Untested Management Team for the US Economy

Henry C.K. Liu

This article appeared in AToL on June 16, 2006


All top posts in the management team of the world biggest economy are now headed by untested appointees with little high-level experience in government or proven policy predilections. First Ben S. Bernanke, a respected academician with little market experience, replaced Alan Greenspan as Chairman of the Federal Reserve in February. So far, every time the new Fed Chairman made a public statement about his resolve on price stability, a technical euphemism for inflation and deflation, the market showed its lack of confidence by a substantial price correction. Edward P. Lazear, a noted labor economist among whose published papers is: “The Peter Principle: A Theory of Decline,” replaced Bernanke as Chairman of the President’s Council of Economic Advisers (CEA). For those who are not familiar with the Peter Principle, it states that routine promotion in organizations continues until incompetence surfaces. Then Rob Portman, former Republican Congressman from Ohio and recent US Trade Representative, replaced Josh Bolton as Director of the Office of Management and Budget, while the latter moved to the White House as Chief of Staff in April. Word was that Bolton was instrumental in persuading Henry Paulson, his former colleague at Goldman Sachs, to accept the post of Treasury Secretary, replacing John W Snow.

According to the Center of Responsive Politics, Bolten had originally joined the White House as Bush’s deputy chief of staff to handle domestic policy. However, as the administration soured on the independent-minded National Economic Advisor Larry Lindsay, Bolten gradually began controlling economic policymaking by framing economic issues for presidential consideration. As Chief of Staff, Bolton is credited as the chief architect of the Bush tax cuts as well as the hiring of another former colleague at Goldman Sachs, Stephen Friedman, to replace Lindsey as Assistant to the President for Economic Policy and Director of the National Economic Council.

At Goldman, Friedman was a fearsome strategist for corporate takeovers. He was co-director along with future Clinton Treasury Secretary Robert Rubin from 1990-1992 and sole director from 1992-94 after Rubin left for Washington.  After leaving Goldman Sachs in 1994, Friedman became a senior principal for Marsh & McLennan Capital, an investment-insurance unit whose parent company faced a government probe into bid rigging and price fixing which has since been settled out of court.

Many are puzzled why Henry Paulson would leave his top job at Goldman Sachs, the world’s preeminent investment banking power house, to take the job of US Treasury Secretary under a premature lame-duck president with an approval rating languishing in the low 30% range.  After all, David Rockefeller declined a personal telephone appeal from President Jimmy Carter to join a demoralized administration after Carter, in response to popular discontent and declining presidential authority, desperately imposed wholesale resignation on his entire cabinet in 1979, the third year of his first and only four-year term,. After isolating himself for 10 days in introspective agonizing at Camp David, Carter emerged back in the White House to make his disconcerting speech of “crisis of the soul and confidence” to a restless nation facing rising gasoline prices at $1.25 a gallon, with gold rising to $300 an ounce but with the US enjoying a trade surplus with China for another 14 years. Today, gasoline is above $3 a gallon and gold broke above $700 while US trade deficit with China is at record high of over $200 billion a year and still rising; yet President Bush continues to tell the nation that the economy is fundamentally strong which begs the question of why the wholesale cabinet changeover.

The Treasury, the top cabinet post that leads the president’s economic team, has not been performing at its most effective level in the past six years of the Bush administration. This was not because of a shortage of talent at the top. Both Paul H. O'Neill, who ran Aluminum Company of America, and John W. Snow, who headed of the CSX transportation network, were successful captains of industry with outstanding performance records in the private sector.  But in a world where industry has been increasingly dominated by finance, their experience in industry might not have prepared them to deal with the complex challenges facing a Treasury Secretary of the world’s top economic hegemon, or to survive in the political jungle of a faith-based ideological administration.

