernandez fell out of favor with voters over her handling of a 2008 tax revolt by farmers. She is however getting a boost by default from the opposition’s failure to unite and achieve major policy victories since gaining ground in Congress in a mid-term election last year.
 
The center-left Kirchners have increased state control over the economy, nationalizing private pension funds and soccer broadcasts, imposed some import barriers and also stepped up intervention in financial and grains markets. Nestor Kirchner ruled during Argentina’s rebound from the deep 2001-2002 crisis, overseeing a five-year economic boom that helped his wife win an easy victory in the presidential election of 2007.
 
However, Cristina has fought back in recent months, cranking up welfare for poor children and pensioners as she seeks to shore up her support base: union workers and the urban poor in populous Buenos Aires province, which rings the capital. If not further hampered by debt problems, the Argentine economy exhibits strength despite the global downturn. Car exports to giant neighbor Brazil have picked up, and a record soy crop is generating foreign exchange income.
 
If the experience of Argentina is any guide, Greece and other eurozone small economies, will be facing a lost decade in economic growth in order to save the euro.
 
Trade with China
 
Argentina is the world’s biggest producer of soybean oil and supplies about 80 percent of Chinese demand. Argentina primarily ships crude soybean oil, which must be refined before human consumption, to the Asian nation. However, trade dispute has risen between the two trading partners. China stopped approving permits to import soybean oil from Argentina, the world’s biggest supplier of the edible oil, after Argentina increased anti-dumping measures against Chinese imports. 
 
On March 29, 2009, China and Argentina have made a tentative agreement to swap $10 billion worth of their currencies.  Argentina will be able to buy the yuan directly, without changing it to dollars. The move, which allows both countries to bypass the US dollar, makes it easier for Argentine businesses to buy Chinese imports directly in yuan. It also gives Argentina hard cash at a time when its finances have been hurt by the global financial crisis.
 
The deal comes after China suggested that the world should create a new reserve currency to replace the dollar. The swap is being seen as a sign of China's ambitions in South America.  China primarily imports agricultural products from Argentina, while the South American nation buys Chinese electronic goods. In the recent past, China has signed similar deals with South Korea, Malaysia, Belarus and Indonesia.
 
The two nations agreed to a three-year currency swap totaling 70 billion yuan, ($10 billion). China's state news agency, Xinhua, reported earlier that Argentina could use the deal to pay for Chinese imports in yuan. But the Central Bank official said the deal's main goal is to restore confidence in the Argentine government's ability to manage the value of the peso.
 
“In our case, the ability to access a significant amount of yuan, in exchange for pesos, is equivalent in practice to being able to restore our financial position if circumstances warrant it,” the official said. China has done similar swaps with other countries but this is its first deal with a Latin American nation.
 
China is Argentina's No. 2 trade partner. The Asian giant imports about two-thirds of Argentina's top export, soybeans. China also has voiced increasing interest in other commodities, not just in Argentina but around the region.
 
The peso has been weakening slowly but consistently since mid-2008, when a major farm strike here spooked investors and led many Argentines to trade in their pesos for dollars. But the peso's decline has picked up speed in recent weeks amid a scarcity of dollars in the local exchange market. That lack of dollars has been aggravated recently as farmers have refused to export grains.
 
To prevent the currency from weakening abruptly, the Central Bank has placed tight controls on banks and forced traders to operate within certain ranges. Government inspectors, including tax officials, have repeatedly visited banks and exchange houses to pressure them into following the Central Bank's trading guidelines. The Central Bank carefully monitors trades and injects dollars into the market on a daily basis to prevent the peso from losing value quickly. But in recent weeks, as demand for dollars has risen alongside increased political noise, the bank used more of its reserves to meet demand.
 
This has led to increased speculation that the government, which is hesitant to use reserves to defend the peso, will let peso depreciate rapidly after a hastily arranged congressional election scheduled for June 28, 2009. But Central Bank officials downplayed this idea, saying the bank’s currency management strategy will remain in place after the election.
 
“The bank has a lot of confidence that its management strategy is the best policy available,” an official said. “The bank’s policy isn’t tied to the electoral calendar. It's going to be the same after the election as it was before the election.”
 
Argentine President Cristina Fernandez de Kirchner is pursuing a restoration of $2 billion soya trade with China in talks begun after she arrived in Beijing on July 11, 2010. China is holding back on soybean oil imports from Argentina, complaining of chemical contamination, in a move seen by observers as retaliation for Argentine curbs on Chinese imports.
 
