America's selective strong dollar policy

America's selective strong dollar policy

By
Henry C K Liu

This article appeared in AToL on August 14, 2003

With its current account deficit approaching US$600 billion this year and the federal deficit running at $450 billion, the United States needs to attract about a net $5 billion of funding every working day, much of it from overseas. That is 5 percent of US gross domestic product (GDP) in nominal value. Assuming money velocity at a conservative multiple of five, foreign fund inflow supports 25 percent of the US economy. A weak dollar is supposed to make it easier to meet this funding requirement, as well as helping to reduce the trade deficit by making exports cheaper and import more expensive. But a falling dollar reduces the net yield of foreign-own dollar debts, generating incentives for foreign holder of US bonds to sell. Therein sits the rationale behind the US Treasury's selective strong-dollar policy, designed to reduce any incentive for large foreign holders of US bonds, such as Japan, to withdraw from the US bond market.

While a strong-dollar policy has officially continued from the administration of president Bill Clinton to the current administration of George W Bush, US Treasury Secretary John Snow, at a Group of Seven (G7) finance ministers' meeting in France in mid-July, defined the strong-dollar policy in what the market considered weak terms. "What you want to be strong is that you want people to have confidence in your currency, you want them to see a currency as a good medium of exchange," he explained. This describes a sound-dollar policy rather than a strong-dollar policy. What Snow was really saying is that you want certain foreigners, such as the Japanese and the Chinese, to continue to buy US bonds.

Federal Reserve governor Ben S Bernanke remarked before the National Economists Club in Washington, DC, last November 21: "In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the secretary of the Treasury has expressed the view that the determination of the value of the US dollar should be left to free market forces." Less than two weeks later, Paul O'Neill, the treasury secretary Bernanke referred to as having expressed that view, was told by the White House to resign on December 5.

In February 2001, O'Neill said publicly: "We are not pursuing, as often said, a policy of a strong dollar. In my opinion, a strong dollar is the result of a strong economy." Financial markets reacted with massive dollar selling, forcing the Treasury Department to issue this clarification a day later: "The secretary supports a strong dollar. There is no change in policy."

O'Neill explained on February 18: "I guess I made a mistake in thinking it was okay to talk beyond simplistic things. So I'll make it very clear: I believe in a strong dollar, and if I decide to shift that stance I will hire out the Yankee Stadium and some rousing brass bands, and announce that change in policy to the whole world."

O'Neill was right that the exchange value of the dollar is not the stuff of "simplistic things". The US economy has locked on to a strong-dollar policy for almost a decade. The US government cannot explicitly abandon it without undermining international market confidence in the dollar, promoting an exodus from US bonds and pushing up long-term interest rates.

While since the start of 2002 the dollar has fallen as much as 30 percent from its peak against the euro, it does not add up to an end of the strong-dollar policy. The United States has been sanguine about the rapid decline of the dollar only against select currencies. Since its low for the year in mid-June, the dollar has rebounded by 6 percent against the euro.

When O'Neill, Snow's predecessor, argued that markets rather than governments should determine exchange rates, he was asserting that US government policies would aim at preserving long-term market support for the dollar. He claimed he had been misunderstood that he meant a strong-dollar policy was no longer in place. The misunderstanding actually came not from the market being simplistic, but from the mismatch of the neo-liberal myth of a free market in foreign exchange, as espoused by central banks, and the market's view of the fact that the foreign-exchange market is anything but free.

During the Clinton administration, Robert Rubin, widely regarded as the father of the strong-dollar policy, declared his aim of a strong dollar soon after his appointment to the Treasury in January 1995. Rubin understood that a capital account surplus is the answer for a current account deficit, based on economics worked out by Martin Fieldstein in the Ronald Reagan administration. A strong dollar is key to this capital account surplus/current account deficit strategy, which has come to be known as dollar hegemony.

The policy exploits the instinctive penchant of other countries to make export gains from an undervalued currency. The United States would open its huge market to the exporting economies of the world and force them to finance the resultant US trade deficit with capital inflows from the exporting economies. A strong dollar ensures the appeal of US companies to overseas investors and thus aligning global support for a strong dollar. Dollar hegemony forces the central banks of US trading partners to hold their dollar trade surplus in US bonds and assets, if they want protection from speculative attacks on their currencies. A fall in domestic currency will cause domestic interest rates to rise, and make dollar loans more expensive to service and amortize.

