Invited Lecture

ERC/METU International Conference on Economics
Ankara, Turkey

September 6, 2003

The Global Economy in Transition

Henry C.K. Liu

An economy is not an abstraction. An economy is the material manifestation of a political system, which in turn is the interplay of group interests representing, among others, gender, age, religion, property, class, sector, region or nation. Individual interests are not issues of politics. Therefore, the politics of individualism is an oxymoron, and by extension, the Hayekian notion of a market of individual decisions is an ideological fantasy. Markets are phenomena of large numbers and herd instinct where unique individualism is of little consequence. The defining basis of politics is power, which takes many forms: moral, intellectual, financial, electoral and military. In an overcapacity environment, company executives lament about the loss of pricing power. The global economy is the material manifestation of the global geopolitical system, and global macroeconomics is the rationalization of that geopolitical system.

The nomenclature of economics reflects, and in turn dictates, the logic of the economic system. Terms such as money, capital, labor, debt, interest, profits, employment, market, etc., have been conceptualized to describe components of an artificial material system created by power politics. The concept of the economic man who presumably always acts in his self-interest is a gross abstraction based on the flawed assumption of market participants acting with perfect information and clear understanding of its meanings. The pervasive use of these terms over time disguises the artificial system as the product of natural laws, rather than the conceptual components of power politics. Just as monarchism was rationalized as a natural law of politics in the past, the same is true with market capitalism today.

The market is not the economy. It is only one aspect of the economy. A market economy can be viewed as an aberration of human civilization. People trade to compensate for deficiencies in their current state of development. Exploitation is slavery, not trade. Imperialism is exploitation on an international level. Neo-imperialism after the end of the Cold War takes the form of neo-liberal international trade. Free trade cannot exist without protection from systemic coercion. To participate in free trade, a trader must have something with which to trade voluntarily in a market free of systemic coercion. That tradable something comes from development, which is a process of self-betterment. International trade is not development, although it can contribute to domestic development. Domestic development must take precedence over international trade, which is a system of external transactions supposedly to augment domestic development. But neo-liberal international trade since the end of the Cold War has increasingly preempted domestic development in both the center and the periphery. Global trade has become a vehicle for exploitation of the weak to strengthen the strong. Aside from being unjust, neo-liberal global trade as it currently exists is unsustainable, because the transfer of wealth from the poor to the rich is unsustainable. Neo-liberal claims of fair benefits of liberalized trade to the poor of the world, both in the center and the peripheral, are simply not supported by facts.

This presentation will discuss the global economy in transition, focusing on the changing nature and role of money, debt, trade, markets and development.

Fiat Money as Sovereign Credit

Most monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking. This view is valid for specie money, which is a certificate that can claim on demand a prescribed amount of gold or other specie of value. Government-issued fiat money, on the other hand, is not a sovereign debt but a sovereign credit instrument. Sovereign government bonds are sovereign debt while local government bonds are institutional debt, but not sovereign debt because local governments cannot print money. When money buys bonds, the transaction represents credit canceling debt. The relationship is rather straightforward, but of fundamental importance.

If fiat money is not sovereign debt, then the entire conceptual structure of capitalism is subject to reordering, just as physics was subject to reordering when man's worldview changed with the realization that the earth is not stationary nor is it the center of the universe. For one thing, capital formation for socially useful development will be exposed as a cruel hoax. With sovereign credit, there is no need for capital formation for socially useful development. For another, private savings are not necessary to finance development, since private savings are not required for the supply of sovereign credit. With sovereign credit, labor should be in perpetual shortage, and the price of labor should constantly rise. A vibrant economy is one in which there is labor shortage. Private savings are needed only for private investment that has no social purpose or value. Savings are deflationary without full employment, as savings reduces current consumption to provide investment to increase future supply. Say's Law of supply creating its own demand is a very special situation that is operative only under full employment. Say's Law ignores a critical time lag between supply and demand that can be fatal to a fast moving modern economy. Savings require interest payments, the compounding of which will regressively make any financial system unsustainable. The religions forbade usury for very practical reasons.

Fiat money issued by government is now legal tender in all modern national economies since the collapse of the Bretton Woods regime of fixed exchange rates linked to a gold-backed dollar in 1971. The State Theory of Money (Chartalism) holds that the general acceptance of government-issued fiat currency rests fundamentally on government's authority to tax. Government's willingness to accept the currency it issues for payment of taxes gives the issuance currency within a national economy. That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government. When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment. A central banking regime operates on the notion of government-issued fiat money as sovereign credit. That is the essential difference between central banking with government-issued fiat money, which is a sovereign credit instrument, and free banking with privately issued specie money, which is a bank IOU that allows the holder to claim the gold behind it.

Thomas Jefferson prophesied: "If the American people allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive people of all property until their children will wake up homeless on the continent their fathers occupied ... The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs." It was a definitive statement against the "political independence" of central banks. This warning applies to the people of the world as well.

The Independent Treasury Act, passed in 1840, removed the federal government from involvement with the nation's banking system by establishing federal depositories for public funds instead of keeping the money in national, state, or private banks. Under the Independent Treasury Act, bank notes were to be gradually phased out for payments to and from the government; by June 30, 1843, only hard money was to be accepted. The Whigs, led by Henry Clay and Daniel Webster, opposed the Independent Treasury, but not to favor private banking. They were committed to the reestablishment of a national bank like the one President Andrew Jackson abolished in 1832. After winning a congressional majority in the election of 1840, the Whigs succeeded in repealing the Independent Treasury Act on August 13, 1841, although they were unable to gain the support of President John Tyler for their national bank proposal. The return of the Democrats to power after the election of 1844 led to the passage in 1846 of a new Independent Treasury Act, nearly identical to that of 1840. This legislation remained substantially unchanged until passage of the Federal Reserve Act in 1913, which established central banking in the US.

When the Civil War began in 1861, the newly installed President Abraham Lincoln, finding the Independent Treasury empty and payments in gold having to be suspended, appealed in vain to the state-chartered private banks for loans to pay for supplies needed to mobilize and equip the Union Army. At that time, there were 1,600 banks chartered by 29 different states, and altogether they were issuing 7,000 different kinds of banknotes in circulation. Lincoln immediately induced the Congress to pass the Legal Tender Act of 1862 to authorize the issuing of government notes (called greenbacks) without any reserve or specie basis, on a par with bank notes backed by specie, promising to pay "on demand" the amount shown on the face of the note with another note of same value. The greenbacks were supposed to be gradually withdrawn through payment of taxes, as specified in the Funding Act of 1866, to allow the government to redeem these greenback notes in an orderly way without interest. Still, during the gloomiest period of the war when Union victory was in serious doubt, the greenback had a market price of only 39 cents in gold. The fall in value was related to the survival prospect of the Union, not to loss of specie basis, which was non-existent. After the war, the Supreme Court in a series of cases declared the Legal Tender Act constitutional and Congress decreed that greenbacks then outstanding would remain a permanent part of the nation's currency. Indisputably, these greenback notes helped Lincoln save the Union. Lincoln wrote: "We finally accomplished it and gave to the people of this Republic the greatest blessing they ever had - their own paper to pay their own debts." The importance of this lesson was never taught to the world's governments by neo-liberal monetarists.

Government levies taxes not to finance its operations, but to give value to its fiat money as credit instruments. If it chooses to, government can finance its operation entirely through user fees, as some fiscal conservatives suggest. Government needs never be indebted to the public. It creates a government debt component to anchor the debt market, not because it needs money. Technically, government never borrows. It issues tax credit in the form of fiat money. So when President Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing a political slogan, with no clear understanding of the true nature of money and credit. Fiat money is all that government makes, freely and without constraint, as Federal Reserve governor Ben S. Bernanke recently warned in a speech on deflation. And only government can make fiat money as sovereign credit.

Sovereign debt is a pretend game to make private debts tradable. The relationship between assets and liabilities is expressed as credit or debt, with the designation determined by the flow of obligation. A flow from asset to liability is known as credit, the reverse is known as debt. A creditor is one who reduces his liability to increase his assets, which include the right of collection on the liabilities of his debtors.

The state, representing the people, owns all assets of a nation not assigned to the private sector. Thus the state's assets is the national wealth less that portion of private sector wealth after tax liabilities, and all other claims on the private sector by sovereign rights. Privatization generally reduces state assets. As long as a state exists, its credit is limited only by the national wealth. If sovereign credit is used to increase national wealth, then sovereign credit is limitless as long as the growth of national wealth keeps pace with the growth of sovereign credit. Even if the private sector has been assigned all of a nation's tangible assets, the state, by virtual of its existence, can still claim that portion of private sector assets allowed by the constitutional regime. Such claims include the state's power of taxation, nationalization, confiscation, condemnation by eminent domain and the power to grant and revoke monopolies, and above all, the power to issue legal tender by fiat - in other words, the inherent rights of sovereignty.

When the state issues money as legal tender, it issues a monetary instrument backed by its sovereign rights, which includes taxation. The state never owes debts except specifically so denoted voluntarily. When a state borrows in order to avoid levying or raising taxes, it is a political expedience, not a financial necessity. When a state borrows, through the selling of government bonds denominated in its own currency, it is withdrawing previously-issued sovereign credit from the financial system. When a state borrows foreign currency, it forfeits its sovereign credit privilege and reduces itself to an ordinary debtor because the state cannot issue foreign currency.

Government bonds can act as absorber of credit from the private sector. Government bonds in the US, through dollar hegemony, enjoy the highest credit rating, topping a credit risk pyramid in the international debt market. Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency of the international finance architecture. Yet, architecture is an art of aesthetics in the moral goodness sense, of which the current international finance architecture is visibly deficient. Thus dollar hegemony is objectionable not only because the dollar usurps a role it does not deserve, but also because its effect on the world community is devoid of moral goodness.

Money issued by government fiat is a sovereign monopoly while debt is not. Anyone with acceptable credit rating can borrow or lend, but only government can issue money as legal tender. When government issues fiat money, it issues certificates of its credit good for discharging tax liabilities imposed by government on its citizens. Privately issued money can exist only with the grace and permission of the sovereign, and is different from government-issued money in that privately issued money is an IOU from the issuer, with the issuer owing the holder the content of the money's backing. But government issued fiat money is not an IOU from the government because the money is backed by a potential IOU from the holder in the form of tax liabilities. Money issued by government by fiat as legal tender is good by law for settling all debts, private and public. Anyone refusing to accept dollars in the US is in violation of US law. Instruments used for settling debts are credit instruments. Buying up government bonds with government-issued fiat money is one of the ways government releases more credit into the economy. By logic, the money supply in an economy is not government debt because, if increasing the money supply means increasing the national debt, then monetary easing would contract credit from the economy. Empirical evidence suggests otherwise: monetary ease increases the supply of credit. Thus if money creation by government increases credit, money issued by government is a credit instrument, quod erat demonstrandum.

Credit and Money Creation

Hyman Minsky rightly said that whenever credit is issued, money is created. The issuing of credit creates debt on the part of the counterparty; but debt is not money; credit is. If anything, debt is negative money, a form of financial antimatter. Physicists understand the relationship between matter and antimatter. Einstein theorized that matter results from concentration of energy and Paul Dirac conceptualized the creation of antimatter through the creation of matter out of energy. The collision of matter and antimatter produces annihilation that returns matter and antimatter to pure energy. The same is true with credit and debt, which are related but opposite. They are created in separate forms out of financial energy to produce matter (credit) and antimatter (debt). The collision of credit and debt will produce an annihilation and return the resultant union to pure financial energy un-harnessed for human benefit.

Monetary debt is repayable with money. Government does not become a debtor by issuing fiat money, which, in the US, takes the form of a Federal Reserve note, not an ordinary bank note. The word "bank" does not appear on US dollars. Zero maturity money (ZMM) in the dollar economy, which grew from $550 billion in 1971 when President Nixon took the dollar off a gold standard, to $6.333 trillion as of June 2003, is not a federal debt. It amounts to over 60% of US GDP, roughly equals to the national debt of $6.67 trillion at the same point in time.

A holder of fiat money is a holder of sovereign credit. The holder of fiat money is not a creditor to the state, as many monetary economists claim. Fiat money only entitles its holder a replacement of the same money from government, nothing more. The holder of fiat money is acting as a state agent, with the full faith and credit of the state behind the instrument, which is also good for paying taxes. Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit. It is a certificate of state financial power inherent in sovereignty.

Bank Reserves as a Money Creation Tool

In the US, government issues fiat money in the form of cash or bank reserves (high power money) through the Federal Reserve System. Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or as deposits at a Federal Reserve Bank. Reserve requirements represent a cost to the banking system. Bank reserves are used in the day-to-day implementation of monetary policy by the Federal Reserve. As of February 2002, the reserve requirement has been 10% on transaction deposits, and zero reserves for time deposits. The monetary base is the sum of high-powered money and an adjustment factor that measures changes in reserve requirement ratios. This adjustment factor is calculated so that it responds to changes in deposit levels in addition to changes in reserve requirements.

The Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to impose a reserve requirement of from 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties) and of up to 9% on non-personal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.

In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank's transaction accounts, and that the $25-million figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the United States. An adjustment late in 2001 put the amount at $41.3 million. Similarly, the Garn-St. Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bank's deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. For 2002, the level is $5.7 million. These data testify to a continuing expansion of the money supply.

Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $80. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500. Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.

In practice, the connection between reserve requirements and money creation is not quite as direct. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market at the prevailing price (above the Federal Funds rate) for borrowed reserves. This is significant in two ways. First, it permits bank reserves to come from bank borrowing rather than bank deposits; and secondly, it reduces the importance of sovereign credit in money creation. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States. This is the main reason why the US is increasingly a private-debt-driven economy and not a sovereign-credit-driven economy. With government deficits (tax revenue shortfalls) financed by government debt (bonds) rather than sovereign credit (money), with tax cuts reducing the demand for sovereign credit, and with privatization of public facilities and services, the public sector has come to dependent increasingly on private credit. As the Fed Funds rate approaches zero, private money creation becomes increasingly free from Fed control. This has led to the co-optation of the state by private special interests and a corruption of democracy by the moneyed classes.

Reserve requirements, open market operations (the Fed's buying and selling of government securities) and the discount rate (the interest rate that Federal Reserve Banks charge depository institutions for short-term loans) are the three main tools of monetary policy used by the Fed. The first two focus on banks reserves while the discount rate deals with bank liquidity. There is a continual flow of reserves among banks, representing the ever-changing supply and demand for these reserves at individual banks. When the Fed engages in open market operations, it adds to or subtracts from the supply of reserves. Open market operations are the Federal Reserve's most flexible means of carrying out monetary policy. Through open market operations, the Federal Reserve buys and sells US Government securities in the secondary market in order to adjust the level of reserves in the banking system. Open market operations enable the Federal Reserve to influence short-term interest rates and reach other monetary policy targets.

The effectiveness of the Fed's actions results from the reasonably predictable demand for reserves set by reserve requirements. The Fed changes reserve requirements for monetary policy purposes only infrequently. Reserve requirements impose a cost on the banks in foregone interest on the amount by which required reserves exceed the reserves that banks would voluntarily hold in order to conduct business, and the Fed has been hesitant to make changes that would increase that cost. Between 1980 and 1987, reserve requirements underwent a series of changes mandated by the MCA. Requirements on banks that were members of the Federal Reserve System were lowered, while those on nonmember depository institutions were raised gradually from zero to the final levels applied to the member banks.

There have been only a handful of policy-related reserve requirement changes since the passage of MCA in 1980. In March 1983, the Fed eliminated the reserve requirement on non-personal time deposits with maturities of 30 months or more, and in September 1983, it reduced that minimum maturity to 18 months. Then, in December 1990, the Fed cut the requirement on non-personal time deposits and on net Eurocurrency liabilities from 3% to 0%. In April 1992, it cut the requirement on transaction deposits from 12% to 10%. In announcing its December 1990 move, the Fed noted that the cut would reduce banks' costs, "providing added incentive to lend to creditworthy borrowers." Similarly, in announcing its April 1992 cut in reserve requirements, the Fed observed that the reduction would put banks "in a better position to extend credit." Current reserve requirements are low by historical standards. From 1937 to 1958, for example, the reserve requirement on demand deposits was always at least 20% for banks in New York and Chicago, which were "central reserve cities" -- a term now obsolete. The central bank of Brazil cut bank reserve requirements on demand deposits from 60% to 40% on August 8, 2003, still a ruinously tight monetary policy.

Before the passage of the MCA in 1980, only banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements. State-chartered banks that were not Federal Reserve members had to meet their state's reserve requirements, which typically were lower. As a result, many banks dropped their Federal Reserve membership, and member bank transaction deposits fell from nearly 85% of total US transaction deposits in the late 1950s to 65% two decades later, weakening the Fed's ability to influence the money supply. The MCA sought to solve this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status.

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has opposed it because of the revenue loss that would result to the US Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would be an additional expense to the Fed. Furthermore, partial reserve banking enables banks to earn profit from leveraging of funds. It would be greedy of banks to want to earn interest from their reserve requirement.

Federal Reserve deposits that banks keep with the Federal Reserve System are used to process, in a systematic, centralized fashion, the millions of checks written each day by customers of one bank that are deposited by customers of another bank. Using these deposits, the Fed acts as a central clearing house for checks, being able to simultaneously debit the account of one bank and credit the account of another. Bank reserves are definitely not government debts. They are sovereign credit assigned to banks on deposits with the Fed. The amount of bank reserve credit over and above that which the Federal Reserve System requires a bank to keep (excess reserves) is what banks use to make loans to create broad money. This is the key to the Fed's ability to control the money supply - the higher the reserve requirement, the tighter the money supply and therefore the slower the economic growth. Using open market operations, the Fed can add to, or subtract from, the excess reserves held by banks without changing the reserve requirements. Banks make loans in relation to the amount of reserves they hold, by adding to their customers' checking account balances. This is of some importance, because checking account balances are a major part of the economy's money supply. In essence, controlling excess reserves is the Fed's main method of "printing" money without physically printing money.

For decades, the Fed published data on the money supply, and for many years, the Fed set targets for money supply growth. Analysts have long monitored the growth of the money supply because of the effects that money supply growth is believed to have on real economic activity and on the price level. Over time, the Fed has tried to achieve its macroeconomic goals of price stability, sustainable economic growth, and high employment in part by influencing the size of the money supply. In the past two decades, developments have broken down the relationship between money supply growth and the performance of the U.S. economy. In July 2000, the Fed announced that it was no longer setting target ranges for money supply growth, and emphasis on the money supply as a guide to monetary policy has waned.

For July 2003, M1 was $1.278 trillion, M2 was $6.093 trillion and M3 was $8.934 trillion. While as much as two-thirds of U.S. currency in circulation may be held outside the United States, all currency held by the public is included in the money supply because it can be spent on goods and services in the U.S. economy. The Federal Reserve began reporting monthly data on the level of currency in circulation, demand deposits, and time deposits in the 1940s, and it introduced the aggregates M1, M2, and M3 in 1971. The original money supply measures totaled bank accounts by type of institution. The original M1, for example, consisted of currency plus demand deposits in commercial banks. Over time, however, new bank laws and financial innovations blurred the distinctions between commercial banks and thrift institutions, and the classification scheme for the money supply measures shifted to one based on liquidity and on a distinction between the accounts of retail and wholesale depositors.

The Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act, required the Fed to set one-year target ranges for money supply growth twice a year and to report the targets to Congress. During the heyday of the monetary aggregates, in the early 1980s, analysts paid a great deal of attention to the Fed's weekly money supply reports, and especially to the reports on M1. If, for example, the Fed released a higher-than-expected M1 figure, the markets surmised that the Fed would soon try to curb money supply growth to bring it back to its target, possibly increasing short-term interest rates in the process.

Following the introduction of NOW accounts nationally in 1981, however, the relationship between M1 growth and measures of economic activity, such as Gross Domestic Product, broke down. Depositors moved funds from savings accounts -- which are included in M2 but not in M1 -- into NOW accounts, which are part of M1. As a result, M1 growth exceeded the Fed's target range in 1982, even though the economy experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.

By the early 1990s, the relationship between M2 growth and the performance of the economy also had weakened. Interest rates were at the lowest levels in more than three decades, prompting some savers to move funds out of the savings and time deposits that are part of M2 into stock and bond mutual funds, which are not included in any of the money supply measures. Thus, in July 1993, when the economy had been growing for more than two years, Fed Chairman Alan Greenspan remarked in Congressional testimony that "if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction." Chairman Greenspan added, "The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."

A variety of factors continue to complicate the relationship between money supply growth and US macroeconomic performance. The size of the M1 aggregate has been held down in recent years by "sweeps" - the practice that banks have adopted of shifting funds by computer out of checking accounts that are subject to reserve requirements into savings accounts that are not subject to reserve requirements. In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy. However, M2, adjusted for changes in the price level, remains a component of the Index of Leading Economic Indicators, which some market analysts use to forecast economic recessions and recoveries.

The Ineffective Discount Rate

The highest historical point for the discount rate occurred on May 5, 1981 at 14%. Reserve Banks lent $45.5 billion to depository institutions at 3% discount rate on September 12, 2001, the day after the 9:11 attacks, the record for a single day. On November 6, 2002, the discount rate was set at 0.75% and the Fed Funds rate target was set a 1.25%, with a customary 50 basis point spread. On January 9, 2003, Regulation A (Extensions of Credit by Reserve Banks) was amended to restructure Federal Reserve credit programs that resulted in a new method of establishing the discount rate. The rule does not entail a change in monetary policy stance. The Federal Open Market Committee's target for the Federal Funds rate will not change as a result of the adoption of these programs, and the level of market interest rates more generally will be unaffected. The rule replaces adjustment credit, which was previously extended at a below-market rate, with a new type of discount window credit called primary credit that will be broadly similar to credit programs offered by many other major central banks. Primary credit will be available for very short terms as a backup source of liquidity to depository institutions that are in generally sound financial condition in the judgment of the lending Federal Reserve Bank. The Board expects that most depository institutions will qualify for primary credit.