Both men had difficult tenures as cabinet officers, routinely sidetracked by White House inner-circle cliques whose members aggressively guarded executive prerogative to set erratic economic policies driven proactively by neo-conservative ideology and reactively by near-term domestic political considerations rather than steady long-range rational responses to developing global economic conditions. Cabinet officers are politically-appointed captains of the bureaucracy. Executive power often regards the bureaucracy as an obstructionist enemy, yet it is the bureaucracy that provides stable continuous implementation of national policies that transcend partisan politics. Just as a strong White House National Security Council chairman can overshadow a weak Secretary of State, most glaringly evidenced in the case of Henry Kissinger over William Rogers, and the case of the Zbigniew Brzezinski over Cyrus Vance, White House political advisor Karl Rove has until the CIA leak scandal this year overshadowed all cabinet appointees over the setting of US economic policies.  The difference is that Kissinger and Brzezinsky formulated foreign policies based on long-range geopolitical interests of the nation while Rove formulated economic policies based mostly on short-term partisan political expediencies.

The Washington Post reported that before finally and reluctantly agreeing to be nominated Treasury Secretary, Paulson sought assurances in a long meeting with the president that “the post, which at times has been seen as subordinated by the White House, would have the proper kind of stature.”

The Importance of the Post of Treasury Secretary 

The power of modern nations rests on economic foundations. Historically, the Treasury Secretary is the vicar of the US economic policy. It was first held by Alexander Hamilton who created the Bank of the United States in a national banking regime that provided needed sovereign credit to finance the development of the young nation and thus launched the US on the path toward becoming a major economic power in record time.  Hamilton engaged Thomas Jefferson, then Secretary of State, in a fateful contest between centralized elitism and decentralized populism in economic policy. He also fought Albert Gallatin, then a Congressman, over the creation of a powerful Treasury for the Federal government with independent financing authority from the states of the union. He designed the collection and disbursing of Federal revenue for the promotion of the economic development of the young nation in an era when market fundamentalism in the context of free trade was an economic weapon employed by a hostile and belligerent Great Britain on its former colonies.

The Secretary of the Treasury is responsible for formulating and recommending domestic and international financial, economic, and tax policy, participating in the formulation of broad fiscal policies that have general significance for the economy, and managing the public debt. The Secretary oversees the activities of the Treasury Department in carrying out major law enforcement responsibilities; in serving as the financial agent for the US Government; and in manufacturing coins and currency. The chief financial officer of the Government, the Secretary serves on the President's National Economic Council. He is also Chairman of the Boards and Managing Trustee of the Social Security and Medicare Trust Funds, Chairman of the Thrift Depositor Protection Oversight Board, and serves as US Governor of the International Monetary Fund, the International Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, and the European Bank for Reconstruction and Development.

Today, with a globalized economy dominated by finance framed largely by the US, the post of US Treasury Secretary is even more critical, for no nation can carry out its foreign policy with its domestic economy in disarray, much less a superpower. Logic would suggest that the top post of the cabinet in today’s world should be the Treasury Secretary rather than the Secretary of State, as super-national financial institutions emerge as powerful agencies of superpower financial hegemony. Instead, in today’s White House, the National Economic Advisor is subordinate to the National Security Advisor.  Apparently, in the high temple of free markets, national security trumps market fundamentalism. The nation that leads in the promotion global free trade is also the most vocal nation in defending economic nationalism.

Albert Gallatin came of an old and noble Swiss family in Geneva who played a vital part in establishing the financial soundness of his adopted new nation.  He graduated with honors from the Geneva Academy, but in 1780 gave up fortune and social position to immigrate to the US, a nation barely 14 years old, to fulfill “a love for independence in the freest country of the universe.” In 1785, he took the Oath of Allegiance in Virginia and settling finally in Pennsylvania. A member of the State Legislature before being sent by voters to the US Senate, where his tentative citizenship caused him to be rejected by that august body, but not before calling on the Senate floor for a statement of the public debt as of January 1, 1794 from the Treasury Secretary, listing revenue received under each government branch and money expended under each appropriation. When Gallatin was again returned by voters to the House of Representatives, he immediately became a member of the new Standing Committee on Finance, the forerunner of the Ways and Means Committee, the most powerful body on US government finance.  While opposing Hamilton on the issue of expanding Federal authority, Gallatin actually reinforced Hamilton’s ambitious plan for a powerful US by making certain that the nation’s finances and currency remained strong.