As US domestic demand skyrocketed in the late 1990s, the 30 percent rise in the trade-weighted dollar between 1996 and 2001 helped keep a lid on domestic inflation and kept dollar interest rates low, even as the Fed began to hike the Fed Funds rate target to preempt wage-pushed inflation caused by structural full employment (at 4 percent unemployment). While US companies managed to attract overseas investors with low yields that translated into high yields in their own home currencies by a strong dollar, the inflow also financed the merger/acquisition mania of US companies that made the resultant entities fiercely competitive global giants.

The budget surplus of the Clinton years did not slow down inflow of funds, which readily went to finance mergers and acquisition and initial public offerings (IPOs). The easy money and credit milked from the backs of underpaid workers in the exporting economies enabled the US economy to venture into new technological fields, such as digitized telecommunication that spurred the dot-com fever, structured finance that gave birth to the hedge funds industry, and all manners of financial and accounting acrobatics. Wealth was being created as fast as the United States could print money, with little penalty of inflation. The rest of the world was shipping products they themselves could not afford to consume to US consumers in exchange for papers of the US financial system that in turn feeds US consumer power with debt.

A new economic sector called financial services came into existence. This was the true meaning of the slogan "a strong dollar is in the national interest". Dollar hegemony allowed the United States to levy a tax on the rest of the world for using the dollar, a fiat currency, as the reserve currency for world trade. The livelihood of the world's workers came to depend on US consumers' appetite for debt sustained by loans from the underpaid workers' own governments. Neo-imperialism works by making the world's poor finance the high living of the world's rich. It transcends the Marxist notion of class struggle and surplus value. In neo-liberal globalization, not just labor but even capital comes from the exploited.

What the Wall Street Journal calls mass capitalism would not have been half-bad if it were not for the fact that the hard-earned capital was squandered through fraud and Ponzi schemes. These new ventures financed by fund inflows did strengthened the US economy at first. But as the real economy in the United States did not grow as fast as the inflow of funds, because fewer and few things were being produced in the US, the excess funds soon channeled toward manipulation and fraud on a massive scale, resulting in financial scandals such as LTCM, Enron, WorldCom, Global Crossing, and thousands of less-known bankruptcies.

Much of the disaster came from the smoke and mirrors of so-called financial services, based on minute technical quantitative advantages that seem benign by themselves, but can accumulate into huge profit or loss in hundreds of billions of dollars on the turn of a penny. Hundreds of billions of dollars of investment and credit went up in smoke from fraudulent schemes perpetrated not only by management under the coaching of ever-enterprising investment banks, but also with the active, knowing participation of the banks, robbing workers and retirees the world over of their pensions and life savings.

Domestic jobs in the United States were eliminated by the millions and shipped overseas, while overseas workers were told to be thankful for inhuman wages and sweatshop conditions that at least warded off starvation. Instead of confessing their regulatory failings, US officials such as Alan Greenspan of the Federal Reserve took comfort in the role derivatives played in allegedly smoothing over massive financial shocks in the system, making the damage longer-lasting. Falling wages and worker benefits were cushioned by the wealth effect from speculation by people who could not afford the risk. Now that the US economy is trapped in a prospect of decade-long slow growth with a pending onslaught of deflation, and the hollowing-out of blue-collar manufacturing and white-collar high-tech sectors, Greenspan has told Congress that the threat of deflation remains "remote" and that thinking jobs are better that doing jobs.

What Greenspan told Congress makes perfect sense in the context of a new strategy for an American empire. The hollowing out of America's manufacturing and digital sectors becomes a compelling rationale for US control of the world to protect its offshore sourcing. After all, wars have been fought to protect the supply of oil in places where nature has placed it; why should the United States not fight to protect where the "free" market puts its manufacturing and data processing? In this strategy, the US needs only two things: a powerful military with instant power-projection capability everywhere around the globe, and dollar hegemony to print dollars that can buy all the things that the world makes for export to the US. The British Empire was rationalized by the need of Britain to import food as domestic agriculture became crowded out by industry. Similarly, the US Empire will be rationalized by the need of the United States to import manufactured goods as domestic production is crowded out by financial services.