Reserve Banks will extend primary credit at a rate above the federal funds rate, which should eliminate the incentive for institutions to borrow simply to exploit the positive spread of money market rates over the discount rate. The Board anticipates that the primary credit rate will be set initially at 100 basis points above the FOMC's target federal funds rate. The Board's final rule also establishes a secondary credit program that will be available in appropriate circumstances to depository institutions that do not qualify for primary credit. The Board anticipates that Reserve Banks will initially establish a secondary credit rate at a level 50 basis points above the primary credit rate. The rate change on January 9, 2003, did not reflect a change in the stance of monetary policy. Prior to 2003, the discount rate's importance as a tool of monetary policy was limited, because banks did little adjustment borrowing at the discount window. On January 9, 2003, the discount rate was raised to 2.25%, while the Fed Funds rate remained at 1.25%. The average discount rate for August 2003 was 2%, 100 basis points above Fed Funds rate at 1%. The effectiveness of the revised discount window lending program as a tool of monetary policy remains to be seen.

The Rise of Non-bank Money Creation

With the advent of unregulated financial markets, the relative role of banks as mediator of credit has been reduced and the portion of bank lending in the aggregated amount of debt in the global financial system has been shrinking. Money now is routinely created not just through banking lending, but in the money markets, through commercial papers, the issuers of which look to bank credit lines only as a back-up facility. According to Federal Reserve data, at the end of 2002, $1.37 trillion of commercial paper was outstanding in US money markets. These commercial paper are traded constantly and the money proceeds from these trades are deposits in banks, which in turn lend the money out. Pacific Investment Management Co. (PIMCO) bond fund manager Bill Gross recently criticized General Electric of using off-balance-sheet activities to manipulate its reported earnings. He also suggested that the company's heavy dependence on the short-term commercial paper market was becoming precariously risky. Questions about Special Purpose Entities (SPEs) and other means of moving risk off corporate balance sheets are being raised in regulatory and investment quarters, with few answers. Commercial banks use SPEs to securitize their own assets, and to sponsor asset-backed commercial-paper conduits, which purchase and securitize assets from third parties. New accounting rules for these activities since the surfacing of fraudulent scandals in the energy and communication sectors will cost both banks and their corporate borrowers. At stake for the business community is the ability to make illiquid assets liquid by packaging them into securities, creating money by sidestepping banks loans - the most significant innovation in the capital markets in the past two decades.

Since Fannie Mae and Freddie Mac began securitization in the mortgage market as part of their mandate to foster home ownership in America decades ago, securitization has expanded into a variety of markets, including credit-card debt, auto and home-equity loans, commercial mortgages, and trade receivables. The practice allows originators to sell assets from their balance sheets and devote their capital to generating new business. The benefit of securitization is that it has enabled the extension of credit to far more individuals and businesses. The danger about securitization is that financial-reporting practices have not kept up with the financial innovation. Because the programs are executed in SPEs off-balance-sheet, investors and regulators know next to nothing about the risks involved in the activities.

Securitization enables banks and corporations to finance assets through the capital markets, but it does not eliminate the risks associated with those assets. In fact, in most cases, banks and other asset-sellers have retained the majority of the risk of assets transferred off-balance-sheet. The process works when the economy is expanding and credit losses are small in relation to growth, as was the case through most of the last decade. In an economic downturn, problem securitization can act as an explosive force to cause a systemic crisis.

Risk cannot be extinguished by mere transfer or redistribution. In the asset securitization process, companies create a hierarchy of securities, or tranches, with escalating degrees of credit risk associated with a pool of assets. The asset-backed deal tranches typically range from AAA credit rating down to BB. With the federal government issuing less sovereign debt during the Clinton years, and hardly any corporation still holding a AAA credit rating, highly rated, asset-backed paper is an easier sell with institutional investors, making securitization a low cost route to capital for companies. But in most cases, the originator of the asset "whether it is a manufacturing company financing trade receivables or a specialty finance lender securitizing loans" retains a residual interest in the performance of the assets. This interest obligates the issuer to cover losses in the asset pool up to a certain percentage. If losses exceed that percentage, other low-rated, subordinate tranches of the issuance begin to absorb them. The identities of the holders of those subordinate tranches remain unknown, among them hedge funds seeking high return for high risk. The banks also agree to provide liquidity support if cash flow from the conduit is insufficient to pay off the paper as it matures. If enough loans in a conduit go bad, the sponsor bank could be liable and its failure can cause systemic problems. This substantial systemic risk is not transparent to the market, or to regulators until it hits the fan.

The repurchase agreement, or repo market is another venue of non-bank money creation. The $2.5 trillion-a-day repo market is the place where bond firms and investors drum up cash to buy securities, and where corporations and money market funds park billions of dollars daily to produce returns on short-term idle funds. A repo is a loan, often for as short as a day, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. The interest rate is usually close to the federal funds rate, which banks charge each other for overnight loans.

Created to raise funds to pay for the flood of securities sold by the US government to finance growing budget deficits in the 1970's, the repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign-exchange. The repo market grew as it came to be used to raise money for other investments. The derivatives markets also require a thriving financing market, and repos are an easy way to raise funds to pay for new securities. Repos are used to raise money to pay for corporate bonds and are increasingly used to finance equities.

Repos chalked up average trading volume of about $2.5 trillion a day in 1999 in the US, up from $2 trillion a year earlier. Conventional perception not withstanding, the repo market is no longer as risk free as presumed because the proceeds are mostly channeled towards risk speculation.

It is difficult to obtain exact statistics about the volume of repo market activity involving financial assets other than US government securities, which are not all tracked by the Fed or cleared or settled in any one system. However, repo activity involving financial assets other than US government obligations are increasing due to dealers' and investors' desire to achieve the least expensive and most efficient funding sources for their inventories. In recent years, market participants have turned to money market instruments, mortgage and asset-backed securities, corporate bonds and foreign sovereign bonds as collateral for repo agreements. Many market participants expect the lending of equity securities to become a growing segment of the repo market, in light of recent US legislative and regulatory changes.

The Government Securities Clearing Corporation (GSCC), a registered clearing corporation that helps facilitate orderly settlement in the US government securities markets, tracks repo trades settled through its system by product type. An estimated $69.5 trillion in repo agreements was submitted and compared by GSCC participants in 1997, representing an average daily total of $277.8 billion in transactions collateralized by US Treasury and agency securities. The bulk of the total involved transactions using treasury notes as collateral, which accounted for $52.0 trillion or 74.8% of the total. Transactions collateralized by Treasury bonds accounted for $9.3 trillion of the total, while repo agreements involving Treasury bills accounted for an additional $7.1 trillion of the total. Repo agreements collateralized by Treasury bonds and bills accounted for 13.4% and 10.2% of the total, respectively.

The direct dependence of the derivatives markets on the repo market is worth noting. According to Fed Chairman Greenspan, by far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. At year-end 1998, US commercial banks, the leading players in global derivatives markets, reported outstanding derivatives contracts with a notional value of $33 trillion, a measure that has been growing at a compound annual rate of around 20 percent since 1990. Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange or over-the-counter (OTC) derivatives. An OTC instrument is traded not on organized exchanges (like futures contracts), but by dealers (typically banks) trading directly with one another or with their counterparties (hedge funds) using electronic means. Most of the funds come from the exploded repo market. The average amount outstanding in the repurchase agreement (repo) market was $2.53 trillion in 1998.

These developments overshadows the role of sovereign credit in the global economy, pushing the financing of socially necessary development towards reliance on private funding. It distorts the balance between the public and private sectors even within the US where dollar hegemony ensures an ample supply of sovereign credit. Thus the denial of sovereign credit is a necessary condition for dollar hegemony. The result is a shortage of credit for the public sector, which is forced to compete for funds with private development. Socially desirable development is simply not funded unless it offers a competitive return to private capital, leaving the world's poor not being able to afford safe drinking water.

Sovereign Debt Not Needed for Economic Development

Government bonds are debts, because the selling of bonds soaks up money (sovereign credit) from circulation. Money is sovereign credit because it soaks up sovereign or private debt when used to buy bonds (debt) and inject credit into the financial system. Sovereign debt is never needed to finance domestic development, which can be financed with sovereign credit. Government issues sovereign credit so that a private debt market can work without specie money. Sovereign credit is the benchmark of all credit ratings. Swapping of bonds is a common practice in finance, particularly in structured finance where a bond can be stripped in many different ways to meet the varying requirements of different buyers. The technical term is unbundling. These unbundled bonds all have one thing in common with sovereign debts, i.e. they entitle the holder at maturity to receive payment in money directly or indirectly from the Treasury, retiring the debt with sovereign credit. When that happens, the retired bond disappears from the debt market. Repo contracts from the Fed are short-term borrowings from the central bank using government bonds as collateral. The Fed gives the repo borrowers money with an agreement for the borrower to repossess the bonds by paying off the short-term loan with money. The process generally can be rolled over with only an interest rate risk. Private repo contract between counterparties do not involve the Fed, but are subject to interest rates target set by the Fed. Repos do not cancel any collateralized bonds, they only monetize the bonds for the duration of the repo agreement. The monetized amounts then become bank deposits, which generate broad money through partial reserves.

Government bonds when traded or use as loan collaterals between private or public entities beside the issuer can generate broad money creation, but not high power money creation. At the initial issuance of the government bond, the money supply is reduced by the discounted amount of the bonds, because money is withdrawn from the market. But if the Treasury deposits the proceeds from the bonds in banks, then the deposits will generate broad money through bank lending. Trading of debt does not turn debt into credit because the owner of a debt is the creditor, and the holder of a government bond is a creditor to the government. At maturity, the debt is payable in fiat money. But the holder of fiat money is only an agent of the government and not a creditor to the government, because the holder of fiat money is only entitled to replacement by government of the same money. Changing money for itself is not a financial transaction. Changing bonds into money at maturity is a financial transaction between government and bond holders, in which government-issued sovereign credit is exchanged for sovereign debt.

A debt instrument, even a government debt instrument, can be used as a credit instrument by the creditor. In that case, the transaction is an assignment. The original buyer of the bond has paid money (a government credit in his possession) for the government bond (a government debt). The bond holder can trade away the government debt to another party by transferring or assigning the right to receive money from the government (government credit) at maturity of the bond. Nevertheless, the debt is cancelled only at bond maturity, not sooner, regardless how many times it is traded and with whom.

Although government-issued money is not a government debt, a government credit instrument can be used by market participants in the private sector either to issue credit or to assume debt. The payer of money for services not yet received is a creditor. The receiver of money for services not yet delivered is a debtor. Government, when issuing money, expects no goods and services other than the future payment of taxes in the form of money. Thus government-issued money is a credit instrument for taxes not yet received. When government buys good and services with money, it is spending its tax credit. The transaction does not make money a government debt.

Fiat money is government credit and fiat money in the hands of a private entity makes the holder an agent of the government, the ultimate creditor. Holders of fiat money acts as an agent for government credit. The money holder earned the right to be a government credit agent by providing goods and service in exchange for the money, or becoming indebted to a bank who acts as an agent of government credit. Money paid for tax liability is government credit cancelled. Money spent for goods and services is assignment of government credit to the money receiving party.

Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the distorted reflection in the mirror as a perfect representation.

Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.

In the language of economics, credit and debt are opposites but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods, whose consumption increases when their prices go up, and creates what US Federal Reserve Board Chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.

The Foreign Capital Hoax

The Chartalist theory of money claims that government, by virtual of its power to levy taxes payable with government-designated legal tender, does not need external financing. Accordingly, sovereign credit should enable the government to act as employer of last resort to maintain full employment even in a regulated market economy. The logic of Chartalism reasons that an excessively low tax rate will result in a low demand for currency and that a chronic government budget surplus is economically counterproductive and unsustainable because it drains credit from the economy. The colonial administration in British Africa learned that land taxes were instrumental in inducing the carefree natives into using its currency and engaging in financial productivity.

Thus, according to Chartalist theory, an economy can finance its domestic developmental needs, to achieve full employment and maximize balanced growth with prosperity without any need for sovereign debt or foreign loans or investment, and without the penalty of hyperinflation. But Chartalist theory is operative only in closed domestic monetary regimes. Countries participating in neo-liberal international "free trade" under the aegis of unregulated global financial and currency markets, cannot operate on Chartalist principles because of the foreign-exchange dilemma. Any government printing its own currency to finance legitimate domestic needs beyond the size of its foreign-exchange reserves will soon find its currency under attack in the foreign-exchange markets, regardless of whether the currency is pegged at a fixed exchanged rate to another currency, or is free-floating. Thus all non-dollar economies are forced to attract foreign capital in dollar to meet domestic needs. But countries must accumulate dollars before they can attract foreign capital. Even then, with capital control, foreign capital will only invest in the export sector where dollar revenue can be earned. But the dollars that accumulate from trade surpluses can only be invested in dollar assets in the United States, depriving local economies of needed capital. The only protection from such attacks on domestic currency is to suspend full convertibility, which then will keep foreign investment away. Thus dollar hegemony starves the non-dollar economies of needed capital by depriving their governments of the power to issue sovereign credit domestically.

Precisely to prevent such currency attacks, tight control on the international flow of capital was instituted by the Bretton Woods system of fixed exchange rates pegged to a gold-backed dollar at $35 per ounce after World War II. Drawing lessons from the prewar 1930s Depression, economics thinking prevalent immediately after WWII had deemed international capital flow undesirable and unnecessary. Trade, a relatively small aspect of most national economies, was to be mediated through fixed exchange rates pegged to a gold-backed dollar. The fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the participating economies. The impact of exchange rates were limited to the finance of international trade, and was not expect to dictate domestic monetary policy, which was crucial to domestic development and regarded as the province of national autonomy.

Under principles of Chartalism, foreign capital serves no useful domestic purpose outside of an imperialistic agenda. Thus dollar hegemony essentially taxes away the ability of the trading partners of the United States to finance their own domestic development in their own currencies, and forces them to seek foreign loans and investment denominated in dollars, which the US, and only the US, can print at will.

The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice between (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment/low interest rates, counter-cyclical fiscal spending, etc). With unregulated global financial markets, a government can have only two of the three options.

Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis. For more than a decade since the end of the Cold War, the US has kept the fiat dollar significantly above its real economic value, attracted capital account surpluses and exercised unilateral policy autonomy within a globalized financial system dictated by dollar hegemony. The reasons for this are complex but the single most important reason is that all major commodities, most notably oil, are denominated in dollars, mostly as an extension of superpower geopolitics. This fact is the anchor for dollar hegemony. Thus dollar hegemony makes possible US finance hegemony, which makes possible US exceptionism and unilateralism.

The Foreign Exchange Carnage

Finance capitalism has operated on fiat money issued by governments worldwide ever since Nixon abandoned in 1971 the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar. Beginning in the early 1960's, with the growth of Eurocurrency markets where banks in one European country could take deposits and make loans in currencies of other countries, the tight controls of international flow of capital set up by the Bretton Woods system of fixed exchange rates after World War II were effectively bypassed. When the fixed exchange rate system set by Bretton Woods finally broke down by 1973, with a gold-backed US dollar that became fatally wounded in 1971 by decades of US fiscal irresponsibility, the developed countries abandoned capital controls officially. In the late 80's, many developing countries followed suit.

Growing from $190 billion at the beginning of the 1990s, daily turnover of foreign exchange grew almost one hundred fold to $1.5 trillion in unregulated foreign exchange markets. Only 5% of theses transaction is related to trade and others trade-associated transactions. The other 95% are financial transactions to facilitate international flow of funds, much of which involve speculative plays as traders bet on exchange rate fluctuations and interest rate differentials between currencies. This kind of financial speculation plays havoc with national budgets, macroeconomic planning and rational allocation of resources. Governments, businesses and individuals have become increasingly frustrated with the whimsical and often irrational activities in global financial markets that have such influence over national economies and are seeking some means to curb damaging and unproductive speculative activities.

By 1996, some $350 billion of private capital flowed into emerging markets, a seven-fold increase in 6 years. The bulk of this inflow went through global commercial banks. After July 1997, the bulk of the outflow left in the form of sudden withdrawal also through commercial banks. For the two decades before the Asian Financial Crises that began in 1997, technical imbalances between interest rates set by different central banks for funds in different currencies distorted capital flow around the world from economic fundamentals. The resultant inflow of capital into Asia through inter-linked financial markets around the globe outstripped the region's viable absorption rate. Financial institutions took advantage of low cost funds denominated in currencies of select countries, namely Japan, Germany and the United States, to make loans at higher interest rates denominated in local Asian currencies. These institutions sought to strategically profit from recurring technical imbalances in global finance by assuming currency risks, rather than from traditional direct investment returns. Economists call this activity international arbitrage on the principle of open interest parity. In banking parlance, this type of activity is known as "carry trade".

This abusive speculation was by no means limited to emerging economies. Corporation in developed economies routinely engaged in global financial and stock manipulative speculation at the expense of sound investment/production strategies. The public announcement of plans to open new factories in emerging markets in Asia and Latin America predictably lifted share value in home markets, regardless of such factories being risky loss-makers, for the loss would be more than offset by the increase market capitalization resulting from the publicity of a presence in an emerging market.

Corporate borrowers in Asia, attracted by low rates in some foreign currency loans, have also assumed currency risks, at times even bypassing local banks to borrow directly overseas in global debt markets. Borrowers, anticipating asset inflation brought on by runaway growth, also succumbed to the irresistible temptation of borrowing short-term to finance long-term projects, thus adding to the risk they assumed. Simultaneously, many Asian banks have taken local currency deposits at low saving rates (in Hong Kong at times at negative interest rates - depositors pay the bank to keep their money in local currency) to invest overseas in risky foreign currency instruments yielding higher returns, engaging in carry trade. Local banks in turn replenished the depleted local capital pool with low-cost foreign currency loans from international banks, taking on both economic and currency risks.

Borrowing low and lending high is the basic business of banks and there is nothing wrong with it if the activities occur within a well-regulated market in a bank's domicile community. With the advent of deregulated global banking, however, the unregulated internationalization of finance has created perilous systemic stress. Banks began to act as international loan brokers, profiting from interest rate spreads between local and foreign funds, often booking the risk premium added to over-valued currency interest rates as legitimate loan profits. These banks also began to maximizing their profits by maximizing loan volume, abrogating their traditional economic function as responsible financial pillars of local economies to ensure the productive allocation of capital. In time, local banks de-coupled their business self-interest from the economic impacts of their loans on the local economies, because they hedged the risk in such loans by passing it to overseas hedge funds which became the real loan originators to whom the banks themselves lend the funds. Western and Japanese international banks in turn provided funds to the local broker banks in Asia whose credit ratings were considered acceptable because the borrowers' exposures were hedged by instruments designed to transfer risk to other international institutions. In effect, the widespread transfer of business risks into currency risks forced the governments of the affected currencies to become lenders of last resort. This is the real economic effect of Hong Kong's, Argentina's and other currency peg regimes to the US dollar.

To increase returns, banks also creatively skirt regulation through structured finance devices such as collateralized mortgage obligations (CMO) which releases pressure on capital requirements. CMOs are essentially new junior debts secured by old senior debts that takes advantage of the theory of large numbers and hierarchy of risk. Similarly, corporations issue convertible bonds that do not appear on the corporation's balance sheets, but expose the borrower to instant repayment requirements should its share value drop below the specified amount. So in an era of allegedly increased transparency, layers of opaqueness are introduced through structured finance. The unbundling of risk acts as a disguise of risk.

Hedging does not eliminate risk, it merely passes risk along to other parties. In fact, complex hedging schemes, with the effect of reducing the risk exposure of individual lenders and inflating the credit worthiness of the hedged individual borrowers, when widely practiced, actually increase systemic risk exposure, initially of regional financial systems and ultimately of the global system. Yet the soundness of financial institutions continue to be assessed singularly without regard to counterparty credit worthiness and the breakdown of insularity within national borders, while financial markets have become intricately linked globally. A poor credit rating seldom means the denial of credit. It only means a higher interest rate which actually attracts more eager lenders who rationalize that the high risk has been compensated for by the increased lending rate. Junk bond rates are calculated from historical industry-wide default frequencies. Through extensive hedging, private financial risks have been largely socialized globally, while profits from systemic efficiencies remain in private hands.

The ingenious layering of protection against risk, while providing comfort to individual players, buys such comfort at the expense of the security of the total global system. At some point, the strained circular chain breaks at the weakest link and panic sets in. That break occurred in Thailand on July 2, 1997. When the Asian financial crises began in Thailand, it had not been triggered by hyperinflation or a sudden drop in corporate earnings. It was triggered by a collapse of an over-valued Thai currency pegged to the US dollar, the defense of which drained the Thai central bank of its foreign exchange reserves. In hindsight, it is indisputable that the conditions that led to the Asian financial crises were: unregulated global foreign exchange markets; the widespread international arbitrage on the principle of open interest parity (carry trade); short term debts to finance long-term projects; hard currency loans for project with only local currency revenue; overvalued currencies unable to adjust to changing market values because of fixed pegs and, above all, instant massive movement of funds that was susceptible to herd panic, known as contagion.

Under these conditions, when a threat of currency devaluation caused by a dwindling of reserves appeared, the entire financial house of cards collapsed, causing havoc in connected economies in a chain reaction, called contagion. Collapse of one currency then quickly grew into regional economic crises within weeks, then turned global, eventually hitting Russia, Brazil, Argentina and Turkey.

Because of this circular system of global hedging, the economic crises in Asia inevitably spread worldwide. The regional crises, each with unique local characteristics, are merely early symptoms of a ticking global time bomb constructed out of the complex calculus of inter-linked financial markets in which countless individual credit risks are legally masked as sound transactions through sophisticated hedging. Derivatives, financial instruments which derive their value from other underlying financial instruments or benchmarks such as stock indices or exchange rates, are the cards in the fragile house of cards built by a financial specialty known as "structured finance".