In July 1800, Gallatin prepared a report entitled: Views of the Public Debt, Receipts and Expenditure of the United States, still regarded today as a classic, analyzing the fiscal operations of the Government under the Constitution.  In Congress, he worked relentlessly and successfully to keep down appropriations, particularly those for “warlike purposes.” Thomas Jefferson believed the Sedition Bill was framed to drive the foreign-born Gallatin from office. When Jefferson was elected President in 1801, he tendered Gallatin the post of Secretary of the Treasury.

Gallatin took office on a "platform" of debt reduction, the necessity for specific appropriations, and strict and immediate accountability for disbursements. Eight years after assuming office, his estimates on revenues and debt reduction proved uncannily accurate, reducing the public debt by $14 million to build up a surplus even after expending $15 million for the purchase of the Louisiana Territory, an acquisition which established the United States as a great continental power. Many accounting practices still in use in the Treasury date back to those introduced by Gallatin.  He also sponsored the establishment of marine hospitals, the forerunner of the present Public Health Service. In 1807 he submitted to Congress an extensive plan for internal improvement through the construction of highways and canals. Under Gallatin, the Treasury began the practice of submitting to Congress a detailed annual report of the country's fiscal situation with a breakdown of receipts, a concise statement of the public debt, and an estimate of expected revenue.

After leaving government, Gallatin became the President of the National Bank of the City of New York, later known as the Gallatin National Bank of the City of New York, a forerunner of CitiGroup of today. He was a founder of New York University, the New York Historical Society and the American Ethnological Society, making valuable contributions on the study of languages of the Native American tribes.

Andrew Mellon and Alan Greenspan

Andrew Mellon, the 49th Treasury Secretary, demonstrated precocious financial ability early in life. At 17, he started a successful lumber company, joined at 19 his father's banking firm, T. Mellon & Sons, and became controlling owner in 1882 at the age of 27. In 1889, he organized the Union Trust Company and the Union Savings Bank of Pittsburgh, branched out from banking into industrial activities and built a great personal fortune from oil, steel, shipbuilding, and construction by investing in growth industries such as coke, coal and iron. Mellon established the Aluminum Company of America, the Gulf Oil Corporation (1895), the Union Trust Company (1898) and the Pittsburgh Coal Company (1899). In 1937, he gave the Nation his magnificent art collection, plus $10 million, to build the National Gallery of Art in Washington, D.C.

Mellon was appointed by President Harding in 1921 to be Treasury Secretary to deal with the post-WWI economy. Along with Mellon, Herbert Hoover was appointed Secretary of Commerce. Harding’s Presidential address on March 4, 1921 reflected Mellon’s ideas of a revision of the tax system, an emergency tariff act, readjustment of war taxes and the creation of a Federal budget system. Mellon campaigned to Congress for tax cuts and lower government spending to reduce the public debt.

In November 1923, Secretary Mellon presented to the House Ways and Means Committee what has come to be known as “The Mellon Plan”, a program for tax reform which subsequently became law as the Revenue Act of 1924, reducing the top income tax rate to 25%. Through the roaring 1920’s, Mellon was a popular official, much like the way Alan Greenspan was throughout the irrational exuberant 1990s. Despite his open conservatism in government finance, Mellon presided over an unprecedented growth of private debt in the economy during his tenure. Total private debt at the time of the 1929 crash reached $200 billion, the equivalent of over $3 trillion in 2005 as relative share of GDP, or about 25%. As late as 1930, Secretary of the Treasury Andrew Mellon held that a financial panic might not be such a bad thing. “It will purge the rottenness out of the system,” he added. “High costs of living...will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.” But the rottenness came from easy credit which Mellon was centrally responsible in releasing. And predators picked up the wrecks from unfortunate hard-working people who lost everything they owned through no fault of their own.

It was comparable to Greenspan’s testimony before the Joint Economic Committee of the US Congress on October 29, 1997, on Turbulence in World Financial Markets: “Yet provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macro-economy.” The Asian economies saw their assets lose up 80% of their market value within a few days. The US did better. From the market peak to the October lows, the S&P 500 lost 35.9% of its peak value but regained the lost value about two years later by the Fed’s massive injection of liquidity. The Greenspan formula was to print money whenever the market faltered. The Asian economies were less lucky. As international finance was denominated mostly in dollars, the Asian central banks were not able to print local currencies to provide needed liquidity to their collapsing markets. They learned from direct experience that dollar hegemony is not benign.