There are only two difficulties with this grand strategy: 1) to build the ideal empire, US workers will have to be retrained for the service sector and large numbers of both blue- and white-collar workers will fall through the cracks - and that creates problems in a democracy; and 2) the rest of the world is not stupid and may not take it lying down. So freedom and democracy at home will have to be modified in the name of homeland security and foreign resistance will have to be crushed in the name of freedom and democracy. The "war on terrorism" is tailor-made for this grand strategy.

There are clear signs that US workers are not taking it lying down. Representative Bernard Sanders (Independent, Vermont) interrupted Greenspan during a congressional hearing on July 16: "I think you just don't know what's going on in the real world. And I would urge you, come with me to Vermont, meet real people. The country clubs and the cocktail parties are not real America. The millionaires and billionaires are the exception to the rule."

In a blistering diatribe, Sanders told Greenspan: "I have long been concerned that you are way out of touch with the needs of the middle class and working families of our country, that you see your major function in your position as the need to represent the wealthy and large corporations.

"And I must tell you that your testimony today only confirms all of my suspicions, and I urge you - and I mean this seriously, because you're an honest person, I think you just don't know what's going on in the real world - and I would urge you come with me to Vermont, meet real people. The country club and the cocktail parties are not real America. The millionaires and billionaires are the exception to the rule.

"You talk about an improving economy while we have lost 3 million private-sector jobs in the last two years, long-term unemployment is more than tripled, unemployment is higher than it's been since 1994.

"We have a $4 trillion national debt, 1.4 million Americans have lost their health insurance, millions of seniors can't afford prescription drugs, middle-class families can't send their kids to college because they don't have the money to do that, bankruptcy cases have increased by a record-breaking 23 percent, business investment is at its lowest level in more than 50 years, CEOs [chief executive officers] make more than 500 times of what their workers make, the middle class is shrinking, we have the greatest gap between the rich and the poor of any industrialized nation, and this is an economy that is improving.

"I'd hate to see what would happen if our economy was sinking.

"Now, today you may not have known this - I suspect that you don't - but you have insulted tens of millions of American workers.

"You have defended over the years, among other things, the abolition of the minimum wage - one of your policies - and giving huge tax breaks to billionaires.

"But today you have reached a new low, I think, by suggesting that manufacturing in America doesn't matter. It doesn't matter where the product is produced. We've lost 2 million manufacturing jobs in the last two years alone; 10 percent of our workforce. Wal-Mart has replaced General Motors as the major employer in America, paying people starvation wages rather than living wages, and all of that does not matter to you - doesn't matter.

"If it's produced in China where workers are making 30 cents an hour, or produced in Vermont where workers can make 20 bucks an hour, it doesn't matter. You have told the American people that you support a trade policy which is selling them out, only working for the CEOs who can take our plants to China, Mexico and India.

"You insulted [Representative Michael] Castle. Mr Castle, a few moments ago - a good Republican - told you that we're seeing not only the decline of manufacturing jobs, but white-collar information technology jobs.

"Forrester Research says that over the next 15 years, 3.3 million US service industry jobs and $136 billion in wages will move offshore to India, Russia, China and the Philippines.

"Does any of this matter to you? Do you give one whit of concern for the middle class and working families of this country? That's my question."

Then the following exchange took place:

Greenspan: Congressman, we have the highest standard of living in the world.

Sanders: No, we do not. You go to Scandinavia, and you will find that people have a much higher standard of living, in terms of education, health care and decent-paying jobs. Wrong, Mister.

Greenspan: May I answer your question?

Sanders: You sure may.

Greenspan: Thank you. For a major industrial country, we have created the most advanced technologies, the highest standard of living for a country of our size. Our economic growth is crucial to us. The incomes, the purchasing power of our employees, our workers, our people are, by far, more important than what it is we produce. The major focus of monetary policy is to create an environment in this country which enables capital investment and innovation to advance. We are at the cutting edge of technologies in the world. We are doing an extraordinary job over the years. And people flock to the United States. Our immigration rates are very high. And why? Because they think this is a wonderful country to come to.