Growth of Structured Finance (Derivatives)

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. International finance in recent years has been saturated with disastrous and scandalous abuses that clearly and repeatedly epitomize the deficiencies of the unregulated global inter-linking of financial markets. Speculators have been blamed for precipitating the run on Asian currencies that started the financial crises. Yet speculation and risk management are two sides of the same coin. At the opposite end of a prudent hedge, a speculator is required. In a structurally flawed system, even perfectly honorable businessmen or institutions individually true to high ethical and financial standards, can unwittingly participate in systemic games of dubious value. Data on the now 6-year-old Asian financial crises show that currency hedging individually by sophisticated businesses and alert government bodies, domestic and foreign, as protective measures against foreign exchange exposures in both debts and revenues, have been mostly responsible for the sudden currency turmoil in the region. In international finance, a game of musical chair in financial risk is in full force in which the players are handcuffed together through inter-linking hedges. This game can cause serious systemic rupture when the music stops.

Specifically, the increased risk associated with a financial environment which profits from instability characterized by abrupt and unpredictable change and flux, has created a demand for financial instruments to protect against that risk. These instruments, generally called derivatives, can be defined simply as aggregated or "bundled" contractually created rights and obligations, the effect of which is to create a transfer or exchange of specified cash flows between counterparties of coupled needs at defined future points in time.

The size of the invisible money pool created by financial derivatives is now many times (no one knows how many) the amount of M3. One firm alone (LTCM) commanded open positions of US$1.2 trillion financed by 100-fold leverage. That is almost the entire daily transactional value of the world's foreign exchange markets. Another hedge fund (Tiger Management) can suffer an asset evaporation (loss) in the amount of US$20 billion in 6 hours by a 10% appreciation of a single currency (yen) against the dollar. At year-end 1998, US commercial banks, the leading players in global derivatives markets, reported outstanding derivatives contracts with a notional value of $33 trillion, a measure that has been growing at a compound annual rate of around 20 percent since 1990. Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange, or over-the-counter (OTC) derivatives. On a loan equivalent basis, a reasonably good measure of such credit exposures, US banks' counterparty exposures on such contracts are estimated to have totaled about $325 billion in December 1999. This amounted to 6 percent of banks' total assets way above the capital requirement level. What's more, these credit exposures have been growing rapidly, more or less in line with the growth of the notional amounts. US high yield default rate reached 16.4 percent in 2002 with nearly $110 billion in defaulted volume, and corporate downgrades outstripped upgrades on global senior debt in 2002 by a factor of nine to one. The creation of a more risk sensitive framework for capital regulation is at the heart of the Basel II Capital Accord. A more risk sensitive minimum capital ratio is also intended to encourage large banks to make lending, investment, and credit risk hedging decisions based on the underlying economics of the transactions. The intent is to eliminate the regulatory distortions and arbitrages under the current rules such as the disincentive to lend to highly rated companies and securitization transactions designed to minimize regulatory capital requirements while transferring little or no risk.

A Bank of International Settlements survey for June 1998 estimated that size of the global OTC market at an aggregate notional value of $70 trillion. At the end of June 2001, global OTC positions in all categories of market risk (including equity, commodity, credit and other derivatives) stood at nearly $100 trillion, a 38% increase relative to the 1998 survey. This nonetheless represented a slowdown in the rate of expansion relative to 1998. With allowance made for the double-counting of transactions between dealers, US commercial banks' share of this global market was about 25 percent, and US investment banks accounted for another 15 percent. While US firms' 40 percent share exceeded that of dealers from any other country, the OTC markets are truly global markets, with significant market shares held by dealers in Canada, France, Germany, Japan, Switzerland, and the United Kingdom.

In a speech on Currency reserves and debt before the World Bank Conference on Recent Trends in Reserves Management, on April 29, 1999, Chairman Greenspan allowed: "The distributions of income that arise in unregulated markets have been presumed unacceptable by most modern societies, and they have endeavored, through fiscal policies and regulation, to alter the outcomes."

The importance of Greenspan's utterances lie not in his wisdom but on the self-fulfilling impact of his power. He admits: "We in the United States built up modest reserve balances of DM and yen only when we perceived that the foreign exchange value of the dollar was no longer something to which we could be indifferent, as when, in the late 1970s, our international trade went into chronic deficit, inflation accelerated, and international confidence in the dollar ebbed." In other words, the US uses reserves in foreign currency not to buttress or stabilize the value of its own as reflected by market fundamentals, but as a tool to manage international trade to its advantage.

After listing some technical reforms that he admitted might not be sufficient or even relevant, Greenspan summarizes: "The adoption of any rule is not a substitute for appropriate macroeconomic, exchange rate, and financial sector policies. Indeed, the endeavor to substitute such a regime for the more difficult fundamentals of sound policy will surely fail." It is a "do as I say, but not as I do" statement.

Greenspan concludes by proposing a liquidity-at-risk approach: "Over the medium term, it would be desirable for emerging market economies to develop a more sophisticated approach to the problem of managing their liquidity. There is an obvious connection between "value-at-risk" techniques used by large financial institutions to manage their exposure to risk and the liquidity-at-risk approach proposed here. It would be productive were those large financial institutions to play a role in helping countries develop their own capabilities to implement this approach, perhaps with technical assistance from G-7 supervisory authorities and international financial institutions."

There are two problems with this proposal:

1) It was the very attempt by emerging market economies to develop a more sophisticated approach to the problem of managing their liquidity and risk that gave birth to the rapid growth of the global foreign exchange markets and the field of sophisticated structured finance of derivatives in the last decade that brought on the global financial crises. Greenspan seems to be advocating an increase rate of mutation of the virus to boost the resistance of the patients.

2) Greenspan's advice for emerging economies to adopt the "value-at-risk" techniques used by large financial institutions to manage their exposure to liquidity risk will only further reduce sovereign governments to the status of commercial enterprises. Value at risk models, widely used for risk management by banks and other financial institutions in the advanced economies, use complex computer algorithms to calculate the maximum that the institution could lose in a single day's complex trading. These models seem to work well in normal conditions but not, alas, during financial crises, which is arguably when it is most necessary to know how much value is at risk.

Unlike multinationals, governments cannot use mass lay-off, market retrenchment, sale of non-core assets as management tools for maximize profit and externalize the burden to society at large. Government's job is not to maximize profit, but to maximize public welfare. This is a point that the Washington Consensus dominated IMF has yet to fully grasped.

Strong Dollar Policy

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 Reagan administration. A strong dollar is key to this capital account surplus - current account deficit coupling strategy, which is a centerpiece of dollar hegemony.

The policy exploits the instinctive penchant of other countries to compete for export gains with 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 own 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 from 5% in August 1999 to 6.5% in June 2000 in a ineffective attempt to preempt wage-pushed inflation, which was anticipated with structural full employment (at 4 percent unemployment). In June 1981, Volcker had to raise the Fed Funds rate to 19.1% to fight inflation, a battle won only at the cost of severe recession. 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. These global transnationals increasing derive their revenue from non-dollar sources, contributing to the current account deficit/capital account coupling in the dollar economy.

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, and from their meager pensions, 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. The Telecom Act of 1996 led to the creation new communication companies, which raised $600 billion from venture capital worldwide to connect the globe with new fiber optic systems and wireless and satellite communications infrastructure. Wealth was being created as fast as the United States could create dollars, with little penalty of hyperinflation. 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. The Fed's aggressive monetary ease during 2001 turned housing from a traditional cyclical drag on the economy during periods of recession into a countercyclical power source in the US economy. Mortgage refinancing jumped to $1.1 trillion from $225 billion during 2000. The combination of low interest rates and sharp home price appreciation permitted US households to extract over $100 billion of tax-exempt capital gains from their residential property to help offset retirement losses in the equity market, while monetary easing helped to stabilize the equity market itself despite the most severe profit recession in decades. Meanwhile, deflation was hitting the rest of the world like a perfect storm from foreign exchange realignment, with places like Hong Kong, Tokyo, Rio and Buenos Aries suffering price depreciation of up to 70% in the property sector while their central banks spent billion to intervene in the market to preserve exchange rates stability.

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 and finance. 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 and capital exploitation of labor. In neo-liberal finance 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 from low wage workers was squandered through fraud and Ponzi schemes on Wall Street. 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 besides the dollar, 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. Thus not only were wages kept low, but the surplus value created by the workers and the retirement benefits due to them were also robbed by financial fraud and manipulation.

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 tells Congress that the threat of deflation remains "remote" and that thinking jobs are better that doing jobs.

What Greenspan tells 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 create 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.

Instability as Profit Center

A controversial feature of the new shape of the financial system is that the bulk of its participants now have a vested interest in instability. This is because the advent of high-tech trading rooms have raised the level of fixed costs, which imply a high turnover is required for profitability. High turnover tends to occur only when markets are volatile. In a way, a relatively stable market has become the most destabilizing environment for modern financial institutions.

A massive transfer of financial resources from central banks to private speculators occurs when the fixed exchange rate collapses. In theory, long-term equilibrium exchange rates are supposed to be determined by underlying or fundamental macroeconomic variables. These variables include international differences in inflation rates, demand and supply of exports and imports, cross-border interest payments, and persistent capital flows deriving from differences in saving and investment rates among national economies. Long-term levels of these variables are determined both by private economic activity and by macroeconomic policy. Short and medium term exchange rates, to the extent that they deviate from equilibrium rates because of sudden policy shocks, are determined by interest arbitrage, and are supposed to return to their long-term equilibrium rates in time.

These theoretical determinants of exchange rates have not performed well in empirical attempts to predict exchange rates. Only some of the movements in the widely fluctuating US dollar in the 1980s can be explained by fundamental economic variables of interest arbitrage. More generally, for prediction horizons out to two years, the random walk model of the exchange rate, which posits no influence of fundamental economic variables, historically outperforms alternative models based on fundamental variables. The variance as well as the average value of exchange rates drift over time. This means that there are alternating periods of a few months or more in which the exchange rate is calm and relatively stable, and in which it is turbulent and tends to move in one direction. The type of news the exchange rate responds to varies also over time. Of the three main currencies, the leading one tends to change every several months or few years. The center of trade-driven exchange rates tends to shift with trade patterns.

Exchange rate behavior is determined not by fundamentals in the short term, but by extensive use in the foreign exchange market of very short-term technical trading rules. These rules may be rational from short-term view of the individual trader. They do not add up to systemic rationality from a macroeconomic perspective, which focuses on long-term movements of fundamental economic variables. Examples of such trading devices are automatic stop-loss rules, which, by instructing traders to sell when rates fall below a pre-set level, limiting the risky-ness of portfolios, and chartism, which bases foreign exchange trading on very short-term analysis and extrapolation of past price movements. In recent years, rumors of central bank intervention and the impending settlement of outstanding derivative contracts also play an increasingly central role in volatility. These devices shorten trading horizons, increase the short-term variability of the exchange rate, and increase the potential for a snowballing effect that can lead to extreme and prolonged exchange rate misalignment. That is why chaos theory is highly valued by traders. Chaos, of course, is the very antithesis of any international finance architecture. Architecture is the art of creating order out of chaos.

Consumption and Investment

One of the shortcomings of economics as a discipline is the inadequate attention paid to it as a behavioral science. The problem is traceable to the neoclassical concept of the economic man who is supposed to act rationally in his own interest, which, in a money economy, is defined rather simplistically as financial gain. Economics is obviously more than finance, and economic well-being is not synonymous with mere financial gain. Modern market economics of course deals with the problem of human behavior with some sophistication, albeit always through the back door, and always equating self-interest with rational individual response to pricing. A market economy is coordinated through the price system operating on the principle of marginal utility.

Human behavior is complex beyond the measurement of price. Price alone is not sufficient to influence market behavior. Karl Marx dealt with the concept of fetish as a factor in demand as expressed in price. Advertising, a critical function in marketing, is essentially irrational psychological conditioning on behavior.

Education is a classic dilemma. Economics literature has never dealt satisfactorily with education, being unable to decide whether it is consumption or investment or both. It has done similarly with health care, environmental preservation and a wide rage of social infrastructure. If these endeavors are consumption, the law of scarcity dictates that society cannot afford too much of them. If they are investment, then supply-side theory would conclude the more the better. If they are both consumption and investment, there should be a limitless upward spiraling supply/demand symbiosis. One could not possibly have an over-educated society or over-healthy population or an over-clean environment, if being more educated, more healthy and more clean is deemed economically productive and thus should be financially profitable.

Debt and Lender Liability

It is obvious that debt changes human behavior. A little debt reinforces responsibility. The US social system of private property is built on the notion that homeowners with a life-long mortgage are better citizens than renters. People tend to take better care of their homes and plant roots in their communities if they "own" their homes, even though 90 percent of the purchase value is in debt that is not expected to be paid off until three decades later.

On the other hand, it is clear that excessive debt encourages irresponsibility. The borrower may develop a rational incentive to walk away from his debt if he perceives the debt to be beyond his ability to repay, or the cost of the debt to exceed its benefits. Even a central bank, which is the domestic lender of last resort, is wary of the problem of moral hazard, that commercial banks within its system would lend irresponsibly if they knew that their lending errors would be bailed out by the central bank.

Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse, but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.

There is a close parallel in most emerging market sovereign debts, particularly foreign currency sovereign debts of Heavily Indebted Poor Countries (HIPC), and International Monetary Fund (IMF) rescue packages, to the above predation examples. Sophisticated international bankers knowingly lent to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston of Citibank famously proclaimed. The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows these bankers to pass the risk to the credit markets, socializing the potential damage after skimming off the privatized profits.

Credit is reserved financial resources ready for deployment. Debt basically is unearned money secured with a promise to repay the principal sum plus interest with optimistically-anticipated earned money in the future. The assumption is that the borrower will not become unemployed through no fault of his own, or a business will not be adversely affected by unanticipated shifts in business paradigm, or an economy will not be destroyed by global financial contagion.

Paying down debt with new debt is a Ponzi scheme - the likelihood of its exposure tends to be inversely proportional to its scale of operation. More and more critics are calling the Enron debacle a Ponzi scheme, now that the company has filed for bankruptcy, even though, for almost a decade up to a few weeks before its bankruptcy filing, many in high places were hailing Enron as the new innovative business model.

On the corporate level, debt inevitably alters management behavior. Leverage increases profit margin on successful business plans. As Henry Kravis, king of leveraged buyout, famously said: "Debt can be an asset. Debt tightens a company." To less creative minds, debt is still a liability, not an asset. But debt also exaggerates losses when business plans fail. In the US financial system, bankruptcy is a legal if not painless way to refute debt. The comfort to lenders is that equity investors are wiped out first before the lenders' various collateralized positions are endangered.

Banks used to be the sole intermediaries of debt. For this reason, a central bank was formed to supervise and provide liquidity to the banking system. Thus a central bank came into existence in the United States in 1913 on the assumption that the existence of a healthy banking system is in the national interest. And to protect the national interest, the central bank, which in the US version is a government institution privately owned by the private banks in the Federal Reserve system, is allowed to act as lender of last resort to the nation's commercial banks with public money, or more accurately, through government authority to create fiat money as certificates of sovereign credit.

Thus regulation on banks is a fair quid pro quo, a social contract. Bank deregulation without corresponding raising of the threshold for central-bank bailout is a direct breach of this social contract. If for the good of the nation, banks cannot be allowed to fail, they should also not be allowed to deregulate. More ominous, the US credit system has broken through the banking system - the bulk of debt now is intermediated through the unregulated credit markets by debt securitization. Securitization acts as more than just providing a vehicle for investment in debt instruments. It restructures simple debt into complex, hybrid instruments sliced infinite ways until the original debt is beyond recognition.

Debt securitization is guerrilla warfare against a sound credit system. Debt proceeds can be disguised through creative accounting as current income with future liabilities, distorting the financial performance of the debtor. In these brave new credit markets, the government is generally only an interested bystander, so far quite unwilling to regulate even over-the-counter (OTC) derivative trading by banks, which are supposed to be regulated, with an "if I don't smoke, someone else will" mentality that such trades can easily be moved offshore.

Systemic Risk Exposure of OTC Derivatives

Over-the-counter (OTC) derivatives are traded off exchanges, directly between counterparties, and as such are not subject to disclosure rules. Adding estimated data from the Bank for International Settlements for OTC derivatives to published figures for exchange-traded derivatives, the total notional principal balance of the reported derivatives market in June 2001 was $119 trillion, about four times the gross domestic product (GDP) of the Organization of Economic Cooperation and Development (OECD) countries and twenty times the value of world merchandise exports in 2000 of $6.2 trillion. The amount unreported remains unknown.

This shows that derivatives performed more than a hedge function to enhance systemic stability, as apologists claim. Derivative trading has become a profit center for banks and non-bank financial institutions. True, the notional principal amount is not at risk, because no principal payments are exchanged. The interest payments derived from that notional principal amount are at risk. A loss on a derivative contract becomes possible when (a) interest rates or commodity prices move in a direction that makes the contract more or less valuable, and (b) the counterparty on the other side of the contract defaults. Credit exposure of a derivative contract is the present value of the cost of restoring the economic value of a contract should a counterparty default.

All kinds of street rumors are flying at this very moment that some of the world's biggest banks are exposed to derivative trades that would cause serious counterparty credit problems if the market capitalization of these banks should fall below a triggering level, or the price of commodities or interest rates should move against their derivative positions. Because there is no way to dispel or confirm such rumors, and the banks involved remain tight-lipped about its true financial conditions, the uncertainties weigh down on the economy.

The Continuing War of False Alternatives between Keynes and Hayek and Friedman

Keynes who advocated government intervention to protect the economy from the effects of the business cycle, which is a necessary by-product of a market economy, and Hayek, who advocated the self-adjusting merits of free markets, had been theoretical opponents in economic theory since the 1930s. Events in the 1930s had shown the socio-economic damage caused by free markets. Subsequently, the macroeconomics of Keynes's 1936 General Theory dominated academic circles as well as government policy establishments in the US.

By the time Keynes died in 1945, Hayek and the neoclassical trade cycle theory had very few serious followers. Economic policy at that time emphasized demand management in which the business cycle was believed to be an undesirable defect to be managed with fiscal policies of deficit financing.

The so-called Socialist Calculation Controversy was prompted by the Austrian School's critique of central planning. From the 1920s until the 1940s, Hayek and his fellow Austrian and teacher, Ludwig von Mises, argued that socialism was bound to fail naturally as an economic system, although they seemed to allow for socialism's political imperative, albeit only as a fallacy. Hayek maintains that only free markets, with individuals making disaggregated decisions in their narrow self-interest, can generate the information necessary to intelligently coordinate social behavior. Freedom of individual choice without "distortive" regard for social impacts is considered as necessary input for an efficient economy that would lead to prosperity. Hayek argues that free market prices are the true expression of a rational economy. This view presupposes the market to be apolitical, and that individual decisions drive the market. It is obvious that markets are inescapably determined by political forces and that markets are dominated not by personal individual decisions but by decisions of economic groups and sectors, such as wage-earners, corporations, economic sectors, national policies, etc. Neoclassical economics conceptualizes the agents, households and firms, as rational actors seeking optimization in free markets. The resulting equilibrium is "optimized" in the sense that any other allocation of goods and services would leave someone worse off. Thus, the social system in the neoclassical vision was supposedly free of un-resolvable conflicts.

For three decades after WWII, reality ran counter to Hayek's theories. Market participants, through their agents, command unequal power that distorts fair equilibrium. Even conceptually, macro-economists began to suggest that with the aid of computerized macro input/output models, central planning can accommodate the very information problem that Hayek had raised. After all, if the boundless complexities of fluid mechanics in producing a silent-running submarine propeller can be simulated by mathematical models, why not the dynamics of a planned economy. Mathematics was challenging ideology in the evaluation of theories in economics. Paradoxically, Hayek, who implies scientific determinism in his ideological argument for free market, is unsympathetic to the efficacy of applying the sophisticated tools of the physical sciences to the social sciences.

The shift from the "gun or butter" trade-off of the pre-war era to the "gun and butter" fantasy of 1960s and '70s pushed post-war prosperity into spiraling inflationary bubbles in countries that had benefited from Keynesianism, led by the United States. As more and more surplus value was siphoned off to non-productive military expenses, wages could only rise by permitting inflation to stay ahead of them, instead of wages keeping ahead of inflation. Employment thus became hostage to the militarization of peace. Even then, full employment could not be maintained by Keynesian measures in peace time because surplus value, having been stored in military inventory, was not being re-circulated in the economy through higher wages to sustained needed demand. The traditional counter-cyclical therapy, such as stimulating consumption and postponing savings through government deficit spending, strained the elasticity of wage/price convergence, pushing the economy into stagflation. The macro models, imperfect as they were, showed that the principle of "guns or butter" was immune to macro-economic management. Too many guns would produce inflation that wages simply could not catch up.

Under Cold War mentality, cutting butter became the only option. The owners of capital were apprehensive that managed inflation would be pro-labor and anti-capital. Keynesian economics was viewed as essentially pro-labor in its macro approach by treating unemployment as a social virus that healthy doses of managed inflation should be tolerated as its cure. Government fiscal policy was deemed the natural venue to administer the medicine. The owners of capital, to combat this serious threat to its very existence, adopted a strategy with three legs. The first leg required that guns remained an untouchable priority. The rationale was that guns were needed geopolitically in a world that had become fatally dangerous to capitalism. The second leg required that government be blamed for high inflation and unemployment. Voters had to be convinced that inflation was bad for them because it causes unemployment and that the pain workers with low wages were suffering was caused by big government and inefficient central planning that distorted the natural self-adjustments of a free market. The third leg required the introduction of the threat of hyperinflation as the inevitable result of the use of sovereign credit in the economy, to scare the gullible masses into accepting an anti-government spending and anti-inflation, sound money frame of mind. This leg of the strategy encouraged the economy to run into prolonged runaway inflation and recurring government deficits that hurt both labor and capital, setting a stage for a anti-labor onslaught through anti-inflation and anti-government rationalization in the name of protecting the nation.