Under Greenspan, the US had amassed $44 trillion of debt by 2005: $10 trillion by the Federal Government, $2 trillion by State and local governments and $32 trillion by the private sector of which the business sector held $8.3 trillion, the finance sector held $12.5 trillion and the household sector held $11.5 trillion.  In addition, the nation faces an unfunded contingent liability of $7 trillion in Social Security and $37 trillion in Medicare obligations. The Greenspan debt monkey is ten folds larger than Mellon’s even after adjustment for inflation. The delayed but unavoidable bursting of Greenspan’s debt bubble will make the 1930 Depression look like minor storm.

Ironically, the onslaught of the depression in 1929 was blamed by voters on Mellon’s fiscal policies, not on his monetary policy or his tolerance if not promotion of private debt. And it contributed to the defeat of Herbert Hoover in 1932 by Franklin D. Roosevelt.  There are clear indications that history would not treat Greenspan’s liquidity joyride with more lenience. This time, since the Greenspan legacy spanned over both political parties, voters having no third party to turn to as they did in 1930 may well vote against the apocalyptic black knight of neo-conservative foreign policy galloping on a neo-liberal free-trade horse.

Henry Morganthau

Henry Morgenthau was nominated by President Roosevelt to be the 52nd Secretary of the Treasury and served from January 1, 1934 until July 22, 1945 in FDR’s “New Deal” and War Administration. During his historic long term, Morgenthau exercised a stabilizing effect on US monetary policies through progressive taxation and sovereign credit, raising $450 billion ($45 trillion in 2005 dollars in relative share of GDP) for anti-depression government spending programs and for war costs. This amount was more than all the money raised by all of the previous 51 Secretaries, enough in current dollar equivalent to pay off all the debts in the US economy today. This shows that under effective leadership the US can be a debt free nation with the proper resolve and fairly-distributed sacrifice to re-emerge as a great nation with unprecedented prosperity without exploitation either at home or abroad.

For seven years during the Depression, from 1934 through December 7, 1941, the day Japan attacked Pearl Harbor, Morgenthau defended the dollar against devaluation by intervening in the world financial markets in an effort to make the dollar the strongest currency in the world despite a weak domestic economy, particularly from the rising strength of the German currency as the Nazi economic miracle took off.  This effort led to an international monetary stabilization agreement reached among the great powers after the Munich Pact of 1938, which did not have a chance to test its worth. When war in Europe broke out in 1939 over German invasion of Poland, Morgenthau established a procurement service in the Treasury Department to facilitate the purchase of US munitions on credit by Britain and France.  He provided the US economy with unlimited sovereign credit to meet enormously expanded spending requirements that followed the attack on Pearl Harbor.  War mobilization for WWII began first in the financial sector.

Morgenthau financed the war with a program of war bonds which in the first year of the war alone amounted to a $1 billion distribution. The war bonds not only supported war spending, but also prevented a serious inflationary wave by siphoning off excess funds from the private sector to prevent the emergence of a black market out of the government’s war-time price control program.  The war-time black market did not flourish simply because few people had the money to pay black-market prices.

In 1944, the Morgenthau plan, under which post-war Germany would be stripped of its industry, the basis for war-making, and be converted into an agricultural nation, became policy until the beginning of the Cold War when the US decided it needed a strong capitalistic, even neo-fascist Germany with a credible military to resist the spread of communism in Europe. At the Bretton Woods conference in 1944, Morgenthau assumed a leading role in establishing post-war economic policies and currency stabilization with the introduction of a gold-backed dollar with fixed exchange rate to finance a revival of world trade under US leadership. In July 1945, three months after the death of President Roosevelt, Morgenthau resigned as Treasury Secretary, but remained in office until President Truman returned from the "Big Three" conference in Potsdam, Germany in early August. The Potsdam Conference and the surrender of Japan on August 14, 1945 brought on the beginning of the Cold War.

From 1947 until 1950, Morganthau was Chairman of the United Jewish Appeal, which raised $465 million during that time, and from 1951 to 1954, he served as Chairman of the Board of Governors of the American Financial and Development Corporation for Israel, which handled a $500 million bond issue for the new nation. It is an ironic tragedy of history that the anti-Semitic sins of Europe are being atoned by the Arab nation with intractable conflicts in the Middle East that will endanger the future peace of the whole world.