Sanders: That is an incredible answer.

Payrolls outside the agricultural sector fell by another 44,000 in July, the sixth consecutive monthly fall. The unemployment rate fell to 6.2 percent from 6.4 percent - because an estimated 556,000 US residents dropped out of the labor force through discouragement.

While Greenspan is losing his infallible image, Congress is nevertheless making only helpless noises about the need for a weaker dollar to revive struggling US manufacturers without sparking inflation. The logic is to increase export through a weak dollar and to retain jobs at home by making imports more expensive. Under these conditions, it seems only natural that the United States should not object to a weaker currency.

The reality is that while a weak dollar makes imports more expensive, it might only reduce import volume but not necessarily the total import value, and while US export may become more price-competitive, a drop in US import may also reduce foreign purchasing power for US exports. Thus the US may increase export volume but not necessarily increase total export value. The only beneficiary is likely to be US transnational corporations with foreign revenue whose dollar profit from non-dollar operations will be boosted by a weak dollar, thus neutralizing any incentive for overseas investors to sell US equity. The fact is that once jobs are being done for 30 cents an hour overseas as a result of "free" trade, the only way these jobs will return to the United States is if employers can find workers in the US who will work for 30 cents an hour. The solution has to be a rapid rise of wages outside the G7 economies that rapidly increase the purchasing power of non-G7 workers.

So far, even with the US dollar at four-year lows against the euro and six-year lows against the Canadian dollar, overseas investors have chosen simply to hedge their currency risks instead of abandoning US assets. Yet today's unregulated financial markets can turn suddenly. If an accelerated fall in the dollar starts to disrupt asset markets and pushes up interest rates, the United States may need to reactivate fully the half-dormant strong-dollar policy. Recent concerns for the budget and trade deficits appear to be undermining already shaky market sentiment further and risk sparking a spiral of dollar selling. The twin deficits imply that the US needs strong inflows into the dollar daily to maintain its value, and if foreign investors become fearful that the currency could fall sharply, those inflows could drop off. There are signs that this fall-off is happening in the US equity market. Recent trading data showed a net outflow from US stocks - the sixth in seven weeks. The dollar is in a fix in which a falling dollar makes the dollar fall more.

The US dollar has fallen by more than 10 percent this year against the euro and nearly 15 percent against the Canadian dollar. These are hefty falls in currency-market terms, where the sheer levels of liquidity available in the leading currencies often limit the size and pace of moves. The speed of the dollar's recent slide has largely caught currency strategists by surprise. Many had previously thought that the main phase of dollar weakness would come to a halt around the middle of 2003, but now expect that weakness to persist for at least through the end of the year, citing deflation fears and the twin deficits. Dollar-based investors take comfort from the fact that few strategists are yet predicting the sort of disorderly market that would precipitate a dollar crash, and that domestic deflation increases the purchasing power of the dollar.

The Bank of Japan (BOJ) is thought to have intervened covertly in the foreign exchange market in July, selling massive amounts of yen for dollars in a bid to stem the yen's rise and support its struggling exporters. There is speculation that BOJ spent at least 1 trillion yen ($8.5 billion) on one Monday alone as the dollar fell to two-year lows against the yen. It bought $34 billion in May to stop the yen from appreciating against the dollar.

Yet even if market participants are scared off by BOJ intervention, market sentiment toward the dollar remains overwhelmingly bearish. Speculators can still find other currencies, such as the euro, where there is less official resistance, to short against the greenback. The European Central Bank (ECB) is institutionally structured to prevent the euro from falling, but it possesses little authority or tools to prevent the euro from rising. It was a worry that seemed unnecessary at the time of the ECB's formation. When the euro was launched in 1999, most observers hoped the euro would strengthen against the dollar.