The general public bought into the propaganda readily, but the intellectuals had to be won over with a new school of economic thought that would seize policy initiative from the Keynesians in government. Hayek's discredited free market theories appeared tailor-made for this purpose.

To provide theoretical underpin for this three-legged strategy to promote the indispensability of private capital, the old neoclassical economics prescriptions: savings, investment, balanced budgets, competition, productivity-determined wage levels and supply-side growth, were dug up from of the intellectual graveyard and dusted off with new bells and whistles to be paraded as the sound economic policy goals of good government.

Conservative politicians began to demonize Keynesianism domestically and rational socialist economic planning internationally. Third World socialism, burdened with endemic poverty from centuries of imperialism, was never given a chance economically by the new financial imperialism and politically by Cold War containment. The Soviet Union, as the only socialist super power, fresh from a war-torn economy, was pushed gradually but systemically into bankruptcy by the ruinous arms race stage-managed by the "guns and butter" policy of the US, the emerging capitalistic superpower which had become rich in WWII. The US could violate the Bretton Woods gold standard fixed exchange rate with immunity. A case can be made, and is still waiting to be made, that the USSR collapsed not from the failure of socialism, but from its decision to abandon socialism and to embrace market capitalism to finance the arms race.

To anoint respectability on the worn theories of free market voodoo economics, as propaganda against Keynesianism in the West and socialist planning in the Third World, Hayek was plucked from three decades of homelessness in the economics fraternity, to be awarded a surprised Nobel Prize in Economics in 1974. For ideological balance, Gunnar Myrdal was named co-winner for the Nobel Prize in the same year. Myrdal would later published an article advocating the abolition of the Nobel Prize for Economics, as a reaction to the awarding of the prize to Milton Friedman and Hayek who would be attacked for "certainly never been much troubled by epistemological worries," not withstanding Hayek's Nobel speech, delivered in Myrdal's presence, dealt with the subject of the methodology of economics. Myrdal's disdain for Hayek was shared by many in academic circles, particularly in Europe.

Nevertheless, overnight, the extremist right transformed Friedrich August von Hayek, born in 1899, died March 23, 1992 in Freiberg, Germany, to guru status, as the greatest philosopher of capitalism since Adam Smith. Actually, Hayek and Keynes were both fundamentally neoclassical, the former a libertarian and the later a liberal, the former rooted Austrian idealism, the latter in English pragmatism. The basic ideas for both are based on the myth of individual freedom in a market economy. Keynes was seduced by political necessity. His famous phrase: "in the long run we will all be dead," implies his recognition of the importance of immediate socio-political constraint over timeless doctrinal purity. The difference between them was that to keep the economy going along capitalist lines, Keynes would fight unemployment with inflation and Hayek would fight inflation with unemployment. They also differed with regard to technical measures, as relating to interest rates, money supply, liquidity, etc., deemed appropriate for achieving the desired effects.

For politicians in capitalist democracies, inflation and unemployment are the two score-keeping measurements in economic policy. Keynes' thesis is that government spending is needed to bolster aggregate demand in times of rising unemployment. Hayek believed that if it were not for government interference with the monetary system, the economy would have no business cycle fluctuations and no periods of depression. To him, business cycles are caused by government monetary authorities creating a semi-monopoly where the basic money is controlled by government, rather than market demand. Since banks issue broad or secondary money, which is redeemable in high power money, a system of indeterminate control is created. So government monopoly over the issue of money is ultimately responsible the economy's structural problems, because nobody in charge of such a monopoly could remain true to the logic of finance, independent of political preconceptions. This is the basic argument for the political independence of central banks. The fallacy of this view is the assumption of the independence of the logic of finance from politics, since the very concept of property rights is a political concept.

Hayek allowed that the Keynesian period from about 1950 to 1975 would go down in history as the Great Prosperity, as opposed to the Great Depression of the 1930s. To Hayek, the hyperinflation of Germany in 1922 was not to maintaining prosperity but was forced upon Germany due to financial difficulties caused by a war debt strategy. If the purpose of inflation was to maintain prosperity, a much more moderate rate would have achieved the aim. Hayek blamed the collapses of the inflationary booms during past business cycles on the gold standard, which put a brake on those expansions after a few years. History has never had a time where a policy of deliberate expansion was unlimited by any framework of monetary order. So Freidman's monetary theory cannot solve any basic problems. Hayek admitted that cuts in inflation have been accomplished through extensive unemployment. He acknowledged that ending inflation need not lead to long-lasting periods of unemployment like the 1930s, because then the monetary policy was wrong during the boom as well as during the Depression, by first prolonging the boom and intensified the depression, and then by allowing deflation to go on and prolonged the Depression. But after an extended period of inflation, an economy cannot get out of it without substantial unemployment.

To Hayek, inflation causes unemployment by drawing people into jobs which exist only because relative demand is temporarily increased, and these temporary employments must disappear as soon as the increase in the quantity of money ceases. Yet, in the United States, a long period of high unemployment would automatically strain income-maintenance programs, such as unemployment insurance, welfare, etc., and run up enormous deficits as to threaten monetary stability with inflation. Hayek acknowledged that there would be intense political struggles on the question of whether social-security benefits ought to be indexed to inflation. He advocated using inflation to reduce the real cost of the social security system. He hoped that the horror of financing this colossal welfare bureaucracy would shock the country into a more rational government framework.

To avoid inflation, Hayek's prescription has been to advocate that monetary policy be pursued with the goal of maintaining stability in the value of money. Since politicians cannot be trusted in a democracy to regulate the money supply, market forces should be allowed to adjust towards a gradual deflation. Hayek wanted a free market of money. He viewed the gold standard as an unconstructive regulation. The gold standard, he argued, even if it were nominally readopted, would never work because people are not willing to play by the rules of the game, which for the gold standard require that an unfavorable balance of trade leads directly to a contraction of currency. But no government can do that; they would opt for going off the gold standard. Hayek attacked monetarism as represented by Friedman, by pointing out the gold standard as based on an irrational superstition. Hayek toyed with the idea of a commodity-reserve system, but the idea of accumulating actual stocks of commodities as reserves is so complex and impractical that he shifted to place the issue of money in the hands of firms whose businesses depend upon their success in keeping the money they issue stable. In that case, there is no necessity of depending upon their obligation to redeem in commodities: it depends on the fact that they must so regulate the supply of their money that the public will accept the money for its stability. Hayek, who would not trust elected officials to regulate the supply of money, thinks that the self-interest of a few firms is better than any other arrangement. Hayek failed to see that in financial capitalism, a free market leads to monopolistic outcomes which only government regulation can prevent.

The Keynesian economic formula seeks a symbiotic relationship with the political forces of the modem welfare state. Keynes accepts the need to adjust monetary policy to a rising wage structure. He opposes restriction on monetary policy that would prevent it to be adjusted to deliver a politically acceptable level of economic performance. Hayek considers the Keynesian formula to be an unsustainable spiral. As unions push up wages, government has to provide enough money to keep employment at these wages, and this leads into an inflationary spiral. Keynes does not dispute this conclusion for the long run, but practical application of Keynesian measures seems to work at least in the short run. The flaw in Keynes' deficit financing idea is its reliance on government fiscal deficits to smooth out the business cycle. Keynesians accept the use of sovereign debt in deficit financing, while there is no such need when sovereign credit is freely available to keep expanding the economy.

Hayek's The Road to Serfdom warns of the invasion of the welfare state in people's private lives, the fundamental conflict between liberty and bureaucracy. In the history of the world, no road has ever been built by popular vote. The Austrian economists who view the economics system as the calculus of independent individual decisions differ with Milton Friedman and the Chicago School, which think macro-economically in analyzing total quantity of money, total price level, total employment, etc., in aggregates and averages terms. Friedman is an arch-positivist who believes nothing must enter scientific arguments except what is empirically proven, while Hayek theoretically rejects the usefulness of statistical studies.

Hayek observes that the Keynesian neoclassical explanation of unemployment is more acceptable by economists over the classical explanation because the former can be statistically tested while the latter cannot. From that point of view, Friedman's monetarism and Keynesianism have more in common with each other than Hayekian theory has with either.

Hayek's rejection of socialist thinking is based on his view that prices are an instrument of communication and guidance, which embodies more information than each market participant individually processes. To him, it is impossible to bring about the same price-based order based on the division of labor by any other means. Similarly, the distributions of incomes based on a vague concept of merit or need is impossible. Prices, including the prices of labor, are needed to direct people to go where they can do the most good. The only effective distribution is one derived from market principles. On that basis, Hayek intellectually rejects socialism. In Hayek's social philosophy, value and merit are and ought to be two distinctly separate issues. Individuals should be remunerated purely on the basis of value and not in accordance with any concept of justice, whether it be Puritan ethic or egalitarianism. Hayek went as far as to deny that the concept of social justice has any meaning whatever, on the basis that justice refers to rules of individual conduct. Since no rules of the conduct of individuals can determine how the good things of life should be distributed, the question of justice is mute. Since a free market is the natural outcome of a multitude of individual decisions, how the market decides is amoral. Hayek refused to acknowledge that what the market decides may also turn out to be economically destructive.

According to Hayek, a spontaneously working market, where prices act as guides to action, cannot take account of what people need or deserve, because it allegedly operates according to a neutral distribution system which nobody has designed. Such a distribution system cannot be just or unjust. And the idea that things ought to be designed in a 'just' manner means, in effect, that one must abandon the market and turn to a planned economy in which somebody decides how much each ought to have. And the price for that justice is the complete abolition of personal liberty. Hayek's free market ideas have been applied to much of unregulated globalization, the socio-economic damage is now very visible. Not withstanding Hayek's repugnant social philosophy, even his "scientific" claims on the efficiency and effectiveness of free markets has not been substantiated by events. The market is a place where individual freedom is singularly ignored in favor of mass response.

In Hayek's social philosophy, economic value and humanity are and ought to be two distinctly separate issues. Market participants should be remunerated purely on the basis of economic value and not in accordance with any concept of justice, whether it be the Puritan ethic or egalitarianism. Hayek went so far as to deny that the concept of social justice had any meaning whatever, on the basis that justice refers only to rules of individual conduct. Since no rules of the conduct of individuals can determine how the good things of life should be distributed, the question of justice is moot. Since a free market is the natural outcome of a multitude of individual decisions, how the market decides is amoral. Hayek denies the validity of fair trade. Yet basic human needs such as safe shelter, food, health care and education are not distributional issues. In a healthy society, all members are entitled to the satisfaction of these basic needs. The world's economy can supply every human being with adequate needs, but for the "market."

But according to Hayek, a spontaneously working market, where prices act as guides to action, cannot take account of what people need or deserve, because it operates according to a neutral distribution system that nobody has designed. Such a distribution system cannot be just or unjust. And the idea that things ought to be designed in a "just" manner means, in effect, that one must abandon the market and turn to a planned economy in which somebody decides how much each ought to have. Yet the price for that justice is not the complete abolition of personal liberty, Hayek's claim notwithstanding. So, in the name of liberty, the world is forced to go hungry while economies suffer overcapacity.

Hayek's free-market ideas have been applied to much of unregulated globalization in recent decades, and the socio-economic damage is now very visible. Not withstanding Hayek's repugnant social philosophy, even his "scientific" claims on the effectiveness of free markets has not been substantiated by events. A transaction requires a buyer and a seller at a price. It is easier for a camel to go through the eye of a needle than for both buyer and seller to be satisfied with any given price. One side of a "win-win" transaction is always an idiot.

Trade and Development

An economy is a comprehensive and complex entity of which trade is only one sector. Yet nowadays, neo-liberal economists and policy-makers tend to view trade as the economy itself, downplaying the importance of the public sector and other non-market social sectors of the economy.

Neo-liberals promote market fundamentalism as the sole, indispensable path for economic development, despite the fact that data of the past decade have shown that trade tends to distort balanced development in a way that hurts not only the less developed, but the developed economies as well. Currently, in the United States, the mecca of free-market entrepreneurship, the statist sectors - government spending on defense, health care, social and education services - are keeping the economy afloat with fiscal measures, such as tax cuts, while finance, entrepreneurial ventures and high-tech manufacturing languish in extended doldrums.

Unregulated markets lead naturally to the emergence of monopolistic enterprises. Thus "free" markets are inherently self-destructive of their own freedom. Free markets depend on enlightened statism to remain free. Unregulated labor markets lead to slavery. For many human social activities, the market has no positive function. Free markets for human relationships, for example, lead to prostitution. Free markets in power breed corruption. Socio-economic Darwinism will eventually deplete the economic food chain: the fittest cannot survive when all the weak that the strong need to exploit in order to survive disappear. Government, from monarchy to democracy, exists solely to protect the weak from the strong.

Globalization since the end of the Cold War has been viewed increasingly as neo-imperialism by many even outside of the radical left. This view is amply supported by field data. It has become obvious to many in both developed economies and emerging markets that the undervaluation of labor is necessary for the creation of surplus value that economists call capital. This capital then must seek new investment opportunities in less developed economies where labor is even cheaper. The investment opportunities of this adventure capital point not to the beneficial development of the less developed economies. This capital seeks higher return than it could get at home for the benefit of its owners by exploiting even cheaper labor overseas. Capital has acquired enormous market power for the suppression of the value of labor both at home and abroad. Neo-liberals rationalize that globalization, while undeniably exploitative, nevertheless produces tangible collateral benefits, even to the exploited. To implement this strategy, private capital will have to preempt sovereign credit. Trade must preempt development. Ironically, with the advent of finance capitalism and unregulated globalization of financial markets, the bulk of institutional capital now comes from pension funds of underpaid workers worldwide. Thus we have reached the final cycle where the exploited is forced to exploit themselves, providing handsome fees for financial services. Wall Street is commonly acknowledged as the most overpaid sector of the economy. For example, responding to criticism of the secretive way it compensates its chief executive, the board of the New York Stock Exchange disclosed on August 27, 2003, for the first time in its two-century-long history, that its top executive, Richard A. Grasso, would receive lump- sum payments totaling $140 million in accrued savings and incentives, in addition to a base annual salary of $1.4 million and an annual bonus of at least $1 million. This is a phenomenal no-risk/no capital return for the head of a quasi-public, regulatory organization, particularly at a time when the US equity market has lost over $6 trillion of investors' money. Worldwide equity markets during 2000-2002 declined by US$13 trillion, or US$2,000 for every man, woman, and child on the planet, where 53.7% of the population, or 2.7 billion people live on less than $2.15 per day.

The infamous Lawrence Summers World Bank memo of December 1991 is a classic example of warped neo-liberal mentality. As chief economist of the World Banks, Summers argued that "the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that," because poor regions such as Africa are under-populated and "under-polluted" and lives in LDCs were worth less because of low productivity and low longevity.

This neo-liberal approach of course was the same argument presented by the defenders of 19th-century imperialism in which moral rationalization was used to justify economic exploitation. Neo-liberal values, namely capitalistic democracy and market fundamentalism, become the new smiling mask for economic exploitation not different from the "white man's burden" of 19th-century Euro-centrism. The recurring financial crises associated with financial globalization in the past two decades have revived economic nationalism worldwide with parallels to the political nationalism against imperialism of the previous century.

John Atkinson Hobson (1858-1940), an English economist, wrote in 1902 one the most insightful critiques of the economic basis of imperialism. Hobson provided a humanist criticism of classical economics, rejecting exclusively materialistic definitions of value. With A F Mummery, he developed the theory of over-saving that was given a generous tribute by John Maynard Keynes. Hobson's second major contribution was his analysis of capitalism on which Lenin drew freely to formulate the theory of imperialism as the highest stage of capitalism. Thus until the Cold War, practically all anti-imperialist movements were also anti-capitalist. Hobson believed that the contradictions of production and consumption, cost and utility, physical and spiritual welfare, individual and social welfare, all find their likeliest mode of reconciliation and of harmony in the treatment of global society as an organism, and not as a collection of competing economies in the market arena. But in today's finance capitalism, the bulk of capital comes not from capitalists, but from the pension funds of workers. Why should workers allow the managers of their own capital to force them to accept low wages in exchange for capital gain that will be siphoned off by financial service charges?

The Myth of the Market

Karl Polanyi is also worth a revisit in this hour of self-induced imminent collapse of the globalized market economy. The principal theme of his Origins of Our Time: The Great Transformation (1945) was that the world market economy in effect collapsed in the 1930s. Yet this familiar system was of very recent origin and had emerged fully formed only as recently as the 19th century, in conjunction with capitalistic industrialization. The current globalization of markets following the fall of the Soviet bloc is also of recent post-Cold War origin, in conjunction with the advent of the information age and finance capitalism.

Prior to the coming of capitalistic industrialization, the market played only a minor part in the economic life of societies. Even where market places could be seen to be operating, they were peripheral to the main economic organization and activity of society. In many societies, there were only two market days per month. Polanyi argued that in modern market economies, the needs of the market determined social behavior, whereas in pre-industrial and pre-market economies, the needs of society determined economic behavior. Polanyi reintroduced the concepts of reciprocity and redistribution in human relationships.

Polanyi observed that this money-based market economy sprang suddenly into existence in the 19th century, thrusting aside the old systems based on reciprocity and redistribution. Polanyi challenged Adam Smith, who suggested that the division of labor depended upon the existence of the market, or upon man's "propensity to barter, truck and exchange one thing for another", because the market economy had not appeared to much extent in Smith's time. Even where it had appeared, it was a subordinate feature of economic life. Polanyi wrote on the formal and substantive meanings of the term "economic". This distinguishes the methodology of economics from that of economic anthropology. He argued that economics as we know it depended on "formal" principles. Thus a set of allegedly self-evident assumptions are made, which become premises used as the basis for a sequence of logical deductions to a set of irrefutable conclusions. Thus one can take Smith's statement about man's "propensity to barter, truck and exchange one thing for another" and develop it to show how money and markets came into being, and how they led in turn to specialization of function, and increased productivity. But the method of economic anthropology was "substantive" and depended upon empirical observation from which principles of economic behavior were induced from perceived evidence. Societies are first observed and the principles of their economic activity recognized from their actual behavior.

Utilitarian ethics presumes that moral discussion originates from the point of view of the individual ego. It consequently construes all values as personal possessions. Christianity, Islam, Buddhism, Confucianism, Marxism and other similarly comprehensive outlooks believe that utilitarianism is mistaken in this. These outlooks begin by recognizing that individuals do not atomically exist: "The real nature of man is the totality of social relations," as Karl Marx asserts. Hence values are social and cannot be adequately defined by an inventory of personal possessions. Quality of life cannot be measured by a bank account or by similarly assessing personal possessions, including, perhaps, how a person is progressing in his or her self-chosen life purpose. Somehow the public dimension must also be assessed, not as utilitarians would do this - to reduce obstacles to private projects - but in the sense of measuring dedication to a goal, such as justice, or realization of other social values, such as brotherly love.

Poverty is Bad Economics

In a money economy, it is a basic truism that only those who have money can pay the bills at the end. If all are to pay their share, ways must be found for all to earn sufficient money to participate constructively on a healthy financial level, without permanent subsidy from the economic order to which the poor have become burdensome wards. In a bountiful world, poverty is seldom caused by someone else's needing more than others, unless desire is distorted by greed. This is particularly true in a society in which both greed and envy are constrained by moral precepts. Obscene profit is not a notion relating to size, but to whether profit is derived from hurting others or helping others. One does not have to be one of the world's richest men in order to avoid feeling poor. Poverty is the result of underdevelopment in relation to the production and consumption norms in a particular socio-economic order. A case can be made that poverty is a byproduct of the institution of money, with which poverty is often measured. It is the quest for accumulation of money as capital that brings about the exploitation of humans at levels that produce poverty. With money recognized as sovereign credit, as sovereignty as belonging to the people, poverty is not necessary, not does it serve any socio-economic function. The cardinal rule on Wall Street is that one can only make money by first making others rich. Tolerating the existence of poverty is simply bad economics and poor business strategy.

It is only when some singular segment of society fails extensively to receive sufficient economic opportunity, or sufficient value for its labor to maintain its fair share of consumption, as normatively prescribed in the socio-economic order, that poverty is born. Social cohesion will be threatened when poverty is perceived as the result of institutionalized mal-distribution of wealth, reflecting unfairness in the sharing of the fruits of co-operative endeavor among different socio-economic groups.

Poverty, however, cannot be defined by absolute income levels alone, because poverty is actually a social problem with an economic dimension. It is only because it is most conveniently recognizable in a money-based economy by its financial aspect that poverty is often mistaken as a simple matter of income deficiency.

Poverty is in reality a phenomenon of social despair. The habitually unemployed, the unemployable, the underemployed and the working poor in developed countries have higher absolute incomes or public assistance payments than the middle class in other less developed countries, whose members nevertheless do not consider themselves poor because they have not lost hope in themselves or self-respect for their own lot.

Poverty is a symptom of economic inefficiency and social dislocation in society. Its existence in an economy hurts the rich as well as the poor, and its pervasiveness in society alienates its members from one another. Aside from being dehumanizing to those suffering from it, it is destructive to the society tolerating it. Poverty becomes a political issue when the poor are structurally excluded from contributing to the economic process at levels that enable its constituents to support a dignified life in a healthy environment consistent with the cultural traditions of their society. While there may always be those who enjoy higher income than others, there is no socio-economic necessity for the poor to exist. Thus when Ronald Reagan, leader of the free world, proclaimed that there would always be poor people, he was defaulting on the responsibility of political leadership. Poverty can be eradicated with sovereign credit to the benefit of the total economy.

Wages and Prices

The issue of wages is a serious one in market economics. The suppression of normal wage rises from truly free-market forces is accomplished by government anti-inflation policies based on a "natural" rate of unemployment - what economists call non-accelerating inflation rate of unemployment (NAIRU).

American writers such as Henry Demarest Lloyd (Wealth Against Commonwealth), Ida M Tarbell (History of The Standard Oil Company), and Lincoln Stephen (The Shame of The Cities) exposed the inequity to herald the rebirth of American populism in early 20th century. In 1912, a third political party came into existence in the US, known as Progressives. In response, monopolists rallied around Herbert Spencer's Social Darwinism of "survival of the fittest". The problem of Social Darwinism is that all workers will eventually die off and the rich would have to wash their own dishes, a fate the rich avoid by keeping "the unfit" surviving at subsistence.