Nixon’s Treasury Secretaries

Appointing Democrat John B. Connally as Treasury Secretary was a shrewd political move for Republican President Nixon, who had to reorganize his cabinet in response to Democratic gains in the 1970 mid-term congressional elections. In response to deteriorating domestic and international economic conditions, Nixon announced his "New Economic Policy" in 1971. In monetary terms, this meant “closing the gold window”, ending US legal obligation to exchange dollars held by foreign banks for gold at $35 per ounce, abandoning the 1944 Bretton Woods regime of a dollar pegged to gold and fixed exchange rates for world currencies to keep trading partners honest. Floating exchange rates allow countries an escape valve from having to correct their economic inefficiencies through currency devaluation.

With Nixon proclaiming: “We are all Keynesian now,” Connally resurrected New Deal anti-cyclical deficit spending with a "full employment budget," and imposed a wage and price freeze to halt inflation. Connally was described by New York Times columnist James Reston as "the spunkiest character in Washington these days.... He is tossing away computerized Treasury speeches, and telling American business and labor off the cuff to get off their duffs if they want more jobs, more profits and a larger share of the competitive world market.” Nixon’s left-leaning NEP, not dissimilar to Lenin’s right-leaning NEP, failed to work because it was merely a revisionist label with little substantive content for lack of ideological commitment. Price control without central planning caused supply bottlenecks in failed markets, the most bizarre example manifested itself in a shortage of toilet seats for new residential construction that delayed occupancy and created cash-flow problems for the mortgage banking sector. FDR forbade US citizens to buy or own gold and devalued the dollar by 60% and kept interest rates at historical low levels. Still, US export trade did not rise with dollar devaluation nor employment in the domestic private sector picked up. Most of the unemployment was absorbed by the expanded public sector.  The economy did not revive until WWII. In contrast, Nixon’s NEP aimed to prevent the dollar from falling by allowing interest rates to rise. Monetarily, the US was heading for run-away inflation not from excess money in circulation, but from fiscal deficits caused by the Vietnam War which, unlike WWII, was not a war whose burden was equally or equitably shared by all.  Foreign wars cannot be sustained without evenly-shared nation-wide sacrifice. Conversely, an all voluntary army takes the wind from the anti-war movements and makes undeclared executive wars routine. A more war-like foreign policy can then prevail because it is easy to risk other people’s lives for one’s own patriotism.

Having served as Secretary of Labor in 1968 and head of the Office of Management and Budget in 1970, George P. Shultz was appointed Treasury Secretary by Nixon in 1973. During his tenure, Shultz reversed Nixon’s New Economic Policy begun under Conally by lifting price control domestically and shifted his attention to the international arena to deal with a renewed dollar crisis that broke out in February 1973. Shultz organized an international monetary conference in Paris in 1973 to formalize the 1971 US decision to close the gold window and the abolition of the fixed rate exchange system, which had actually begun to collapse in 1971, causing all key currencies since to float. However, cross-border flow of funds continued to be restricted to keep contagious financial instability at bay.

1973 was a very bad year for the US economy. Phasing out domestic price control released pent-up inflation in the US, causing the dollar to fall in the new foreign exchange market in London. Then in autumn, OPEC induced an oil crisis, pushing the US economy into a severe recession not seen since 1929, with industrial production shrinking 15%, unemployment reaching above 9% and economic output declining 6%.  Shultz resigned shortly before Nixon did, only to return to Washington in 1982 as Reagan’s Secretary of State.