According to conventional wisdom, a weaker dollar is supposed to provide just the relief that corporate America needs as companies confront the threat of deflation and continued weakness in the domestic economy. But US companies are unlikely to change their investment and sourcing plans unless they can be sure that the dollar will not spring back soon. Most US transnationals, such as General Electric and Citigroup, routinely hedge against currency risks, or their revenue is so well spread across the globe that the overall exchange-rate impact is almost neutral. In fact, currency hedges have become one of their major sources of corporate profit. If the dollar stays low for long periods, companies may decide to source more expensive raw materials from new, cheaper plants - possibly even in the United States, but this is unlikely to make high US wages competitive with wages in Asia or Latin America. Even an illegal immigrant worker in the lowest-paying job in the US commands a higher wage than does a floor manager in a Third World sweatshop. Certainly, no re-sourcing decisions will be made by short-term currency fluctuations.

The 2003 first-quarter earnings from the immediate impact of a weaker dollar on the translation of international sales into US currency benefited many US companies. United Technologies (UT), the US industrial group that owns Otis, the elevator company, and Pratt & Whitney, the aircraft-engine maker, recorded $1 in earnings per share for the first quarter, of which 5 cents was from favorable foreign-currency translation. UT receives 60 percent of its revenue from outside the United States and 20 percent alone from Asia, where growth is expected to remain strong. The currency effect helped offset weakness in some other major markets such as the EU, Latin America and the US.

The stronger pound sterling, euro and Canadian dollar contributed $219 million to the $10.3 billion of revenues that Wal-Mart, the retailer, recorded in its international operations in the first quarter. But most big US companies' trading relationships are founded on multilateral rather than bilateral exchange rates. Walt-Mart's positive currency effect was offset by the weaker Mexican peso. The change in the euro-dollar exchange rate has also allowed some companies - such as Dell, the computer maker - to raise market share outside the United States by cutting prices.

Experience has shown that it will take a lag of at least four or sometimes eight quarters for the realignment of the dollar to feed through into US exports. Trade economists have claimed that each percentage-point drop in the trade-weighted dollar index (TWDI), if sustained over at least eight quarters, is worth a $10 billion annual increase in exports, measured in constant dollars. Imports are quicker to respond, with a fall normally detected within one quarter of a change in the value of the currency. The US trade deficit in May 2003 was $41.84 billion. The TWDI in April 2003 was 109 and was 88.5 on June 13, still above the 1990s average of 87.8. The TWDI was 178.9 in August 1998 at the height of the Asian financial crisis.
Speculators appear to be gearing up to bid the euro even higher, creating fresh challenges for global companies as they navigate volatile currency markets amid difficult economic conditions. After rising more than 10 percent against the dollar so far in 2003, the euro in mid-July matched its 1999 launch level, above $1.1742. Against sterling, the euro has gained 9 percent, peaking in July above its launch level Stg0.706. More than half of the fund managers recently surveyed believed for the first time that the euro to be overvalued rather than undervalued. Yet more than half said the euro was their favorite currency, with long-euro, short-dollar trades the most popular. This indicates that herd instinct is alive and well.

G7 finance ministers, in concert with US Treasury Secretary John Snow, raised doubt about Washington's strong-dollar policy. As usual, the sole dissent came from Japan. Eurozone finance ministers reiterated support for a "strong and stable" euro. They echoed Wim Duisenberg, outgoing president of the European Central Bank, who recently said the euro was trading at fair value.

Recent surveys showed that average forecast projects the euro to trade up toward $1.20 from the $1.13-$1.14 level by year-end. Policymakers' comments could extend those forecasts further still to $1.25 or even beyond $1.30.

The dollar's gains in the late 1990s were based partly on dollar-buying by eurozone groups, such as Vivendi and Daimler, which bought US companies. These companies and their eurozone investors are now nursing heavy losses after three years of falling equity prices in the United States and worldwide. The result is a drying up of capital flows to the US from the eurozone. In deficit until 2002, the eurozone current account now runs a surplus that gives confidence to investors assessing the currency risk of eurozone assets.

The US twin deficits by contrast are seen as a risk for the dollar's value, leading greater numbers of investors to hedge against the risk by buying forward contracts - sending the dollar lower still. The eurozone's economy is likely to fall into deflation if the euro returns to its equivalent peak levels of the mid-1990s and stays there for long periods. Simulations models suggest that if the euro rises by about another 20 percent, there is a roughly two in three chance that deflation will hit the eurozone.