Social Darwinism went out of fashion in the US in the 1920s, defeated by undeniable socio-economic litters of its failure, but conservatives found a new line of defense against organizing the economy for collective benefits. They argued that while the aim was desirable, the task was beyond human capacity and that even if doable, the direction was alien to American values. The October Revolution gave this line of argument substance. If Russia had it, Americans did not want it, despite the fact that much of the economic planning by the early USSR was copied from highly successful US war planning efforts.

During World War I, while money wages increased all around, the lower wages increased more than the cost the living. Labor benefited from full employment. The railroads, shipping and shipbuilding were taken over by government, resulting in huge increases in productivity in guaranteed markets. The same happened in World War II.

The theory of rising wages asserts that employers should understand that rising wages are the only venue of assuring strong demand for their products, supported by the theory of technology-driven productivity increases, and the broad-based ownership of securities to spread wealth. The historical data show that the largest average increases in purchasing power have taken place at recession times when employers and bankers tried their beast to keep wages down, but the stickiness of wages made wage deflation slower that price deflation, as in the 1920-22 depression. The result was that when full employment returned in 1923, US workers had higher purchasing power than they had in 1920. But average manufacturing worker's yearly income decreased by $55 between 1923 and 1928, a miner's income by $187. Falling wages amid prosperity was a major structural cause, albeit little noticed, of the 1929 crash. If wages had been higher, equity prices would not have risen as much, thus dampening the speculative fever. Wealth effects from the speculative boom made low wages tolerable and caused a corresponding rise in debt without altering prudential debt to equity ratios. But when the speculative bubble burst, debt-equity ratios skyrocketed and there were insufficient wage levels to sustain consumption. Similar conditions appear to be facing the US economy now.

After the 1929 crash, the economic downward spiral was caused mainly by falling wages. Despite all promises of maintaining production, goods could not be sold as fast as they were produced because of a collapse of income due to layoffs and wage reductions. Globalization in the past two decades temporarily kept US purchasing power increasing despite a slow growth of domestic wages. This resulted from still lower wages in the emerging markets. Now the world is awash with overcapacity in relations to low demand caused by insufficient wage levels. For the past five years, China is the only nation that has adopted a wage policy to stimulate domestic demand, which has been largely responsible for China's continued growth in the face of global recession.

The failed first Hoover Plan in respond to the Great Depression, of holding the industrial status quo and injecting "confidence", was built on the theory that nothing much was fundamentally wrong with the system and that what was needed was for everyone to go on as before. When this theory failed to arrest the downward spiral, Hoover shifted to a second phase, admitting that something was amiss, that in mysterious ways the system had gone off track, but the remedy was to let the excesses run their natural course without government interference. The economic system if left alone was deemed a self-compensating mechanism through market forces, and would eventually restore equilibrium. Wages should be allowed to sink, which would reduce costs and profit would return and give incentive for renewed production, which would create jobs, etc. No one asked how falling wages could promote sales and what good were low production costs without sales. This was the forerunner of supply-side economics, which even in the early phase of a boom would accelerate the downturn because it by design leaves demand behind supply - a classic case of increasing speculative risk for production in hope that demand will follow. Production in the absence of ready demand is pure speculative investing. It is suicide as a cure for a recession. Yet current policymakers in many countries subscribe to the same faulty theory, hoping for a "recovery" without having to correct structural defects of the system, which is essentially the pre-emption of sovereign credit by private debt.

There is a fundamental relationship between wages and prices. Pricing policies of firms as they are actually practiced in the real world, both by cartels such as the Organization of Petroleum Exporting Countries (OPEC), and by market leaders in pharmaceuticals, software, communication and by commodity producers, have one thing in common. Pricing policies across all these different economic sectors are predicated on the proposition that price is seldom, if ever, set by the intersection of supply and demand, as neo-classical economics textbooks teach. The bottom line is that price is determined not by supply and demand, but by strategies that aim at optimizing the long-term value of assets and market power.

OPEC pricing is a good example. Throughout the history of oil, price has been set by highly complex considerations and supply has always been adjusted to maintain the set price. In pharmaceuticals, price is set neither by cost nor demand. The pricing model of any new drug aims at achieving maximum lifetime value of the drug that has very little to do with current supply and demand. Microsoft's pricing model for Windows is an expression of market power, and it has little to do with supply and demand, or marginal costs, which are approaches zero as sales increase. Telephone charges, as networks, are similarly disconnected from supply and demand, or marginal costs. Even in the auto industry, the dinosaur of the old economy, where cost input is high and discounted return on capital low, pricing is based more on complex considerations than simple demand. With 80 percent of autos financed or leased, subsidy of financing costs is the name of the game, not sticker price. Farm commodities prices are definitely not set by the intersection of supply and demand. They are set artificially high by political considerations by practically all producer governments; and both supply and demand are artificially distorted to maintain the politically set price. The general consensus of mainstream economists on the global steel overcapacity problem is to reduce capacity, not to let prices fall. The 2001 Bank of Sweden Prize in Economic Sciences (Nobel Prize) was awarded to Joseph Stiglitz, George Akerlof and A Michael Spence for "their analyses of markets with asymmetric information". In his acceptance press conference, Stiglitz said, "Market economies are characterized by a high degree of imperfections."

Price in fact is the most manipulated component in trade. That is the fundamental flaw of market fundamentalism. Friedrich Hayek's rejection of socialist thinking is based on his view that prices are an instrument of communication and guidance, which embodies more information than each market participant individually processes. To Hayek, it is impossible to bring about the same price-based order based on the division of labor by any other means. Similarly, the distribution of incomes based on a vague concept of merit or need is impossible. Prices, including the price of labor, are needed to direct people to go where they can do the most good. The only effective distribution is one derived from market principles. On that basis, Hayek intellectually rejects socialism. The trouble with this view is that Hayek's notion of price is a romantic illusion and nowhere practiced. That was how the native Americans sold Manhattan to the Dutch for a handful of beads.

The Denial of Planning

The notion that market capitalism is superior as an economic system is only a recent invention. And its success in the past decade has been propped up by complex geopolitical factors. From the 1930s to the 1950s, the US in fact adopted many aspects of the Soviet model of planned economy. In 1931, a book about Russian planning, New Russia's Primer by M Ilin, was one of the more popular monthly choices in the Book of the Month Club. Stuart Chase, an economist at the Massachusetts Institute of Technology (MIT), proposed a Peace Industries Board as a successor of the War Industries Board of 1918 and historian Charles Beard suggested a National Economic Council to organize industrial syndicates regulated under the theory of public-utility control and supplemented by planning agencies for agriculture, public works, foreign trade and the rebuilding of cities. A committee of the National Progressive Conference in 1931 published a memo on "Long Range Planning for the Stabilization of Industry". Schemes for planning by separate autonomous industries according to the principles of trade associations or cartel came from many business sources, from Gerald Swope of GE and even the US Chamber of Commerce. National planning was the mantra of the day. The National Bureau of Economic Research put together the figures that came to be known today as GNP (gross national product), NNI (net national income) and other indices. The growth of US higher education was a centrally planned affair. The Federal Reserve Bulletin on money credit and industrial production was issued for the purpose of planning. The profession of economics itself grew up in the US under the aegis of planning. Hoover was also a planner. He attempted to save capitalism through government planning by abandoning laissez faire and threw government credit into the breach to protect the great capital hoard from the onslaught of deflation, not unlike what US Federal Reserve chairman Alan Greenspan is trying to do to prop up the over-valued equity markets today.

Hoover, while in the name of laissez faire vetoing government measures to help the unemployed, was at the same time unleashing government to interfere with the free play of market forces to protect the centers of economic power. The net result was history. Not until President Franklin D Roosevelt adopted Keynesian and many so-called socialist measures of demand management did the US economy stir, and it remains controversial today whether a Keynesian program could have succeeded in reviving the US economy without World War II. The RFC (Reconstruction Finance Corp) was established at the end of 1931 to prevent pending bankruptcies by lending government guaranteed funds raised from tax-free debentures ($1.5 billion) to banks and business corporations that were frozen out of the credit market - and the loans were even kept secret to protect the credit ratings of the corporate borrowers. The RFC's original two-year temporary life was extended to well beyond the end of World War II, until 1950, financing war expenditure in the interim. The planned economy did not came under attack in the US until well into the final phase of the Cold War, with the rise of supply-side economics in the late 1970s.

Warren Nutter made a well-known study in 1962 for the National Bureau of Economic Research: The Growth of Industrial Production in the Soviet Union. It estimated the percentage of planned output achieved by important industries at the end of successive five-year plans, in "value-added" terms. The first five-year plan (1928-32) achieved 75 percent of its target, the second (1932-37), 76 percent. The plan ending in 1950 achieved 94 percent and 1955 achieved 99 percent. The area of trouble in Soviet planning was in agriculture, not so much in the state farms but in the collective farms made of small farmers. The knotty problem of reward and incentive in collective enterprise has yet to be solved by human ingenuity. The same was also true in China. When China abandoned collective farming, the agricultural problem also eased. Even in the US, free-market principles never touched agriculture, which has remained a fortress of government subsidy with both government credit and price support.

The Agenbeguan report, published on July 9, 1965, in the New Statesmen, gave a revealing assessment of the Soviet economy as still backward in industrial production compared with other developed economies, even though Russia had come from a lower base. The USSR had as many machine tools as the US, but some 50 percent of them were in constant repair. Production was siphoned off to maintenance. The report proposed a form of just-in-time inventory (in 1965!), which has become the management craze of the 90s. And the agricultural problem had not been solved (and would not be solved by the end of the USSR and is still not solved today). The report focused also on rising unemployment, which had been denied in official figures. The report identified the defense sector as the cause of these problems. It was a direct attack on incompetent management disguised as planning, not on planning itself.

This is an important point. The US excels in corporate and strategic planning, despite the myth of free enterprise and competition. The Soviets erred by neglecting the science of management and suffered from both excessive centralization of policy formulation and excessive democracy at the operational level. Workers could not be fired or laid off by mangers and were not particularly obliged to carry out instructions, on the ground of misinterpreted political equality. China was faced with the same problem with its copying of the Soviet model, which Chinese planners did not correct until after 1978. In management terms, production increased in the Chinese economy when management was given more autocratic power, not less, despite Western liberal wishful thinking. General Motors was not run by democracy. There is no democracy in the corporate organizational structure or governance, power being vested in the number of shares rather than the corporate population. In fact, the American managers in the GM joint-venture operation in Shanghai repeatedly complained openly about increasing Chinese political liberalization and its damaging effect on productivity. They longed for a return of the good old days when the Communist Party commissar called all the shots and problems could be solved by getting the approval of a few powerful persons rather than endless levels of power centers. The Central Intelligence Agency never predicted the collapse of the USSR, especially from structural economic shortcomings.

All economies are planned. Some are planned through "market" mechanism in order to deny societal values, while others are planned according to societal values. Demand, in the sense neo-classical economists use the term, has to do with market forces as expressed in price. Yet the manipulation of demand against market forces is widely practiced by all market participants with unequal market power, in intervention against truly free markets. Free marketeers consider the unseen hand of government as intervention, but the unseen hand of price setters as a cannon of natural laws.

What about supply? Neo-classical economists do not construct supply curves for non-competitive markets. However, supply curves in competitive markets are just cost summaries, and every firm has a cost structure. Supply and demand are two sides of the same coin and in fact quite inseparable. In pharmaceuticals, demand is related to the illness, not the availability of drugs. But many useless drugs are marketed and sold with proper warnings, often at great profit (a perverse version of Say's law - supply creates its own demand). Addiction to cigarette smoking creates demand that leads to supply in the form of tobacco production, which for centuries received government subsidy in tobacco farming. Smoking causes cancer, which created demand for health care and cancer prevention. The tobacco industry contributes support to cancer research on cure but not on prevention, because the hope of a cure for cancer will neutralize the great threat to the future of the tobacco industry, while prevention directly threatens the industry. Now, all that eventually comes out in the wash in cigarette pricing models. Take the case of drugs for AIDS. There is an intense debate going on regarding the pricing and availability of "promising" drugs for human immunodeficiency virus (HIV) infections. And the drugs are not available for those who need them most, nor in areas that need them most to reduce HIV's spread, but to those who most are able to pay for it or who are adequately covered by health insurance.

It's time for a fundamental rethink of the theology of supply and demand and the function of price in so-called free markets. To start with, all markets are coercive, participants are seldom, if ever, free to act, but are compelled to act, with very little room to reduce their individual disadvantages. The law governing markets is power, with government, being as institution endowed with the most power, always the most influential participant. Some governments choose to control the market indirectly while other choose to control it directly. All governments reserve the right to set the rules of the market. Some governments subscribe to ideologies that tilt toward market power equalization in the name of fairness, while others subscribe to ideologies that tilt toward hierarchy in the name of efficiency. These rules predetermine the winners and losers, while the average market participant innocently hangs on to the Horatio Alger myth of hard work and honesty as the ingredients of success.

Friedrich List, in his National System of Political Economy (1841), asserts that political economy as espoused in England in the 19th century, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List's institutional school of economics asserts that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and it must be fought with protective tariffs and other protective devises of economic nationalism by the weaker countries. Henry Clay's "American system" was a national system of political economy in opposition to British hegemony.

Market fundamentalism has wrecked economies all around the world. Yet neo-liberals continue to promote the false hope that the market will save the world from the onslaught of a severe depression. It is time to rein in this monstrous institution known as the market and to plan rationally for human development

Interest Rate, Money Supply and Debt

There is ample evidence that the level of interest rates does not always control the aggregate level of debt in an economy, conventional expectations notwithstanding. When interest rates are high, they often merely reflect the systemic credit-unworthiness of borrowers as a group or the high risk assumed by lenders collectively. High interest rates in fact create more incentive for both lenders and borrowers to take higher risk to shoot for the higher returns needed to meet higher interest cost. High interest rates also direct money to more desperate borrowers. As William Zeckendorf, the bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent interest than be dead at 3 percent."

However, interest rates do affect the distribution of credit in the economy. When rationed by interest rates, debt actually puts money to work for those who need it most desperately, and not necessarily the highest and best use in the economy, or where it is socially needed most. Debts at high interest rates can only be justified by high risk, which tends to destabilize the economy. Debt securitization actually lowers systemic credit quality by socializing risk across the whole system rather than concentrating it on singular, isolatable defaults.

The US Federal Reserve's fixation on interest-rate policy as the sole tool of regulating monetary policy is increasingly taking on the look of shadow boxing, with declining effect on the economy. As Fed Chairman Greenspan is fond of saying: "Bad loans are made in good times." As interest rates are artificially raised by Fed action to tighten money supply, distressed borrowers with bad loans made in better times will need to borrow more, thus increasing demand for credit and enlarging the credit pool, defeating the Fed's purpose of a tight monetary policy. As interest rates are artificially lowered by Fed action to stimulate a slowing economy, banks raise their credit threshold to compensate for the narrowing of rate spread, thus reducing the number of qualified borrowers and shrinking aggregate loan volume. This is known as the Fed pushing on a credit string or what Keynes called a liquidity trap.

Credit rationed by interest rates also discourages economic democracy, since the poor generally find it much harder to obtain or afford credit and the financial weak lack the credit ratings to obtain loans. The poor and the financially weak also do not have the sophistication to participate in structured finance. There is much truth in the saying that it is not how much you own, it is how much you owe that measures how rich or financially powerful you are.

Debt also encourages carelessness with money, since lending implies faith in the borrower's ability to repay in the future. People tend to be more careful with money they earned in the past in the form of savings because they remember how hard they had to work for it. In contrast, debt is based on future earnings, which is deemed easier money by the existence of debt itself. High interest rates also encourage high risks to justify the high cost of money.

The problem with debt is that it needs to be serviced regularly (except zero coupons, which are discounted from the principal sum at the outset and cost more and are monitored with bond covenants and triggers to activate automatic foreclosure). Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail. Thus runaway systemic debt frequently leads to hyperinflation.

Bankruptcy only relieves the debtor, not the economy. If money is created whenever credit is extended, then the erasure of debt with money absorbs credit and shrinks the economy. There is a circular link among deregulation, debt, overcapacity and bankruptcy. Deregulation has created a havoc of bankruptcy in the airline, health-care, communication, energy and finance sectors. Deregulation permits predatory pricing in the name of competition, which often leads to monopolistic consolidation within industries. The surviving giants then take on massive debt to acquire vanquished competitors and to expand capacity in anticipation of increased demand. They soon reach a point where increased sales do not increase net revenue to offset low margin. Once a company is trapped in the whirlpool of debt, a downward spiral of low prices and shrinking revenue will push the cost of debt beyond sustainability, leading to bankruptcy. This is known as the bursting of the debt bubble.

In March 1980, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in the United States. It was a deregulation initiative by the administration of president Jimmy Carter aimed at eliminating many of the distinctions among different types of depository institutions and ultimately removing interest rate ceiling on deposit accounts. Authority for federal savings and loan associations to make risky ADC (acquisition, development, construction) loans was expanded, which ended up with the savings and loan (S&L) crisis five years later. Deregulation of airlines also began under Carter, leading to recurring waves of airline bankruptcy.

Conventional wisdom suggests that a good credit rating is necessary to borrow. But the financial world works differently in reality. A good credit rating is first necessary to issue credit. Without the ability of some entity to issue credit, no one can borrow. And since no modern financial institution lends its own money, lenders must first secure funds wholesale to lend to retail borrowers. For that, a lender must maintain a good credit rating.

Banks are protected from this requirement by their discount window at the central bank, which is backed by the full faith and credit of the nation, and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central banks and the Bank of International Settlement (BIS) set capital and reserve requirements for commercial banks to assure risk prudence.

In testimony concerning Private-sector refinancing of the large hedge fund, Long-Term Capital Management before the Committee on Banking and Financial Services, US House of Representatives on October 1, 1998, Fed Chairman Greenspan said: "we should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs."

GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it commands good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.

The US National Housing Act was enacted on June 27, 1934, as one of several economic-recovery measures of the New Deal. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home mortgage loans made by private lenders, taking the risk in lending to low income borrowers off the private lenders. Title III of the Act provided for the chartering of national mortgage associations by the administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages to be insured by the FHA under Title II.

Only one association was ever formed under this authority on February 10, 1938, as a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was National Mortgage Association of Washington, and this was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III became a statutory charter for Fannie Mae.

Before the Great Depression, affording a home was difficult for most people in the United States. At that time, a prospective homeowner had to make a down payment of 40 percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was due in one lump sum as the final "balloon" payment. During the 1920s boom time in real estate, a rudimentary secondary mortgage market emerged. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more people defaulted on mortgages because they did not have the money for the final balloon payment or were unable to roll over their mortgage because of low market value of their homes.

To help lift the country out of the Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.

As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.

By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act. By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.

By the early '70s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.

In the early 1980s, the US economy spiraled into deep recession. Interest rates and housing prices were high, while income growth was stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95 percent of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. It does not issue, sell, or buy MBSs, or purchase mortgage loans.

Fannie Mae operates under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America. The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. It continues to operate under a congressional charter with oversight from the US Department of Housing and Urban Development and the US Treasury.

Fannie Mae has two primary lines of business: Portfolio Investment, in which the company buys mortgages and MBSs as investments, and funds those purchases with debt, and Credit Guaranty, which involves guaranteeing the credit performance of single-family and multi-family loans for a fee. Its Portfolio Investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the costs to fund these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today, about 35% of GDP. Approximately one third of Fannie Mae debt is sold outside the US.

The corporation accomplishes its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income Americans by operating in the secondary rather than the primary mortgage market. Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Fannie Mae either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio.

Fannie Mae is one of the world's largest issuers of debt securities, the leader in the $5 trillion US home-mortgage market. Fannie Mae's debt obligations are treated as US agency securities in the marketplace, which is just below US Treasuries and above AAA corporate debt. This agency status is due in part to the creation and existence of the corporation pursuant to a federal law, the public mission that it serves, and the corporation's continuing ties to the US government. It benefits from the appearance, though not the essence, of being backed by government credit.

Fannie Mae debt obligations receive favorable treatment from a regulatory perspective. Fannie Mae securities are "exempted securities" under the laws administered by the US Securities and Exchange Commission to the same extent as US government obligations. Also, Fannie Mae debt qualifies for more liberal treatment than corporate debt under US federal statutes and regulations and, to a limited extent, foreign overseas statutes and regulations. Some of these statutes and regulations make it possible for deposit-taking institutions to invest in Fannie Mae debt more liberally than in corporate debt and mortgage-backed and asset-backed securities. Others enable certain institutions to invest in Fannie Mae debt on par with obligations of the United States and in unlimited amounts. Fannie Mae uses a variety of funding vehicles to provide investors with debt securities that meet their investment, trading, hedging, and financing needs. Fannie Mae is able to issue different debt structures at various points on the yield curve because of its large and consistent funding needs. As the Treasury retires 30-year bonds in recent years, agencies have stepped in to fill the void.

The privatization of Fannie Mae and Freddie Mac was an ideological move. It was financially unnecessary and government credit could have funded the entire low-, moderate- and middle-income housing-mortgage needs without profit being siphoned off to private investors. These agency debt instruments played a crucial role in developing and sustaining the credit markets in the US. It is part of the evidence of the trend of preemption of sovereign credit by private debt.

In fact, the funding risk of both agencies was questioned by the Wall Street Journal on February 20, 2003, in an editorial about Fannie Mae's and Freddie Mac's safety, soundness and financial management. The editorial characterized both agencies as risky, fast-growing companies that "look like poorly run hedge funds", "unduly exposed to credit risk with large derivative positions", and that they "use all manner of derivatives" and "are exposed to unquantified counterparty risk on these positions." Such concerns would have been avoided if both agencies had been funded with sovereign credit, and the cost of housing to low-, moderate- and middle-income Americans would have been lower, avoiding handsome returns to private investors.