William E. Simon, Deputy Secretary of the Treasury under Secretary George Shultz, served concurrently as the director of the Federal Energy Office during the oil crisis of 1973. He was named as the 63rd Secretary of the Treasury by President Nixon in 1974 and continued under President Gerald Ford after Nixon resigned. Domestically, Simon faced a worsening economic slump as he took control of the Treasury. In response to the oil crisis, he strong-armed oil-producing nations to deposit their petrodollar in US banks but discouraged them from direct investment in US corporations. This led US banks to lend the petrodollars to developing economies who could only repay the loans with earning from export to US markets. This was the beginning of globalization, the dependence of the emerging economies on US markets for consumer goods forced them to open their financial markets to US capital denominated in dollars. This deregulated flow of dollar –denominated funds across national borders led to financial crises in Mexico, Latin America and eventually ended up with the 1997 Asian Financial Crisis. As Treasury Secretary, Simon continued the policies begun under Shultz of pressuring Europe, Japan and the Soviet Bloc with US financial prowess, keeping international economic policy initiative in US hands to ensure a competitive advantage for the US. Simon resigned at the end of Ford’s partial term when Jimmy Carter won the presidency in the 1976.

Carter and the Fed under Volcker

William G Milller, after only 17 months as Chairman of the Federal Reserve, was named the 65th Treasury Secretary on August 6, 1979 as part of President Carter’s desperate wholesale cabinet shakeup in response to popular discontent and declining presidential authority. After isolating himself for 10 days of introspective agonizing at Camp David, Carter emerged to make his confessional speech of “crisis of the soul and confidence” to a restless nation. In response to a national political leader consumed with self-doubt, the market dropped in free fall. Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration facing a difficult election in 14 months.

In August 1979 Carter felt that he needed someone like Paul A. Volcker, an intelligent if not intellectual Republican, a term many liberal Democrats considered an oxymoron, who was highly respected on Wall Street, if not in academia, to be at the Fed to regenerate needed bipartisan support in his time of presidential leadership crisis. Bert Lance, Carter's chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own re-election a year later to a less-than-sympathetic Fed chairman. As it turned out, the Ayatollah Khomeini of Iran held Carter’s second term in his hands.

Volcker won a Pyrrhic victory against inflation by letting financial blood run all over the country and most of the world. It was a toss-up whether the cure was worse than the disease.  He observed correctly that inflation ceases to be stimulative once it is anticipated by the market because lenders will raise interest rates above anticipated inflation rates, leading to economic stagflation.

But what was worse than temporary high interest rates was that the temporary deregulation that had made limited sense under conditions of near hyper-inflation was kept permanent under conditions of restored normal inflation. Deregulation, particularly of interest-rate ceilings and credit market segregation and restrictions, put an end to market diversity by killing off small independent firms in the financial sector since they could not compete with the larger institutions without the protection of regulated financial markets. Small operations had to offer increasingly higher interest rates to attract funds while their localized lending could not compete with the big volume, narrow rate-spreads of the big institutions. Big banks could take advantage of their access to lower-cost funds in global markets to assume higher risk and therefore play in higher-interest-rate loan markets nationally and internationally, quite the opposite of what Keynes predicted, that the abundant supply of capital would lower interest rates to bring about the “euthanasia of the rentier.” Securitization of unbundled risk levels allowed high-yield, or junk, bonds with high rates to dominate the credit market, giving birth to new breeds of super rentiers.

Ultimately, Keynes will turn out to be prescient, as the finance sector, not unlike the transportation sectors such as railroads, trucking and airlines in earlier waves, or the communication sector such as telecom companies in recent years, has been plagued by predatory mergers of the big fish eating smaller fish, after which the big fish, having grown accustomed to an unsustainably rich diet that damaged their financial livers, begin to die from self-generated starvation from a collapse of the food chain. Financial diversity, similar to bio-diversity, is critical to the maintenance of a sustainable ecosystem which can be endangered by the extinction of any component species.  Survival of the fittest is merely an acknowledgment of primitive savagery, not a theory of progress. All species enjoy equal fitness in any ecosystem. Eagles die when small preys are gone.

The Fed has traditionally never been keen on changing interest rates too abruptly, trying always to prevent inflation without stalling the economy excessively - thus resulting in interest rates increases often trailing rampant inflation, or stimulating the economy without triggering inflation down the road, thus resulting in interest rates reductions trailing a stalling economy. Market demand for new loans, or the pace of new lending, obviously would not be moderated by raising the price of money, as long as the inflation/interest gap remains profitable. Deflation has a more direct effect in moderating loan demands, causing what is known as a liquidity trap or the Fed pushing on a credit string.