Before Fernandez landed in Beijing, Buenos Aires repeatedly denied it had engaged in any underhanded curbs on imports from China. Published reports, however, cited Fernandez government’s unhappiness over “dumping” of cheap Chinese goods into Argentina's market.
 
Chinese officials likewise show no acknowledgment a trade war is afoot behind the scenes or that their decision to suspend soybean oil imports from Argentina is anything but scientists’ reaction to contamination in the soybean oil.
 
However, China began diverting its imports to other countries, including the United States, as news spread of Argentine restrictions on a whole range of Chinese imports. Analysts cited similarities between the Argentina-China trade tussle and Argentina-European row earlier in June which led to European Union taking its grievance to the World Trade Organization. In that instance, too, Argentina denied restricting European goods' entry but EU officials said they had evidence of "unofficial" blocking of EU merchandise at Argentine ports.
 
The difference between the two scenarios is that Argentina's $2 billion earnings from soybean oil sales to China are at risk while Chinese imports of the commodity remain suspended.
 
Fernandez cited “strategic” partnership between Argentina and China but it wasn't clear if the talks had led to a resolution of the key issue of a resumption in the soybean oil trade.
Fernandez is under mounting pressure from Argentina's business community to secure a resumption of the trade, as the consequences of a continued Chinese ban are seen likely to be disastrous for Argentina's soya industry.
 
Argentina is the world's leading producer of soybean oil and in 2009 China purchased 4.6 million tons equivalent to 70 percent of Argentina's exports of the commodity. CEPAL, the U.N. Economic Office for Latin America said that between the end of 2008 and January 2010, two-thirds of the 33 "disloyal trade" claims from Argentina before the WTO were targeted at China.
 
Fernandez also upset the Chinese when she canceled a scheduled official trip to China earlier in the year as her government fought the opposition on the use of Central Bank's foreign currency reserves to meet debt payments.
 
Fernandez apologized to Chinese President Hu Jintao over the cancellation but the issue of soybean oil trade suspension remains unresolved.
 
Argentine goverment said on June 15, 2010 it had reached an agreement with China to end the Asian giant’s freeze on Argentine soyoil imports, bringing a possible end to a two-month old trade dispute.
 
China, the world’s largest buyer of soyoil, halted shipments from Argentina, the top global exporter, in late March following anti-dumping measures imposed by the South American country on some Chinese manufactured goods.
 
Argentina is the world’s biggest exporter of soyoil and soymeal, as well as the third global supplier of soybeans. In 2009, the South American country exported 1.84 million tonnes of soyoil to China, worth $1.4 billion and accounting for 77 percent of all Chinese soyoil imports. In 2009, Argentina reaped $16.19 billion from its soy exports -- which include the oilseed, oilmeal and oil derivatives. In 2010, soy exports could reach $17 billion. In 2009, Argentina registered a $1.2 billion trade deficit with China, a 71 percent increase from 2008. During the first two months of 2010, the trade deficit was $600 million.
 
Cargill, Bunge, Louis Dreyfus, Aceitera General Deheza and Molinos Rio de la Plata are the country's main soy-exporting companies. Argentina's 2009/10 soy harvest is forecast to reach a record 54 million tons.

Brazil, the world’s second-largest soybean producer, said it is “ready” to boost exports to China after it blocked shipments of the oilseed from Argentina, its largest supplier, over a trade dispute. Brazilian President Luiz Inacio Lula da Silva discussed the country’s potential for increasing soy oil shipments with Chinese President Hu Jintao during their meeting in Brasilia on April 16, 2010.
 
Similarly, as EU member states looks to trade with China to help speed up economic recovery, it would be counterproductive for the EU to fan trade disputes with China.  A two-day review of China’s trade policy and practice has concluded in Geneva on June 2, 2010 with the EU praising China’s impressive role in world trade and its swift rebound from the global financial crisis. A closing statement said the EU believes China could have a positive knock-on effect on other economies if it uses its vast stimulus package to boost internal demand and sticks to its WTO promise for an open economy. China, as a leading trading nation, is subjected every two years to this comprehensive multilateral peer-review. However, for international trade to be constructive, a new international finance architecture to replace dollar hegemony is a fundamental prerequisite.
 
July 12, 2010
 
Next: Effects of the Greek Sovereign Debt Crisis on the ECB