A Sovereign Credit Economy vs. A Private Debt Economy

A sovereign credit economy is different from a private debt economy in its sustainability. The Japanese economy has stagnated for more than a decade primarily because it shifted from a sovereign credit economy to a private debt economy in the name of financial liberalization and market fundamentalism. The Japanese version of London's Big Bang on April 1, 1998, and the adoption of the Central Bank Law on the same day, accelerated the bursting of the Japanese debt bubble that subsequently infected all Asian economies.

The Big Bang in London refers to deregulation on October 27, 1986, of London-based securities markets, an event comparable to May Day in New York, marking a major step toward a single global financial market. May Day refers to May 1, 1975, when fixed minimum brokerage commissions ended in the US, ushering in the era of discount brokerage firms and the beginning of diversification by the brokerage industry into a wide range of financial services using computerization and digitized data communication systems. This started the offering of new genres of financial products and the emergence of structured finance that made possible a new private-debt economy that turned quickly into a global debt bubble. As the US reaped the fleeting benefits of dollar hegemony, a government budget surplus accompanied with sovereign debt reduction merely pushed more debt on to the private sector to feed the debt bubble.

The most fundamental aspect of a private-debt economy is that it cannot sustain a slowdown, even a soft landing. If Greenspan had been better versed in debt economics, he would have understood that a debt bubble, unlike the conventional business cycle, cannot survive the slightest deflation. Rising inflation is the oxygen for a debt bubble.

Greenspan's attempt to engineer a soft landing for the US debt bubble by raising the Fed Funds rate target in August 1999 to fight pending inflation pre-emptively only accelerated the debt bubble's burst. His only option was to prevent the debt bubble from forming by tightening credit quality years ago, but he chose to rely on the market to exercise its discipline. He rejected the suggestion of such Wall Street gurus as Henry Kaufman to raise margin requirements for stock purchase. Instead of discipline, the market gave him an insatiable appetite for addictive debt, which he had previously called "irrational exuberance" at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C. on December 5, 1996, when the Dow Jones Industrial Average was at 6,437, against 11,723 when the DJIA peaked on January 14, 2000.

On March 16, 2000, the DJIA experienced its largest one-day point gain historically - 499.19 points - to close at 10,630.60. A month later, on April 14, 2000, the DJIA plummeted 617.78 points, closing at 10,305.77 - its steepest point decline in a single day historically so far. The Dow Jones Industrial Average experienced its largest one-day percentage drop in history, 508 points or 22.61 percent on October 19, 1987, causing volume to surge to an unprecedented 604 million shares. The next day, volume reached 608 million shares. Nowadays, a daily volume of 1.5 trillion shares is normal. On July 2002, the highest daily trade was 2.81 trillion shares. Stock prices fell sharply on October 24, 1929 - Black Thursday, with record volume of less than 13 million shares. Five days later, the market crashes on volume of over 16 million shares -- a level not to be surpassed for another 39 years. In popular imagery, the crash has come to mark the beginning of the Great Depression. On September 3, 1929 the Dow Jones Industrial Average reached its 1929 peak of 381.17. On October 29, 1929 "Black Tuesday," prices fell sharply and the stock market "crashes." This "crash" produced a record volume of nearly 16 million shares. The Dow Jones Industrial Average fell more than 11 percent. The Dow finally reached bottom in July, 1932 at 41.9, down 89 percent from its 1929 peak. Down 89% of the Dow's 2000 high would leave the Dow at 1,289.

Once the bubble was on its way, Greenspan was on top of a debt tiger that he could not get off without being devoured by the beast. It was not the New Economy, it was not the unprecedented productivity that gave the US its decade-long boom. It was debt. Without debt, there would have been no New Economy, no dotcom industry, no telecom explosion, no structured finance, no budget surplus and no current account deficit or its flip side, capital account surplus.

The 1990s was the debt decade. Much of the technology was invented prior to the beginning of the decade of finance capitalism and became widely applied through debt in the form of vendor finance. The communication revolution was built on debt that had been accumulated in the last decade. The greatest invention of the 1990s was more and more sophisticated debt instruments.

Greenspan warned in December 1996 about "irrational exuberance when the DJIA was at 6,437, that inflation down the road was inevitable unless the Fed started to raise Fed funds rate pre-emptively. Yet as rates rose, the DJIA rose to 11,723 by January 2000, because inflation as measured by the government failed take into account the wealth effect.

The reason for this was twofold. Inflation was kept low by imports and inflation was measured mostly by rising wages but not by rising asset value. Stock prices doubled and real-estate prices tripled, but the economy officially did not register inflation because of low wages and cheap imports. As stock prices rose, the price to earnings ratio skyrocketed. As the economy inched toward structural full employment with 4 percent unemployed, Greenspan reflexively raised the interest rate to cut off anticipated wage-pushed inflation. The high interest rate adversely affected the earnings of debt-ridden companies. To boost earnings, companies cut employees, which started the downward spiral.

Since July 1997, the risks of protracted global asset deflation caused by the aftermath of excessive private debt have become reality, first in the emerging markets and then in the United States. Neither the IMF nor the Group of Seven (G-7) have been able to deal effectively with the twin problems of the artificially strong but debt-driven dollar and the spreading manipulated devaluation of other national currencies around the globe.

For the affected nations, the combination of mountains of foreign-currency debt and massive short-term capital flight through stock-market collapses, exacerbated by IMF conditionalities of high interest rates, austerity measures that insisted on reduced government deficits and sharp currency devaluations coupled with asset deflation, have led to tragic destruction of hard-earned wealth and a severe drop of living standards.

Certainly market forces in a runaway-debt economy have not created Adam Smith's "universal opulence which extends itself to the lowest ranks of the people". The only trickling down has been poverty and misery. In a world of 6 billion people, only about 1,000 currency traders and a small circle of rich investors in their hedge funds seem to enrich themselves further through the unbridled manipulation of the free financial market. Even in advanced economies, workers are misled to accept low wages as a trade-off for stock options that become worthless when the debt bubble bursts.

Corporations seduce share owners with fantasy capital gains based on debt to replace regular dividend payouts. When market capitalization of major corporations inflated by debt can fall by 90 percent within a matter of months while top executives can cash out at peak prices and resign with severance packages worth tens of millions of dollars, there is no other way to describe the situation than reverse Robin Hood: robbing the poor to help the dishonest rich.

This view is now shared by increasing numbers across ideological spectrums. Economist John Kenneth Galbraith's famous description of trickling down prosperity was if you feed the horse enough oats, the sparrows will some day benefit from its droppings. In finance capitalism, the poor sparrows are crushed by the wheels of the carriage of debt that the horse pulls.

If debt is dilapidating, foreign-currency debt, mostly dollar debt, is deadly to non-dollar economies. Thus those governments that had been misled by neo-liberals to borrow massive amounts of foreign currency unnecessarily and subsequently dutifully implemented IMF prescriptions, such as Brazil, Argentina, Turkey, South Korea and Indonesia, Thailand and Malaysia saw their economies destroyed to the point where recovery may now take decades, if ever, and only if the poisonous IMF medicine is quickly rejected.

The IMF has now admitted that it made a "slight mistake" in dealing with the Asian financial crisis of 1997. It might have been slight for the IMF, but the cost to the economies of Asia was horrendous. Trillions of dollars of hard-earned assets and economic capacities have been destroyed, lost forever. In fact, lives have been lost, children malnourished, families ruined, governments fallen and ethnic animosities intensified. The cooperative partnership among neighboring countries has been undermined and regions destabilized. This is the direct result of predatory lending followed by predatory IMF rescues. The operations were technically successful but the patients died. All this came about because non-dollar economies were tricked into trading away their power to use sovereign credit for domestic development and to embark down the path of exporting for dollar with low domestic wages.

National Banking vs. Central Banking

Banking is an important institution in the economy, but it is not the economy. Banks' traditional role is primarily that of an intermediary for money. Under finance capitalism, banks on the one hand take on new importance in the financial system (apart from their traditional lending role in industrial capitalism). On the other hand, they lose their traditional monopoly, as sole conduits of credit, to the unregulated global capital and debt markets dominated by non-bank financial entities and over-the-counter (OTC) derivative trades between market participants without intermediaries and outside of exchanges.

In these markets, banks are reduced to merely special market participants that both enjoy the protection of and are restrained by national regulatory regimes. The securities exchange commission views the difference between equity and debt as only technical, a distinction only meaningful in the legal accounting of risk. Convertible bonds, for example, blur the distinction by assigning the choice between debt and equity to the terms of credit.

Even under market capitalism, banking systems in different economies serve different economic policy goals, which invariably evolve and change over the course of history, reflecting the financial needs of various developmental stages in different economies. In developmental terms, economies in the take-off stages require different economic policies than those in consolidation stages. Economies that need a quick hard landing from exuberant growth also require different economic policies than ones aiming toward a soft landing. These differing economic policies are most effectively supported by differing banking regulations.

The United States did not have a central bank until 1913. President Franklin D Roosevelt's New Deal responded to the Great Depression of 1929 with massive banking reform, adding to the Reconstruction Finance Corp (RFC) already set up by president Herbert Hoover, which lent to distressed corporations and banks. The RFC, designed as an emergency institution to be liquidated within two years, had a capital of US$500 million, and authority to issue government-backed, tax-free debentures of $1.5 billion. A Farm Credit Administration took over problem farm mortgages. A Home Owners' Loan Corp did the same for problem urban mortgages. An abrupt bank "holiday" was declared to make the government the lender of last resort. Export of gold as well as the redemption of currency for gold were forbidden by executive order.

The Emergency Banking Act of 1933 endorsed emergency actions already taken by the president and created the Federal Deposit Insurance Corp to protect depositors. The Security Act of 1933 and the Securities and Exchange Act of 1934 created the Securities and Exchange Commission (SEC) to regulate equity markets. The Glass-Steagall Act of 1933 split investment banking from commercial banking to prevent the conflict of interest in pushing new issues of shares of the banks' clients on the banks' own depositors. The New Deal made recent emergency banking measures in Argentina look like a tea party. The difference was that the New Deal did not have an International Monetary Fund (IMF) to insist on conditionalities of austerity on the government.

The emergence of junk bonds, providing risky ventures with open access to institutional money, was instrumental in restructuring the US economy, bringing into existence new productive apparatus, such as MCI, Turner Broadcasting, Dell, AOL and Microsoft, which constituted the so-called New Economy. Drexel's Michael Milken created a new use for junk bonds in the 1980s, persuading executives to issue them to restructure and grow their companies and speculators and investors to buy and trade them. Much of the phenomenal increase in indebtedness of US corporations during past decades has been due to junk-bond holdings, not bank loans, at least until creative accounting allowed corporation new off-balance-sheet access to virtual money. With Drexel's aggressive campaign, the amount of junk bonds in the market swelled to $200 billion, and bonds became an important component in pension plans and mutual-fund investment. Charles Keating of Lincoln Savings and Loan purchased the since-defunct institution in 1983 with $50 million raised by Milken through the sale of junk bonds, which started a daisy chain set of transactions that became a centerpiece of the savings and loan crisis.

Despite Drexel's demise, corporate bonds outstanding in the United States has grown from $366 billion in 1980 to more than $3.4 trillion at the end of 2000. Corporate bond issuance has increased more than fivefold since 1990 and, for high-yield junk bonds, more than 10-fold. A total of $16.4 billion of junk bonds, or 3.1 percent of the $510 billion outstanding, went into default in January and February 2002 alone - led by bankrupt telecommunications company Global Crossing Ltd ($3.4 billion) - on the heels of $43.6 billion of defaults the previous year. The corporate bond market is large and liquid, with daily trading volume estimated at $15 billion. Issuance for 2000 was above $626 billion. General Motors' $17.55 billion multi-currency offering of bonds and convertible securities on June 26 2000 set a record for the largest single fundraising by a company to that date. The offering surpassed the previous record of $16.4 billion set by France Télécom in March 2001. The previous US record of $11.9 billion for such an offering was set by WorldCom in May 2001. The GM deal comprised $13.55 billion in fixed- and floating-rate bonds in US dollars, euros and British pounds, as well as $4 billion of convertible debentures. GM said it would use most of the proceeds to partially fund its US pension plans and other benefits for retired employees, which had lost value from the collapse of the equity market. The issue was increased from an initially planned $10 billion in the face of strong investor demand.

From their different historical and social backgrounds, different banking systems and regulatory regimes have evolved for different national economies. The globalization of finance, accelerated by "big bangs" in major financial markets, has brought about the urgent push for global regulatory standards applicable to banks worldwide, while leaving credit and capital markets largely unregulated, and a foreign exchange regime driven by predatory processes disguised as free markets for currencies.

The situation is further complicated by the use of new instruments in structured finance: securitization and derivatives which permit the unbundling of risks that are marketed to bidders willing to take different levels of risks for compensatory returns. Looking to keep such risks from infesting the banking system while not preventing the banks from participating in the highly profitable new markets, national banking systems are suddenly thrown into the rigid arms of the Basel Capital Accord sponsored by the Bank of International Settlement (BIS), or to face the penalty of usurious risk premium in securing international inter-bank loans. Thus national banking systems are all forced to march to the same tune, designed to serve the needs of highly sophisticated global financial markets, regardless of the developmental needs of their national economies.

Banking reform becomes the mantra of neo-liberal globalization while the real systemic risk in the global economy has been socialized globally through structured finance, and the benefits of socializing such risk remains concentrated in the hands of private investors in the rich economies.

Many national banking systems came into existence to support mercantilist or national industrial policy goals, such as rapid industrialization, gaining global market share, building an armament sector, rural electrification, regional development, flood management, etc, free from the dictate of private institutional profitability.

Both the prewar and postwar German and Japan economic miracles were clear examples. With financial globalization, these banking structures of national policy have been forced to transform themselves into components of a globalized private banking system that puts institutional creditworthiness and profitability as prerequisites, serving the needs of the global financial system to preserve the security and value of global private capital. National policies suddenly are subjected to profit incentives of private financial institutions, all members of a hierarchical system controlled and directed from the money center banks in New York. The result is to force national banking systems to privatize under central banking regimes and, in order to compete for inter-bank funds, to redefine and recognize domestic non-performing loans (NPLs) under Bank of International Settlement (BIS) guidelines.

BIS regulations serve only the single purpose of strengthening international private banking under a central banking system, even at the peril of national economies. The BIS does to national banking systems what the IMF has done to national monetary regimes. National economies under financial globalization no longer serve national interests. They operate to strengthen what US Federal Reserve Chairman Alan Greenspan calls US financial hegemony in the name of private profit. The IMF and the international banks regulated by the BIS are a team: the international banks lend recklessly to borrowers in emerging economies to create a foreign currency debt crisis, the IMF arrives as a carrier of monetary virus in the name of sound monetary policy, then the international banks come as vulture investors in the name of financial rescue to acquire national banks deemed capital inadequate and insolvent by the BIS.

Profit of financial institutions now depends on increased price volatility more than on interest-rate spreads. Price adjustments in capital markets have been most clearly visible in a re-pricing of risks in a wide range of equity and high-yield bond markets. The high correlation of asset price movements across countries reflects the globalization of finance and the heightened tendency of global investors to invest on the basis of industrial sectors or credit ratings, rather than geographic location. Yet large segments of many national economies have no intrinsic need for foreign direct investment (FDI), or even market capitalization in foreign currencies. Applying the State Theory of Money, any government can fund with its own currency all its domestic developmental needs to maintain full employment without inflation. FDI denominated in foreign currencies, mostly dollars, has condemned many national economies into unbalanced development toward export, merely to make dollar-denominated interest payments to FDI, with little net benefit to the domestic economies. This trend of dependence on foreign capital has pushed many emerging market economies toward a whirlpool of sinking debt, from which these economies have no hope of ever extricating themselves.

Further, assessment of risks is complicated by recent structured financial developments in the advanced national financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.

Even blue-chip global giants such as GE, JP Morgan/Chase and CitiGroup have overhangs of dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary, one-size-fits-all BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in OTC derivatives enjoy exemption from commensurate risk premiums.

National capital markets around the globe are vulnerable to spillovers and contagion from volatility in US capital markets. Continuous and steady access by emerging markets to global capital has been strongly affected by events in the mature markets. While the emergence of exchange-rate and banking crises in emerging markets and the ensuing contagion led to an abrupt loss of markets access in the past, many emerging markets now lose market access mainly because of developments in distant mature markets, such as the collapse of market capitalization on the Nasdaq, or the collapse of the telecom sector debt market built on the US formula of "air ball" financing - loans based on pro forma future cashflow rather than hard assets or current profits.

The BIS is an international organization that aims to foster cooperation among central banks and other agencies in pursuit of global monetary and financial stability in the interest of the rich nations. It was established in the context of the Young Plan (1930), which dealt with the issue of the reparation payments imposed on Germany by the Treaty of Versailles. Thus from its birth, its institutional bias has been genetically in favor of winners/creditors. The reparations issue quickly faded into the background, focusing BIS activities entirely on cooperation among central banks and, increasingly, other agencies, such as the IMF, in pursuit of monetary and financial stability for the benefit of global private creditors. Incidentally, the US Federal Reserve, the head of the central-bank snake, is privately owned by member private banks, though it presents itself to the world as a government institution, with the power to issue sovereign credit, presumably along the same logic as Christ being both God and man.

The BIS aimed at defending the Bretton Woods system until 1971, when the US abandoned the gold standard. It aimed at managing capital flows after the two oil crises and the international debt crisis in the 1980s. More recently, its thrust has been to foster financial stability in the wake of economic integration and globalization. Its Basel Committee on Banking Supervision recommended a risk-weighted capital ratio for internationally active banks (1988 Basel Capital Accord, currently under revision toward Basel II) that has become international standard, forcing banks in poor nations to observe the same rules as banks in rich nations. The BIS performs traditional banking functions, such as reserve management and gold transactions, for the accounts of central-bank customers and international organizations.

The total of currency deposits placed with the BIS amounted to $128 billion as of March 31, 2000, representing about 7 percent of world foreign-exchange reserves. In addition, the BIS has performed trustee and agency functions, acting as agent for the European Payments Union (EPU, 1950-58), helping the Western European currencies restore convertibility after World War II; as the agent for various European exchange-rate arrangements, including the European Monetary System (EMS, 1979-94), which preceded the move to a single currency. The BIS has also provided or organized emergency financing to support the international monetary system when needed. During the 1931-33 financial crisis, the BIS organized support credits for both the Austrian and the German central banks, resulting in a systemic financial collapse that contributed in no small way to the political success of the Nazis. In the 1960s, the BIS arranged special support credits for the Italian lira (1964) and for the French franc (1968) and two so-called Group Arrangements (1968 and 1969) to support sterling. More recently, the BIS has provided finance in the context of IMF-led stabilization programs (e.g. for Mexico in 1982, for Brazil in 1998, and for Turkey and Argentina in 2000-present).

On January 8, 2001, the BIS decided to restrict, for the future, the right to hold shares in the BIS exclusively to central banks. It approved the mandatory repurchase of all BIS shares held by private shareholders, against payment of compensation of 16,000 Swiss francs for each share (equivalent to some $9,950 at the USD/CHF exchange rate on January 8, 2001). Financial affirmative action for weak economies is not part of the BIS lexicon of international finance.

Since 1988, banks that trade internationally have been "invited" to observe the terms of the Basel Capital Accord signed by more than 110 countries. The accord has been made compulsory for all credit institutions in the G10 (Group of 10, comprising Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) countries. The 1988 accord, with a deadline implementation by the end of 1992, focused on a single risk measure, with a one-size-fits-all, broad-brush approach, setting a minimum capital requirement at 8 percent. While Third World banks that do not meet BIS capital requirements are frozen from the global inter-bank funds, BIS rules have been eroded by LCBOs in advanced economies through capital arbitrage, which refers to strategies that reduce a bank's regulatory capital requirements without a commensurate reduction in the bank's risk exposures. One example of such arbitrage is the sale, or other shift-off, from the balance sheet of assets with economic capital allocations below regulatory capital requirements, and the retention of those for which regulatory requirements are less than the economic capital burden. Aggregate regulatory capital thus ends up being lower than the economic risks require. Although regulatory capital ratios rise, they are, in effect, merely meaningless statistical artifacts. Risks never disappear; they are always passed on. LCBOs in effect pass their unaccounted-for risks onto the global financial system. Thus the fierce opponents of socialism have become the deft operators in the socialization of risk while retaining profits from such risk socialization in private hands.

Set for 2004, implementation of the new Basel Capital Accord II is meant to respond to such regulatory erosion by LCBOs. "Synthetic securitization" refers to structured transactions in which banks use credit derivatives to transfer the credit risk of a specified pool of assets to third parties, such as insurance companies, other banks, and unregulated entities, known as Special Purpose Entities (SPE), used widely by the likes of Enron and GE. The transfer may be either funded, for example, by issuing credit-linked securities in tranches with various seniorities (collateralized loan obligations or CLOs) or unfunded, for example, using credit default swaps. Synthetic securitization can replicate the economic risk transfer characteristics of securitization without removing assets from the originating bank's balance sheet or recorded banking book exposures. Synthetic securitization may also be used more flexibly than traditional securitization. For example, to transfer the junior (first and second loss) element of credit risk and retain a senior tranche; to embed extra features such as leverage or foreign currency payouts; and to package for sale the credit risk of a portfolio (or reference portfolio) not originated by the bank. Banks may also exchange the credit risk on parts of their portfolios bilaterally, without any issuance of rated notes to the market.

Another variant is to use credit derivatives to transfer the risk of a small number of corporate "names" rather than that of a larger portfolio. In this type of synthetic securitization, a SPE acquires the credit risk on a reference portfolio by purchasing credit-linked notes (CLNs) issued by the sponsoring banking organization. The SPE funds the purchase of the CLNs by issuing a series of notes in several tranches to third party investors. The investor notes are in effect collateralized by the CLNs. Each CLN represents one obligor and the bank's credit risk exposure to that obligor, which may take the form of, for example, bonds, commitments, loans, and counterparty exposures. Since the noteholders are exposed to the full amount of credit risk associated with the individual reference obligors, all of the credit risk of the reference portfolio is shifted from the sponsoring bank to the capital markets. The dollar amount of notes issued to investors equals the notional amount of the reference portfolio.