The dollar has fallen 30 percent against the euro since its peak in 2000. In 1985-87, it fell by 54 percent against the deutschmark. The dollar rose by a trade-weighted average of 35-50 percent (depending on which index is used) from early 1995 until February 2002. Since trade economists claim that every 1 percent increase in the dollar produces an increase of $10 billion in the annual US current account deficit after a phase-in period of two to three years, this appreciation accounts for the bulk of the total deficit that now approaches $600 billion (about 6 percent of GDP) per year. These deficits have risen by almost one full percentage point of GDP in each of four of the last five years. The exception occurred during the recession year of 2001.

As a result of the current account deficits of the past 20 years, the negative net international investment position (NIIP) of the United States now exceeds $3 trillion (30 percent of its GDP) and is climbing by about 20 percent per year. This has been sustained by dollar hegemony in which the role of the dollar as the reserve currency for trade keeps the trade surplus in dollars earned by countries exporting to the US as captured investment or loans in the dollar economy. It is a phenomenon in which the US produces dollars and the rest of the world produces things dollars can buy, making the US trade deficit tolerable and its impact on the exchange value of the dollar negligible.

The dollar has been declining in a gradual and orderly manner since early 2002 by 10-20 percent as measured by various indices. So far it has reversed one-third to one-half of the run-up of the previous six-and-one-half years, since 1996. The sharp rise of the dollar that began in 1996 in an unregulated global financial market detonated the Asian financial crisis of 1997. If the dollar stays down, which is likely as long as the Fed maintains its near-zero interest-rate policy, the US annual current account deficit may decline by $100 billion to $200 billion over the coming two to three years from where it would otherwise have been. The impact on imports on the fall of the dollar up to this point would translate into a drop of more than half from its $600 billion peak. This means the economies exporting to the United States will not be in any position to absorb more US exports, even if prices are lowered by the lower dollar exchange rates, unless they incur massive trade deficits. But because of dollar hegemony, no country can sustained a dollar trade deficit without the penalty of a collapse of its currency, except the United States.

Adverse effects of the dollar's decline on the US economy are just beginning to show up in the bond market and in the US capital account. The Bush administration has accepted the correction, frequently reiterating that the exchange rate should be left to market forces and discouraging any thought that it might intervene directly to interrupt the decline. But the market knows that the Fed, unlike other central banks, can intervene in the foreign-currency market indirectly because of dollar hegemony. The Fed has unlimited dollar resources, through what Bernanke called "the printing press", to keep dollar interest rates low and the dollar exchange rate high. Other central banks cannot print dollars.

Some economists suggest that the United States can sustain a current account deficit at about half the current level, or $250 billion to $300 billion per year (2.5-3 percent of present GDP). At this level, the ratio of the US NIIP to GDP could level off at 30-35 percent, below the conventional "danger zone" of 40 percent. Given that every 1 percent decline in the dollar will produce a reduction of $10 billion in the external imbalance, the US trade-weighted exchange rate needed to fall by 25-30 percent from its recent peak. Hence the depreciation of the dollar to date has probably gone only about half the needed distance to date. But the conventional 40 percent danger zone may not apply to the United States because of dollar hegemony.

The dollar decline to date, however, has been selective among the major trading partners of the United States. The dollar has fallen by about 30 percent against the euro but only about 15 percent against the yen. The dollar rose against the Chinese yuan in 1994 to 8.278 to a dollar when it had been pegged in a very narrow range around 5.8 per dollar. But since the yuan is not freely convertible, its effect on the foreign-exchange market is immaterial. To sell dollars, the Chinese central bank would have to accept other foreign currencies rather than yuan.

The concentration on euro appreciation against the dollar is paradoxical, since Japan is by far the world's largest surplus and creditor country, while China is the second-largest holder of foreign-exchange reserves. As for Chinese exports, many economists have pointed out that China's share of world trade is still small for the size of its population. A World Bank report estimates that China's share of world trade will be 9.8 percent by the year 2020, with 20 percent of the world's population. The Plaza Accord in 1985 forced the Japanese to push the yen up to reduce its trade surplus, but it did not help the US economy, nor did it help the Japanese economy. Chinese exports rose by one-third in the six months to June, to $190 billion, while imports jumped 46 percent to $186 billion. On a global basis, Chinese foreign trade has been balanced. The Chinese economy has been holding up the anemic global economy.