Basel II regulation requires banks to build capital that will reflect a certain proportion of their financial activity, which occurs because of market volatility of financial instruments such as bonds, equities and derivatives. This discrepancy between the outcomes of the regulation capital and risk analysis has indeed fueled the development of new categories for financial instruments, such as credit derivatives or asset-backed securities, where regulated financial institutions transfer their low, but regulatorily expensive risks to non-regulated investors in order to extract value. As of December 31, 2001, CitiGroup held derivative exposure of $6.25 trillion, while its combined total asset was only $500 billion, according to the FDIC.

The proposed new Basel Accord II is built around three pillars, each of which reinforces the other. The first pillar establishes the way to quantify the minimum capital requirements in the context of the brave new world of structured finance, the second organizes the regulator's supervision and the third establishes the foundations for market discipline through public disclosure of the way that banks implement the accord. Accurate internal risk-based (IRB) inputs are crucial to obtaining reasonably accurate regulatory measures of capital adequacy.

And the market will not believe or use risk disclosures unless it believes that the underlying risk measures, such as ratings and the probabilities of default, have been validated. Thus, supervisors must validate the risk measures to support both capital regulation and market discipline. While international rating agencies have been slow in coming to terms with true risk exposures of giant transnational corporations such as Enron and GE, the rating agencies are subject of complaint from the government of Japan with regard to their "qualitative" judgment that lacks "objective criteria" of Japanese sovereign creditworthiness, despite Japan's undisputed status as the world's leading creditor nation.

Japan is singled out among its peers in the advanced industrial world for scrutiny over the basic rating question of threat of default. Yet Japan has the largest savings surplus in the world and the largest foreign exchange reserves. There is increasing evidence that the Japanese bank system crisis is not the cause but merely the symptom of its economic malaise which has resulted from the disadvantaged structural position Japan has allowed itself to fall into in terms of the global financial system. BIS regulations are a big part of that structural disadvantage. This is the reason why Japan has been resistant toward US demands for Japanese bank reform. No doubt Japan needs to reform its banking system, but it is highly debatable that the reform needs to go along the line proposed by US neo-liberals or that bank reform alone will lift the Japanese economy out of its decade-long doldrums.

The record of US supervisory effectiveness has been gravely tarnished by the shameful performance of the US accounting profession and the unethical behavior of corporate management and financial institutions. The SEC is only now frantically trying to play catch-up after the horses have fled the barn, with dead and wounded corporate bodies strewn around the market landscape.

Fed governor Laurence H Meyer has publicly declared that at this moment and with current systems, no bank in the US likely would qualify to use the advanced IRB approach. LCBOs will be under pressure to enhance their risk management practices so that they might be prepared to adopt the advanced IRB approach. Tension exists between setting high standards and the expectation of wide adoption of the advanced IRB approach by LCBOs. There is a possibility that the US banking industry will simply stick with the standardized approach and turn a cold shoulder to advanced IRB. It would be the financial version of US unilateralism and exceptionism in a globahlized world.

The effective average risk weight for a bank as a whole should decline with the more sophisticated approaches depending on the extent of capital arbitrage already accomplished. Such banks would achieve lower total regulatory capital charges and, consequently, a higher reported risk-weighted capital ratio. Given the different risk profiles at individual banks, capital requirements almost certainly would vary more widely under the new risk-based capital ratios than under current BIS measure. A bank with a relatively low risk portfolio would find that its risk-weighted capital ratio increased because its risk-weighted exposures had declined. It would, as a result, presumably reduce its capital, or increase its leverage, or even increase its risk exposure, defeating the purpose of the new accord. Banks in the emerging economies will definitely be put at a disadvantage due to their lack of sophisticated risk management capabilities and limited access to global capital and credit markets.

A look at US credit-market debt as a percentage of gross domestic product (GDP) is revealing. Domestic financial debt jumped from 12.3 percent of GDP in 1971 to 91.8 percent of GDP in 2001. According to Fed data on the flow of funds, banks' share of net credit markets dropped from a peak of over 62 percent in 1975 to 26 percent in 1995 and is still falling rapidly, while security markets' share rose from negligible in 1975 to over 20 percent in 1995 and still rising rapidly, with insurers and pension funds taking the rest. In 1999, US credit market debt amounted to $25.6 trillion, two and a half times GDP, of which commercial banking debt was only $5.0 trillion. Treasuries was $5.2 trillion, agencies were $8.5 trillion and mortgage or asset backed securities was $3 trillion. Commercial papers was $1.4 trillion. Money market instrument was $2.3 trillion. Securitization now stand at over $3 trillion, up from $375 billion in 1985. Insurance companies and banks in the US fell from 75 percent of financial industry assets in the 1950s to less than 35 percent today, while mutual-fund and pension-fund firms increased their share from 6 percent to 43 percent over the same time period. The fund-management industry has profited as individuals replaced the majority of their directly held equities with managed funds. Banks have lost assets to the financial markets, as those markets have become more attractive to debtors and investors.

More than 75 percent of the global volumes in securitization originate from the US. Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 financial crisis, primarily because of underdeveloped debt and securitization markets in Asia. And the Basel Accord capital requirements have a more restrictive impact on Asian economies for that reason.

Financial market creativity has brought forth an explosion in the number of securitized products which in turn has contributed significantly to the growth of capital and debt markets, which in turn has paralleled the decline of the banks' share of financial industry assets. The importance of banks in the management of credit risk has also declined with the growth in the commercial paper and high-yield bond markets. Banks' loss of market share in the credit card market has been extremely rapid, as their share of credit card receivables fell from 95 percent in 1986 to 25 percent in 1998. During this period, non-bank credit card companies and the securitization of receivables have exploded.

Over the same time period, securitized mortgages grew from 10 percent to 41 percent of the US mortgage market. Finally, there was the rise of money market accounts and brokerage firm sponsored cash management accounts. Banks' share of checkable deposits fell from 85 percent to 55 percent from 1980 to 1998, while money markets and alternative checking accounts grew to 45 percent of checkable deposits. These new products have allowed consumers unparalleled declines in funding costs and transactions convenience.

Despite these tremendous losses in market share, banks have been able to maintain a position of importance in the modern economy. Banks have experienced an erosion in their core business of borrowing and lending, and net interest income has fallen precipitously. But banks have successfully replaced this income by growing fee-based and value-added services such as brokerage, trusts, annuities, mutual funds, trading, mortgage banking and insurance. In other words, by becoming non-bank financial entities, instead of providing safety to its customers, banks have become brokers of risk rather than cushions against risk.

A case study from Brady bond prices (July 2001) applying a reduced-form model to uncover from secondary market's Brady bond prices, together with Libor interest rates, shows how the risk of sovereign default is perceived to depend on time. Thus Walter Wriston of Citibank was essentially correct that countries do not go bankrupt in the long run. What Wriston failed to take into account was that governments can default on their foreign currency loans. Subsuming liquidity risk in default risk may result in a mis-specified model that, while generating the desired negative correlation between credit spreads and default-free interest rates, also generates negative probabilities of default at long horizons. Floating exchange rates, of course, further complicates the situation on foreign currency loans, which every sane government should avoid at all cost.

Globalization of markets has put a premium on cooperation between national authorities and institutions as a means of achieving a more harmonized financial environment, while in the foreign exchange arena, violent volatility, erratic spreads, high trading volumes and liquidity crises are commonly expected as natural. In this context, national banks are pushed to fall in line with guidelines developed by the BIS, which demanded simplistic risk management formulae, not to mitigate real risk, but to appease rating agencies, which act as a police force for the BIS and global investors. Rating agencies now exercise powerful arbitration on the cost of sovereign and private sector credit.

Reversing the logic that a sound banking system should lead to full employment and developmental growth, BIS regulations demand high unemployment and developmental degradation in national economies as the fair price for a sound global private banking system. Stephen Roach, Morgan Stanley's chief economist, wrote, "In theory, globalization is all about a shared prosperity - bringing the less-advantaged developing world into the tent of the far wealthier industrial world. But, in reality, when there's less prosperity to share, these benefits start to ring hollow. As the world economy now tips into recession, the assault on globalization can only intensify. The intrinsic tensions of globalization: market-driven forces of cross-border economic integration are increasingly at odds with the politics of fragmentation and nationalism. In the end, it probably boils down to jobs, voters and the social contracts that bind politicians to these key constituencies. Disparities in social contracts around the world underscore the inherent contractions of globalization."

While banks in the US have successfully shifted bad loans off their books through securitization, banks in Asia, including Japan, are saddled with a NPL crisis created largely by the Basel Accord capital requirements. Post-Keynesian economist Paul Davidson's distinguishing NPLs into episodic or systemic types is very perceptive, as is his conclusion that "we should never let the score keeping per se retard the game as long as there are real resources available to engage in productive activities".

Obviously, the most effective resolution of NPLs is to turn them into performing loans. Yet the approach of the BIS (escalating capital requirement, loan write-offs and liquidation, and restructuring through sell-offs, layoffs, downsizing, cost-cutting and freeze on capital spending), a banking version of the IMF austerity conditionality, creates macroeconomic conditions that would turn more performing loans into NPLs and NPLs into total loss.

Dollar Hegemony

There is an economics-textbook myth that foreign-exchange rates are determined by supply and demand based on market fundamentals. Economics tends to dismiss socio-political factors that shape market fundamentals that affect supply and demand.

The current international finance architecture is based on the US dollar as the dominant reserve currency, which now accounts for 68 percent of global currency reserves, up from 51 percent a decade ago. Yet in 2000, the US share of global exports (US$781.1 billon out of a world total of $6.2 trillion) was only 12.3 percent and its share of global imports ($1.257 trillion out of a world total of $6.65 trillion) was 18.9 percent. World merchandise exports per capita amounted to $1,094 in 2000, while 30 percent of the world's population lived on less than $1 a day, about one-third of per capita export value.

Ever since 1971, when US president Richard Nixon took the dollar off the gold standard (at $35 per ounce) that had been agreed to at the Bretton Woods Conference at the end of World War II, the dollar has been a global monetary instrument that the United States, and only the United States, can produce by fiat. The dollar, now a fiat currency, is at a 16-year trade-weighted high despite record US current-account deficits and the status of the US as the leading debtor nation. The US national debt as of August 14, 2003 was $6.753 trillion against a gross domestic product (GDP) of $10 trillion.

World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world's interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies. To prevent speculative and manipulative attacks on their currencies, the world's central banks must acquire and hold dollar reserves in corresponding amounts to their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creates a built-in support for a strong dollar that in turn forces the world's central banks to acquire and hold more dollar reserves, making it stronger. This phenomenon is known as dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973.

By definition, dollar reserves must be invested in US assets, creating a capital-accounts surplus for the US economy. Even after a year of sharp correction, US stock valuation is still at a 25-year high and trading at a 56 percent premium compared with emerging markets.

The Quantity Theory of Money is clearly at work. US assets are not growing at a pace on par with the growth of the quantity of dollars. US companies still represent 56 percent of global market capitalization despite recent retrenchment in which entire sectors suffered some 80 percent a fall in value. The cumulative return of the Dow Jones Industrial Average (DJIA) from 1990 through 2001 was 281 percent, while the Morgan Stanley Capital International (MSCI) developed-country index posted a return of only 12.4 percent even without counting Japan. The MSCI emerging-market index posted a mere 7.7 percent return. The US capital-account surplus in turn finances the US trade deficit. Moreover, any asset, regardless of location, that is denominated in dollars is a US asset in essence. When oil is denominated in dollars through US state action and the dollar is a fiat currency, the US essentially owns the world's oil for free. And the more the US prints greenbacks, the higher the price of US assets will rise. Thus a strong-dollar policy gives the US a double win.

Historically, the processes of globalization has always been the result of state action, as opposed to the mere surrender of state sovereignty to market forces. Currency monopoly of course is the most fundamental trade restraint by one single government. Adam Smith published Wealth of Nations in 1776, the year of US independence. By the time the constitution was framed 11 years later, the US founding fathers were deeply influenced by Smith's ideas, which constituted a reasoned abhorrence of trade monopoly and government policy in restricting trade. What Smith abhorred most was a policy known as mercantilism, which was practiced by all the major powers of the time. It is necessary to bear in mind that Smith's notion of the limitation of government action was exclusively related to mercantilist issues of trade restraint. Smith never advocated government tolerance of trade restraint, whether by big business monopolies or by other governments.

A central aim of mercantilism was to ensure that a nation's exports remained higher in value than its imports, the surplus in that era being paid only in specie money (gold-backed as opposed to fiat money). This trade surplus in gold permitted the surplus country, such as England, to invest in more factories to manufacture more for export, thus bringing home more gold. The importing regions, such as the American colonies, not only found the gold reserves backing their currency depleted, causing free-fall devaluation (not unlike that faced today by many emerging-economy currencies), but also wanting in surplus capital for building factories to produce for export. So despite plentiful iron ore in America, only pig iron was exported to England in return for English finished iron goods.

In 1795, when the Americans began finally to wake up to their disadvantaged trade relationship and began to raise European (mostly French and Dutch) capital to start a manufacturing industry, England decreed the Iron Act, forbidding the manufacture of iron goods in America, which caused great dissatisfaction among the prospering colonials. Smith favored an opposite government policy toward promoting domestic economic production and free foreign trade, a policy that came to be known as "laissez faire" (because the English, having nothing to do with such heretical ideas, refuse to give it an English name). Laissez faire, notwithstanding its literal meaning of "leave alone", meant nothing of the sort. It meant an activist government policy to counteract mercantilism. Neo-liberal free-market economists are just bad historians, among their other defective characteristics, when they propagandize "laissez faire" as no government interference in trade affairs.

A strong-dollar policy is in the US national interest because it keeps US inflation low through low-cost imports and it makes US assets expensive for foreign investors. This arrangement, which Federal Reserve Board chairman Alan Greenspan proudly calls US financial hegemony in congressional testimony, has kept the US economy booming in the face of recurrent financial crises in the rest of the world. It has distorted globalization into a "race to the bottom" process of exploiting the lowest labor costs and the highest environmental abuse worldwide to produce items and produce for export to US markets in a quest for the almighty dollar, which has not been backed by gold since 1971, nor by economic fundamentals for more than a decade. The adverse effect of this type of globalization on the developing economies are obvious. It robs them of the meager fruits of their exports and keeps their domestic economies starved for capital, as all surplus dollars must be reinvested in US treasuries to prevent the collapse of their own domestic currencies.

The adverse effect of this type of globalization on the US economy is also becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a debt bubble that thrives on conspicuous consumption and fraudulent accounting. The unsustainable and irrational rise of US equity prices, unsupported by revenue or profit, had merely been a devaluation of the dollar. Ironically, the current fall in US equity prices reflects a trend to an even stronger dollar, as it can buy more deflated shares.

The world economy, through technological progress and non-regulated markets, has entered a stage of overcapacity in which the management of aggregate demand is the obvious solution. Yet we have a situation in which the people producing the goods cannot afford to buy them and the people receiving the profit from goods production cannot consume more of these goods. The size of the US market, large as it is, is insufficient to absorb the continuous growth of the world's new productive power. For the world economy to grow, the whole population of the world needs to be allowed to participate with its fair share of consumption. Yet economic and monetary policy makers continue to view full employment and rising fair wages as the direct cause of inflation, which is deemed a threat to sound money.

The Italian Marxist thinker Antonio Gramsci, while under Fascist imprisonment, developed the concept of cultural hegemony: control people's minds, and their hearts and hands will follow. Gramsci explained how one dominant class can establish its control over others through ideological dominance. Whereas orthodox Marxism explains social structure as shaped by economic forces, Gramsci adds the crucial cultural dimension. He showed how, once ideological authority (or "cultural hegemony") is established, the use of overt violence to impose control can become superfluous.

Today, the world lives under the virtually undisputed rule of a market-dominated, ultra-competitive (yet not fairly competitive), globalized society with its cortege of manifold iniquities and legalized violence. Many public and private institutions in all nations that genuinely believe they are working for a more equitable world have unwittingly contributed to the violent triumph of neo-liberalism. Field evidence, however, shows that perpetual prosperity for anyone, let alone all, under market fundamentalism is merely an empty promise of neo-liberalism.

The chairman of the US Federal Reserve Board, Allan Greenspan, now proudly uses the term "hegemony", in congressional testimony to describe officially US financial preeminence and structural advantage. Unlike ideology, politics deal not only with moral validity, but also with power. The ideology of neo-liberalism appears empirically operative because it has the hegemonic power to construct a "real" world that appears internally consistent and theoretically rational, with the aid of "scientific" neoclassical economics theories. No matter how many socioeconomic disasters the neo-liberal globalized system of market fundamentalism has visibly caused, no matter what financial crises neo-liberal free markets have engendered, no matter how many losers and outcasts it has created, market fundamentalism is still promoted as indispensable, like the word of God, as the only possible economic and social order available for human salvation. Margaret Thatcher's TINA (There Is No Alternative) explains it all. Economic slavery, though unfortunate, is preferable to starvation, according to neo-liberal doctrine, which falsely poses slavery or death by starvation as natural alternatives of human civilization. The World Bank has estimated that neo-liberal globalization has created 200 million newly poor people around the world in the past decade. Yet claims of globalization's contribution to global prosperity continue unabated.

Former US president Bill Clinton's claim at the 2000 Asia Pacific Economic Cooperation (APEC) meeting that open economies have shown the highest growth rate is part of this cultural hegemonic push. Clinton had it backwards: it is the countries that have the highest growth rates resulting from complex conditions of structural advantage that are pushing for further selective openness in the poorer economies. The most fundamental flaw in the neo-liberal logic is that the selective push for full and unregulated mobility for capital across national borders is not accompanied with the same mobility for labor.

It is self-evident that capital cannot exist without labor. Without labor, capital is merely an idle asset, unable to contribute to productivity. Until labor can move freely in the globalized system, there is no real openness. The current system is not true globalization. It is merely a global expansion of US financial hegemony through dollar hegemony: the domination of the global economy by the US national currency.

Dollar hegemony is a structural condition in world finance and trade in which the US produces dollars and the rest of the world produce things dollars can buy. In 1971, the late US president Richard Nixon abandoned the Bretton Woods regime of a gold-backed dollar and fixed exchange rates to stop the gold drain from the US Treasury caused by chronic lapses of US fiscal discipline. At that point, the dollar, as a fiat currency, theoretically abdicated its reserve-currency status for world trade. Yet for more than three decades since, the dollar has remained the reserve currency for world trade despite continued chronic US government and trade deficits and the transformation of the United States into the world's most indebted nation. Notwithstanding its role as the leading proponent of market fundamentalism, the United States maintains a strong-dollar policy as a matter of national interest, in defiance of market forces.

A reserve currency for world trade without the necessary disciplinary backup is in reality a tax by the issuing sovereign on all other sovereigns participating in world trade via that currency.

The Keynesian starting point is that full employment is the basis of good economics. It is through full employment at fair wages that all other economic inefficiencies can best be handled, through an accommodating monetary policy. Say's Law (supply creates its own demand) turns this principle upside down with its bias toward supply/production. Monetarists in support of Say's Law thus develop a phobia against inflation, claiming unemployment to be a necessary tool for fighting inflation and that in the long run, sound money produces the highest possible employment level. They call that level a "natural" rate of unemployment, the technical term being NAIRU (non-accelerating inflation rate of unemployment).

It is hard to see how sound money can ever lead to full employment when unemployment is necessary to maintain sound money. Within limits and within reason, unemployment hurts people and inflation hurts money. And if money exists to serve people, then the choice becomes obvious. Without global full employment, the theory of comparative advantage in world trade is merely Say's Law internationalized.

No single economy can profit for long at the expense of the rest of an interdependent world. There is an urgent need to restructure the global finance architecture to return to exchange rates based on purchasing-power parity, and to reorient the world trading system toward true comparative advantage based on global full employment with rising wages and living standards. The key starting point is to focus on the hegemony of the dollar.

China's Monetary Leadership Potential

The time may be ripe for China, as Asia's largest economy, to break free of a global market economy that is near collapse. The Chinese economy is at a point where it also can defy the Mundell-Fleming thesis and free itself from dollar hegemony.

China has the power to make the yuan an alternative reserve currency in world trade by simply denominating all Chinese export in yuan. This sovereign action can be taken unilaterally at any time of China's choosing. All the Chinese government has to do is to announce that as of, say, October 1, 2003, all Chinese exports must be paid for in yuan, making it illegal for Chinese exporters to accept payment in any other currencies. This will set off a frantic scramble by importers of Chinese goods around the world to buy yuan at the State Administration for Foreign Exchange (SAFE), making the yuan a preferred currency with ready market demand. Companies with yuan revenue no longer need to exchange yuan into dollars, as the yuan, backed by the value of Chinese exports, becomes universally accepted in trade. Members of the Organization of Petroleum Exporting Countries (OPEC), which import sizable amount of Chinese goods, would accept yuan for payment for their oil. If other governments follow with similar policies, the world will see a de facto multi-currency regime within a short time.

In 2000, the United States exported US$781.1 billion (12.3 percent of world exports - 11 percent year-to-year growth) and imported $1.2576 trillion (18.9 percent of world imports - 19 percent year-to-year growth). Germany exported $551.5 billion (8.7 percent of world exports - 1 percent year-to-year growth) and imported $502.8 billion (7.5 percent of world imports - 6 percent year-to-year growth). Japan exported $479.2 billion (7.5 percent of world exports - 14 percent year-to-year growth) and imported $379.5 billion (5.7 percent of world imports - 22 percent year-to-year growth). France exported $298.1 billion (4.7 percent of world exports - 1 percent year-to-year decline) and imported $305.4 billion (4.6 percent of world imports - 4 percent year-to-year growth). The United Kingdom exported $337 billion (5.1 percent of world export - 5 percent year-to-year growth) and imported $284.1 billion (4.5 percent of world imports - 6 percent year-to-year growth).