The International Monetary Fund has thrown its weight behind the Chinese exchange-rate policy and rejected mounting global pressure for China to revalue its currency. IMF chief economist Kenneth Rogoff, speaking at a Washington conference on the US dollar and the world economy recently, said currency appreciation was risky for some countries. The IMF's support of China is at odds with US Treasury Secretary Snow and Fed chairman Greenspan, both having suggested that China should liberalize its exchange-rate system so that its currency can gain in value. The EU and Japan have also made calls on China to abandon the peg for the yuan.

Hugo Restall, editorial-page editor of The Asian Wall Street Journal, wrote on July 31: "Asians seem to have realized that not only is the China threat overrated, but the country is an engine of growth that benefits them.

"In fact, US and Chinese economic interests are quite closely aligned, because the two economies are so complementary. You might even say that China is an economic colony of the US, with its currency so tightly pegged to the dollar and American companies using it as a base for their low-cost manufacturing.

"That might seem like a strange idea given how nationalistic the Beijing regime is. But consider the government's actual behavior, and it's not hard to imagine that if Paul Bremer were running China instead of Hu Jintao, he'd be accused of exploiting the country's economy to benefit the US and other Western countries.

"First of all, the most productive sector of the economy is largely run by foreigners, for the benefit of foreigners. China may boast of being the largest recipient of foreign direct investment in the world, but it got that way in part by offering preferential tax treatment and other incentives to multinational companies. Those ventures in turn export not only their products, but also their profits, often hidden by manipulating the prices used for transactions within the companies.
"There's still time for China to get wise. But the point here is that Americans should be sanguine about China's development model. Thanks to Beijing's own policies, China is giving them cheap capital, cheap manufactured goods sold below their true cost and a market for sophisticated, high-value-added goods. At the end of the day, China will be left with uncompetitive companies, depleted savings and a balance-sheet recession. It will have to sell off the distressed assets of its failed banking system, at which point Western companies can buy up even more of the economy at fire-sale prices.

"One more thought about China: Since the two economies are complementary, it's ultimately not in the US interest for Beijing to continue with its self-defeating policies. A sudden collapse would hurt the US because the market for US Treasurys might be disrupted, social unrest could damage American-owned factories and the market for US goods could dry up. In short, Americans should be somewhat concerned about China, but not for the reason they think. The good deal they're getting now can't last forever."

Though the article's focus on inefficient state-own enterprises is not directly on target, truer words have seldom been said about the stupidity of an export policy that depresses domestic wages to earn dollar trade surpluses within the context of dollar hegemony. Mercantilist policies are rendered inoperative by dollar hegemony. The aim of China's planners to build the domestic economy through export earnings is fundamentally flawed. Trade can only supplement domestic development, never replace it. With a non-convertible currency, a large economy such as China's can finance its domestic development through state credits based of the State Theory of Money, with no need for foreign loans or capital. The value of the Chinese currency is a function of the strength of the Chinese economy, from which the government has the authority to levy taxes, and not by the foreign-currency reserves held by its central bank. Central banks can affect the supply of money through monetary policy, but they cannot affect, except in very indirect ways, the demand for money in the economy. James A Baker, treasury secretary under Reagan, has a score to settle with Greenspan, whom both George Bush Sr and Baker blamed for Bush's one-term presidency. Baker's record of outsmarting Fed chairmen was nevertheless impressive.

Baker's aim of pushing down the dollar in 1985 was to cure the anemic US economy, not to cause it. Baker became Reagan's White House chief of staff in 1980, with Don Regan of Merrill Lynch as treasury secretary. Paul Volcker was a holdover Fed chairman appointed by Jimmy Carter, whose supporters justifiably thought Volcker's monetary policies were the reasons for Carter's one-term presidency.

Volcker on September 29, 1979, presented the Fed's "new operating system" to combat hyper-inflation on board the Treasury secretary's official plane on the way to an IMF meeting in Belgrade to secretary G William Miller and Charles Schultz, chairman of the Council of Economic Advisers (CEA). While agreeing that the Fed must do more to tighten money supply and credit, both immediately opposed the idea that would set the Fed on a course of target money supply, a pure monetarist measure.

Miller, the businessman, objected that if the Fed targeted reserves directly, it would result in more volatility in interest rates that would exacerbate both inflation and market instability. Schultz, the economist, objected to fundamental issues of locking the Fed on a course toward recession it could not reverse. Volcker listened politely but held on to his belief that the technical decision was the Fed's "independent" prerogative. The new operating system caused the Fed to lose control of US interest rates and cost Carter a second term.

The economic disorder that had helped to elect Reagan reached a new height as he took office. Price inflation remained in double digits. Interest rates were driven to double digits by inflation and the Fed's tight money supply policy. Bank prime rate hit 21 percent. Unemployment hit 7.4 percent. Both were rising with no end in sight. Reagan declared that government was the problem, not the solution, reversing the failed Carter approach of relying on government policy to halt inflation. The Reagan cure was a 30 percent, three-year tax cut and a balanced budget, cutting $100 billion a year from government revenue over the next five years and a $41 billion budget reduction in the first year. Voodoo economics was in full swing.

Reagan wanted "sound money", a fixation of his half-baked monetarist preoccupation. Optimism was relied upon to defy economic logic. Volcker made obscure speeches on the unavoidable clashes between monetary restraint and economic growth, but the White House was not listening. The United States was ignoring an economic truth about inflation: that the economy must always decline first, before prices will decline. Sound money means capping the money supply, which means either price inflation or that real output would fall. Historical data have always sided with real output falling first, before prices will fall. Thus sound money is a recipe for negative growth: recession, way before any benefit can appear. Moreover, despite slogans, Reagan's policies of slowing the economy and tax cuts were heading for increased deficits, the opposite direction of sound money. Reagan rehabilitated classical economics, which had been discredited since 1930, and its four main strands of conservative economic thinking: monetarism, tricking down growth, balanced government budgets and unregulated markets.

Baker was uneducated about monetary policy and did not claim to be otherwise. Ironically, Reagan, who was a passive president on most other issues, was forceful on monetary policy on account of decades of ideological incubation. He was a diehard anti-inflation monetarist and an apt student of Milton Friedman as superficially presented by the popular press. Now Baker and the two Bushes, being all Texans, have a genetic hostility toward big money center banks in the eastern US, and despite being financial elites themselves, are imbedded with Texan populism. Bush Sr even proposed, when he was still Reagan's vice president, an excess profit tax on banks if prime rates remained high. But Ronald the king had spoken, and everyone worked to give the king what he wanted. The economy plunged from the frying pan to the fire. Penn Square Bank failed from bad loans due to falling oil prices and a Third World debt crisis developed due to a fall in inflation engineered by the Fed, most dangerously in Mexico, which was about to default on $80 billion of debt owed to US banks, placing the US banking system under threat of collapse.

Predictably with US domestic politics, what severe pain suffered by US citizens could not accomplish, the threat to the banking system produced immediate government action. A deal was made between the Fed and the White House to cut the interest rate and to raise taxes to cut the deficit. A Mexican bailout with $3.5 billion from the Fed and the Treasury, plus a $1 billion advance payment oil purchase from Mexico by the Department of Energy, another $1 billion line of credit from Department of Agriculture for future purchase of US grain and a Fed-orchestrated $1.85 billion from other central banks, half from the Fed. This was the beginning of the international debt crisis that still remains unresolved. It set the basic formula for protecting the banks while the price is paid by the world's poor in hunger and deaths.

Alan Greenspan has in essence followed this policy since he took over from Volcker. The Fed has since shifted its role from regulator to that of a cleanup crew, and the biggest cleanup job is yet to come.

But Snow and Greenspan in 2003 have less room to maneuver than Baker and Volcker did in 1985. The odds are that Snow will still push down the dollar at least by another 10 percent and the Fed will keep Fed Funds rate target near zero. But while these moves may deflect some political heat, they are not likely to save the US economy from a long period of stagnation