China exported $249.3 (3.9 percent of world exports - 28 percent year-to-year growth) and imported $225.1 billion (3.4 percent of world imports - 36 percent year-to-year growth). Hong Kong exported $214.2 billion (3.2 percent of world exports- 19 percent year-to-year growth) and imported $202.4 billion (3.2 percent of world imports - 16 percent year-to-year growth).

China (including Hong Kong) exported more than $463 billion (7.3 percent of world exports) in 2000 and imported about $428 billion, yielding a trade surplus of around $35 billion. If all Chinese exports are paid in yuan, China will have no need to hold foreign reserves, which amounted to $346.5 billion at the end of June 2003. And if the Hong Kong dollar is pegged to the yuan instead of the dollar, Hong Kong's more than $100 billion foreign-exchange reserves can also be freed for domestic restructuring and development.

China's spectacular export growth has not reversed the shrinking of world trade volume since 1997. Its growth has come at the expense of the now wounded "tigers" of Southeast Asia. China is on the way to becoming a world economic giant but it has yet to assert its rightful financial power.

There is no stopping China from being a powerhouse in manufacturing. With Asian and other economies trapped in protracted financial crisis from excessive foreign-currency debts and falling export revenue resulting from predatory currency devaluation, the International Monetary Fund, orchestrated by the US, has come to their "rescue" with a new agenda beyond the usual IMF austerity conditionalities to protect Group of Seven (G7) creditors. IMF rescues forces the debtor nation to adopt "Washington Consensus"; reforms, to liberalize domestic financial, labor, merchandise and services markets and the debtor government to run fiscal surpluses and tight monetary (high interest) policies that will depress the debtor nation's economy.

This new agenda aims to open Asian for US transnational corporations to acquire distressed local companies so that their newly acquired Asian subsidiaries can produce inside their own national borders. The United States, through the IMF, aims to break down the traditionally closed financial systems all over the world, particularly Asia, that can mobilize high national savings to serve giant national industrial conglomerates, for massive investment in targeted export sectors. The IMF, controlled by the US, aims at dismantling traditional Asian financial systems and forcing Asians to replace them with a structurally alien global system, characterized by open markets in products and, crucially, in finance and financial services. The real target is of course China. For the US knows: as China goes, so goes the rest of Asia. Similar strategy are also in place in Latin America and the Middle East.

Trade flows under neo-liberal globalization have put Asian countries in a position of unsustainable dependency on foreign loans and capital to finance export sectors that are at the mercy of saturated foreign markets while neglecting domestic development to foster productive forces and to support budding domestic consumer markets. In Asia, outside the small circled of well-heeled compradors, most people cannot afford the products that they produce in abundance for export, nor the high-cost imports. An average worker in Asia would have to work days making hundreds of pairs of shoes to earn enough to buy one McDonald's hamburger meal for his family while Asian compradors entertain their Western backers in luxurious five-star hotels with prime steaks imported from Omaha. Markets outside of Asia cannot grow quickly enough to satisfy the developmental needs of the populous Asian economies. Thus intra-region trade to promote domestic development within Asia needs to be the main focus of growth if Asia is ever to rise above the level of semi-colonial subsistence. The same is true with other regions.

The Chinese economy will move quickly up the trade-value chain, in advanced electronics, telecommunications, and aerospace, which are inherently "dual use" technologies with military implications. Strategic phobia will push the United States to exert all its influence to keep the global market for "dual use" technologies closed to China. Thus "free trade" for the US is not the same as freedom to trade. Still, China will inevitably be a major global player in the knowledge industries because of its abundant supply of raw human potential. Even in the US, a high percentage of its scientists are of Chinese ethnicity. With an updated educational system, China will be the top producer of brain power within another decade. As China moves up the technology ladder, coupled with rising consumer demand in tandem with a growth economy, global trade flow will be affected, modifying the "race to the bottom" predatory competitive game of a decade of globalization among Asian exporters.

Asian economies will find in China an alternative trading partner to the United States, and possibly with more symbiotic trading terms, providing more room to structure trade to enhance domestic development along the path of converging regional interest and solidarity. The rise in living standards in all of Asia will change the path of history, restoring Asia as a center of advanced civilization, putting an end to two centuries of Western economic and cultural imperialism.

The foreign-trade strategies of all trading nations in the decade of neo-liberal globalization have contributed to the destabilizing of the global trading system. It is not possible or rational for all countries to export themselves out of domestic recessions or poverty. The contradictions between national strategic industrial policies and neoliberal open-market systems will generate friction between the United States and all its trading partners, as well as among regional trade blocs and inter-region competitors. The US engages in global trade to enhance its superpower status, not to undermine it. Thus the US does not seek equal partners. With economic sanctions as a tool of foreign policy, the US government is preventing, or trying to prevent, an increasing number of US companies, and foreign companies trading with the US, from doing business in an increasing number of countries. Trade flows not where it is needed most, but to where it best serves the US national interest.

Neo-liberal globalization has promoted the illusion that trade is a win-win transaction for all, based on the Ricardian model of comparative advantage. Yet economists recognize that without global full employment, comparative advantage is merely Say's Law internationalized. After a decade, this illusion has been shattered by concrete data: 30 percent of the world's population live on less than $1 a day, and global wages, already low to begin with, have declined since the Asian financial crisis of 1997, and by 45 percent in Indonesia.

Yet export to the United States under dollar hegemony is merely an arrangement in which the exporting nations, in order to earn dollars to buy needed commodities denominated in dollars and to service dollar loans, are forced to finance the consumption of US consumers by the need to invest their trade surpluses in US assets (as foreign-exchange reserves), giving the US a capital account surplus to finance its current account deficit.

Furthermore, the trade surpluses are achieved not by an advantage in the terms of trade, but by sheer self-denial of basic domestic needs and critical imports. Not only are the exporting nations debasing the value of their labor, degrading their environment and depleting their natural resources for the privilege of running on the poverty treadmill, they are enriching the US economy and strengthening dollar hegemony in the process. Thus the exporting nations allow themselves to be robbed of needed capital for critical domestic development in such vital areas as education, health and other social infrastructure, by assuming heavy foreign debt to finance export, while they beg for even more foreign investment in the export sector by offering still more exorbitant returns and tax exemptions. Yet many small economies around the world have no option but to continue to serve dollar hegemony like a drug addiction. And by abandoning capital control, the emerging market economies forfeit the important option of financing domestic development with sovereign credit.

Japan provides the perfect proof that even a dynamic, successful export machine does not by itself produce a healthy economy. Japan is aware that it needs to restructure its domestic economy, away from its export fixation and upgrade the living standard of its overworked population and to reorder its domestic consumption patterns. But Japan is trapped into helplessness by dollar hegemony.

Japan sees its sovereign credit rating lowered by international rating agencies while it remains the world's biggest creditor nation. Moody's Investor Service downgraded Japanese government bonds by two notches recently to A2, or one grade below Botswana's, not to mention Chile and Hungary. Japan has the world's largest foreign-exchange reserves: $446 billion; the world's biggest domestic savings: $11.4 trillion (US gross domestic product was $10 trillion in 2001); and $1 trillion in overseas investment. And 95 percent of the sovereign debt is held by Japanese nationals, which rules out risk of default similar to Argentina. Japan has given Botswana, where half of the population are infected with the AIDS virus, $12 million in grants and $102 million in loans.

Why does the New York-based rating agency prefer Botswana to Japan? The Botswanan government budget is controlled by the foreign diamond-mining interests to protect their investment in the mines. Botswana does not run a budget deficit to develop its domestic economy or to help its poverty-stricken people. Thus Botswana is considered a good credit risk for foreign loans and investment. Japan, on the other hand, is forced to suffer the high interest cost of a low credit rating because its government attempts to solve, through deficit financing, the nation's economic woes that have resulted from excessive focus on export. Dollar hegemony denies a good credit rating even to the world's largest holder of dollar reserves.

The Asia-Pacific trade system has been structured to serve markets outside of Asia by providing low manufacturing production cost through the use of cheap Asian labor. This enables the United States to consume more without inflation and without raising domestic wages. Yet all the trade surpluses accumulated by the Asian economies have ended up financing the US debt bubble, which is not even good for the US economy in the long run. Cheap imports allow the US to keep domestic wages low and contribute to a rising disparity of both income and wealth within the US where consumer purchasing power comes increasingly from capital gain rather than rising wages. The result is that when the equity bubble of inflated price-earning ratio finally bursts, wages are too low to keep the economy from crashing from a collapse of the wealth effect.

After thoroughly impoverishing the Asian economies with financial manipulation of crisis proportions, the US now works to penetrate the remaining Asian markets that have stayed relatively closed: notably Japan, China and South Korea. Control of access to its markets has been Asia's principal instrument for its sub-optimized trade advantage and distorted industrial development. This strategy had been practiced successfully first by Japan and copied with various degree of success by the Asian tigers. Protectionism will survive in Asian economies long after formal accession to the World Trade Organization (WTO).

China, with a giant integrated market composed of a fifth of the world population, can swap market access for technology transfer from the world's transnational technology corporations. Once free from dollar hegemony, China can finance its domestic development without foreign loans and capital. The Chinese economy then will no longer be distorted by excessive reliance on export merely to earn dollars that by definition must be invested in dollar assets, not yuan assets. The aim of development is to raise wage levels, not to push wages down to achieve predatory competitiveness. Yet export under dollar hegemony requires keeping wages low, a prerequisite that condemns an economy to perpetual underdevelopment.

Terms such as "openness" need to be reconsidered away from the distorted meanings assigned to them by neo-liberal cultural hegemony. The contradiction between globalizing and territorially-based national social and political forces is framed in the context of past, present and future world orders.

The emerging world order has always been, and will again be, the result of a struggle for the direction of structural transformation of the current order, involving economic, political and socio-cultural changes. The prevailing trend of the past two decades toward the marketization and commodification of social relations has led to the argument that socialism needs to be redefined away from the total visions associated with Marxism-Leninism, and toward the idea of the self-defense of society and social choice to counter the disintegrating and atomizing effects of globalizing and unregulated market forces. But this is precisely a Marxist-Leninist vision: that under globalization, national sovereignty in the form of nation-states and governments will give way to a pervasive socioeconomic order. In other words, the withering away of the state.

The sole function of government is to protect the weak, because the strong is itself government and needs no other. This truth gave birth to monarchism: the king's function was to protect the peasants from aristocratic abuse. So in modern terms, the government's function is to maintain socialist/populists values in the context of capitalist market fundamentalism. So the withering away of the state prior to the end of economic exploitation is putting the cart before the horse.

The unwitting by-product of the rightist quest to get government off the back of the people is a Marxist dialectic. The only flaw is the economic structure. The right wants the withering away of the state prior to the progressive transformation of capitalism into socialism.

The perpetual boom has not replaced the business cycle, new economy or not. In the age of information and communication, the majority interest will prevail - with luck, without violence. Despite US fixations, majority interest does not necessarily spell capitalism, corporatism or representative democracy. Socialism collapsed in the 1980s not because its economic theories were inoperative, but because in defending the authority to make socialist principles work, socialist governments had to adopt a garrison-state mentality that overshadowed all other potential benefits. On the other hand, capitalist market fundamentalism appeared more desirable as long as this mutation of socialism was posed as a false alternative. Now, as the sole surviving operative system, capitalist market fundamentalism is faced squarely with its own internal contradictions. Unregulated markets have produced the debt bubble and financial manipulation and corporate fraud that impoverish unsuspecting investors and workers who placed their pensions in the shares of the companies that employed them. And the war on terrorism runs the risk of instilling in the United States the same garrison-state mentality that brought about the demise of the Soviet bloc.

Finance capitalism may turn out to be the deadliest enemy of industrial capitalism, and it may well be the last transformation of capitalism. There are clear indications that insufficient demand is caused by the abandonment of the labor theory of value and the wholesale acceptance by neo-liberalism of the theory of marginal utility. Lack of demand caused by insufficient wages is more deadly to finance capitalism than the fear of socialism. Technology has finally turned Charlie Chaplin's Modern Times into reality. The rhetoric of the current political debate in the United States on corporate fraud is more populist than those of the New Deal, and the recession has yet to begin in earnest. Socialism, by other names (the Wall Street Journal calls it mass capitalism), is now about to be viewed as the vaccine against a catastrophic implosion of the capitalist system in its home garden.

Globalization is not a new trend. It is the natural policy for all empire building. Globalization under modern capitalism began with the British Empire, marked by the repeal of the Corn Laws in 1846, five years after the Opium War with China, and two years before the Revolutions of 1848. Great Britain embarked on a systemic promotion of free trade and chose to depend on imported food, which gave a survivalist justification to empire. France adopted free trade in 1860 and within 10 years was faced with the Paris Commune, which was suppressed ruthlessly by the French bourgeoisie, who put to death 20,000 workers and peasants, including children. Despite a backlash movement toward protective tariffs in Britain, Holland and Belgium, the global economy of the 19th century was characterized by high mobility of goods across political borders. As Europe adopted political nationalism, international economic liberalism developed in parallel, until 1914. Only World War I, the 1929 Depression and World War II caused a temporary halt of free trade.

Like the United States now, Britain was a predominantly importing economy by the close of the 18th century. Despite the Industrial Revolution's expanded export of manufacturing goods, import of raw material, food and consumer amenities grew faster than export of manufacturing goods and coal. The key factor that sustained this imbalance was the predominance of the British pound, as it is today with the US dollar and its impact of the trade deficit. British hegemony of marine transportation and financial services (cross-currency trade finance and insurance) earned Britain vast amounts of foreign currencies that could be sold in the London money markets to importers of Argentine meat and Canadian bacon. International credit and capital markets were centered in London. The export of financial services and capital produced the returns that serve as hidden surplus to cushioned the trade deficit. To enhance financial hegemony, the British maintained separate dependent currencies in all parts of the empire under pound-sterling hegemony. This financial hegemony is now centered on New York with the dollar as the base currency. When the Asian tigers export to the United States, all they get in return are US Treasury bills, not direct investment in Asia. Asian labor in fact is working at low wages mainly to finance the expansion of the US economy.

Market fundamentalism, a modern euphemism of capitalism, is thus made necessary by the international finance architecture imposed on the world by the hegemonic finance power, first 19th-century Great Britain, now the United States. When the developing economies call for a new international finance architecture, this is what they are really driving at, not some new arrangement of special drawing rights (SDR) with the IMF. Foreign-exchange markets ensure the endless demand for dollar capital import by the poor exporting nations. John A Hobson and Lenin identified the surplus of capital in the core economies and the need for its export to the impoverished parts of the world as the material basis of imperialism. For neo-imperialism of the 21st century, this remains fundamentally true, with the exception that the surplus capital now comes from the impoverished part of the world.

Then and now, the international economy rests on an international money system. Britain adopted the gold standard in 1816, with Western Europe and the US following in the 1870s. Until 1914, the exchange rates of most currencies were highly stable, except in victimized, semi-colonial economies such as Turkey and China. The gold standard, while greatly facilitating free trade, was hard on economies that produced no gold, and the gold-based monetary regime was generally deflationary (until the discovery of new gold deposits in South Africa, California and Alaska), which favored capital. William Jenning Bryan spoke for the world in 1896 when he declared that mankind should not be "crucified upon this cross of gold". But the 50-year lead time of the British gold standard firmly established London as the world's financial center. The world's capital was drawn to London to be redistributed to investment of the highest return around the world. Borrowers around the world were reduced to playing a game of "race to the bottom".

The bulk of economic theories within the context of capitalism were invented to rationalize this global system as natural truth. The fundamental shift from the labor value theory to the marginal utility theory was a circular self-validation of the artificial characteristics of an artificial construct based on the sanctity of capital, despite Karl Marx's dissection that capital cannot exit without labor - until assets are put to use to increase labor productivity, it remains idle assets.

Mergers and acquisitions became rampant. Small business capitalism disappeared between 1880 and 1890. Workers and small businesses found that they were not competing against their neighbors, but those on other sides of the world, operating from structurally different socioeconomic systems. The corporation, first used to facilitate the private ownership of railroads, became the organization of choice for large industries and commerce, issuing stocks and bonds to finance its undertakings that fell beyond the normal financial resources of individual entrepreneurs.

This process increased the power of banks and financial institutions and brought forth finance capitalism. Cartels and trusts emerged, using vertical and horizontal integration to eliminate competition and manipulate markets and prices for entire sectors of the economy. Middle-class membership was mainly concentrated in salaried workers of corporations, while the working class were hourly wage earners in factories. The 1848 Revolutions were the first proletariat revolutions in modern time. The creation of an integrated world market, the financing and development of economies outside of Europe and the consequence of rising standards of living for Europeans were the triumphs of the 19th-century system of unregulated capitalism. In the 20th century, the process continued, with the center shifting to the United States.

Friedrich List, in his National System of Political Economy (1841), asserted that political economy as espoused in England at that time, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List's institutional school of economics asserted that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and that it had to be fought with protective tariffs and other protective devices of economic nationalism by the weaker countries. List influenced revolutionaries in Asia, including Sun Yatsen, who until coming under the influence of Marx and Lenin after the October Revolution was primarily relying on List in formulating his policy of economic nationalism for China. List was also the influence behind the Meiji Reform Movement in Japan.

The current impending collapse of neo-liberal globalized market fundamentalism offers Asia a timely opportunity to forge a fairer deal in its economic relation with the West. The United States, as a bicoastal nation, must begin to treat Asian-Pacific nations as equal members of an Asian-Pacific commonwealth in a new world economic order that makes economic nationalism unnecessary.

China, as the largest economy in the Asia-Pacific region, has a key role to play in shaping this new world order. To do that, China must look beyond its current myopic effort to join a collapsing globalized market economy and provide a model of national domestic development in which foreign trade is reassigned to its proper place in the economy from its current all-consuming priority. The first step in that direction is for China to free itself from dollar hegemony and to rely on sovereign credit to finance its domestic development.


Since World War II, the term "capitalism" has been displaced by the more benign label of the free market. Capitalism ceased to be mentioned in most neo-liberal economic literature. In the process, economists also squeezed out of official dialogues the word "capitalism", the once-traditional name for the market system, with its subjective connotation of class struggle between owners of capital, through their professional managers, and the workers capital employs, through their trade and industrial unions. The free market provides legitimization of the socio-political privileges that go with various levels of wealth in the name of property rights.

The word "capitalism" no longer appears in textbooks for Economics 101. Harvard economist N Gregory Mankiw, author of a popular new textbook, Principles of Economics, told the New York Times: "We make a distinction now between positive or descriptive statements that are scientifically verifiable, and normative statements that reflect values and judgments." A whole new generation of economists have grown up thinking of "capitalism" only as a historical term like "slavery", unreal in the modern world of market fundamentalism.

Capital, when monetized in dollars, is in essence sovereign credit from government. Capitalism in a fiat money economy is a system based on sovereign credit. Thus a case can be made that in a capitalistic democracy, access to capital and credit should be available equally to all in accordance with national purpose and social needs. The anti-statist posture of neo-liberalism is not only logically flawed, but its glorification of a private-debt economy will inevitably lead to self-destruction.

Neo-imperialism works by making the world's poor finance the high living and privileged station of the world's rich. It transcends the Marxist notion of class struggle and surplus value. In neo-liberal globalization under dollar hegemony, not just labor but even capital comes from the exploited through trade surpluses of the exporting economies. Except for dollar hegemony, capitalism is unnecessary for socially beneficial domestic development because of the availability of sovereign credit. International capitalism based on dollar hegemony, through its co-optation of sovereign credit, is a threat to national sovereignty, and a threat to the world system of nation states that has existed since the Peace of Westphalia of 1648.

The Path toward the Future

To save the world from the path of impending disaster, we must:
Promote an awareness among policy makers globally that excessive dependence on exports merely to service dollar debt is self-destructive to any economy;
Promote a new global finance architecture away from a dollar hegemony that forces the world to export not only goods but also dollar earnings from trade to the US;
Abolish central banking that supports international monetarism and return to national banks to support domestic development;
Promote the application of the State Theory of Money (which asserts that the value of money is ultimately backed by a government's authority to levy taxes) to provide needed domestic credit for sound economic development and to free developing economies from the tyranny of dependence on foreign capital;
Restructure international economic relations toward aggregate demand management away from the current overemphasis on predatory supply expansion through redundant competition; and
Restructure world trade toward true comparative advantage in the context of global full employment and global wage and environmental standards.

This is easier done than imagined. The starting point is for the major exporting nations each to unilaterally require that all its exports be payable only in its currency, so that the global finance architecture will turn into a multi-currency regime overnight. There would be no need for reserve currencies and exchange rates would reflect market fundamentals of world trade.

As for aggregate demand management, Asia leads the world in both overcapacity and under-consumption. It is high time for Asia to realize the potential of its market power. If the people of Asia are to be compensated fairly for their labor, the global economy will see its fastest growth ever.

Central banking is genetically disposed to favor the center against the periphery, which conflicts with democratic, populist politics. This problem continues today with central banking in a globalized international finance architecture. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery. Central banking carries with it an institutional bias against economic nationalism, particularly in the poor countries.

Ideas do change the world. But the acceptance of new ideas often lags behind reality and only become generally acceptable when the reality described by new ideas can no longer be denied. Apples have been falling from trees ever since they grew on trees, but it took several millennia before Newton observed the effects of gravity. We are now in a time when the real world is changing faster than the world of ideas. The age of equality producing prosperity has long since arrived and finally being recognized. The monetary expression of wealth in a finance economy is through money. Thus, on a fundamental basis, a tight monetary policy will inevitably lead to a decline of wealth. There is an old saying even on Wall Street: to make money, you have to help others make money. The global economy as it is currently constituted is a game of exploitation of the weak, and exploitation of the weak is not a perpetual game. We need to change it to a game of development.