Yet bank deregulation has diluted the Fed's control of the supply of credit, leaving the price of short-term money as the only lever. Price is not always an effective lever against runaway demand, as Fed chairman Alan Greenspan was also to find out in the 1990s. Raising the price of money to fight inflation is by definition self-neutralizing because high interest cost is itself inflationary in a debt-driven economy. Lowering the price of money to fight deflation is also futile because low interest cost is deflationary for creditors who would be hit by both loss of asset price, deteriorating collateral value and falling interest income. Abnormal gaps between short- and long-term interest rates, as expressed in an inverted yield curve, do violence to the health of many financial sectors that depend on long-term financing, such as insurance, energy and communication. Deregulation also allows the price of money to allocate credit within the economy, often directing credit to where the economy needs it least, namely the high-risk speculative arena, or desperate borrowers who need money at any price.

Reagan Voodoo Economics

The monetary disorder that elected Reagan in 1980 followed him into office. Carter blamed inflation on prodigal consumer demand and promised government action to halt hyper-inflation. Reagan reversed the blame for inflation and put it on big government. Yet Reagan’s economic agenda of tax cuts, defense spending and supply-side economic growth was in conflict with the Fed’s anti-inflation tight-money policy. The monetarists in the Reagan administration were all longtime right-wing critics of the Fed, which they condemned as being infected with a Keynesian virus. Yet the self-contradicting aims in fiscal policies of the Reagan administration (a balanced budget in the face of massive tax cuts and increased defense spending) overshadowed its fundamental monetary-policy inconsistency. Economic growth with shrinking money supply is simply not internally consistent, monetarism or no monetarism.

The Reagan presidency marked the rehabilitation of classical economic doctrines that had been in eclipse for half a century. Economics students since World War II had been taught classical economics as a historical relic, like creationism in biology. They viewed its theories as negative examples of intellectual underdevelopment attendant with a lower stage of civilization. Three strands of classical economics theory were evident in the Reagan program: monetarism, supply-side theory, and phobia against deficit financing (but not deficit itself) coupled with a fixation on tax cuts but no on government spending. Yet these three strands are mutually contradictory if pursued with equal vigor, what Volcker gently warned about in his esoteric speeches as a “collision of purposes”. Supply-side tax cuts and investment-led economic growth conflict with monetarist money-supply deceleration, while massive military spending with tax cuts means inescapable budgetary deficits. Voodoo economics was in full swing, with the politician who coined the term during the primary, George H W Bush, would later serve as the administration’s vice president. Reagan, the shining white knight of small-government conservatism, left the US economy with the biggest national debt in history.

A tightening of money supply alongside a budget deficit is a sure recipe for a recession. Long-term high-grade corporate and government bonds were seeing their market rates jump 100 basis points in one month. New issues had difficulty selling at any price. The possibility of a "double dip" recession was bandied about by commentators. The Volcker Fed was attacked from all sides, including the commercial banks, which held substantial bond portfolios, and Reagan White House supply-siders, despite the fact that everyone knew the trouble originated with Reagan's ideology-fixated economic agenda. The Democrats were attacking the Fed for raising interest rates in a slowing economy, which was at least conceptually consistent.

The Reagan White House accused the Volcker Fed of targeting interest rates again instead of focusing on controlling monetary aggregates, and Volcker himself was accused of undermining the president's re-election chances in 1984. Reagan publicly discussed “abolishing” the Fed, notwithstanding his disingenuous defense of the Fed from attacks by Carter during the 1980 election campaign. Earlier, back in mid-April 1984, Volcker had publicly committed himself to gradualism in reining in the money supply and avoiding shock therapy, to give the economy time to adjust. But he reneged on his promise by May, and decided to further tighten on an economy already weakened by high rates imposed six months earlier, yielding to White House pressure and bond-market signals. Gradualism in interest-rate policy was again discarded. Volcker’s justification was amazing, in fact farcical. He told a group of Wall Street finance experts in a two-day invited seminar that since policy mistakes in the past had been on the side of excessive ease, in the future it made sense to err on the side of restraint. Feast-and-famine was now not only a policy effect but a policy rationale as well. Compound errors, like compound interest, were selected as the magical cure for the sick economy.

Financial Markets Not the Real Economy

Financial markets are not the real economy. They are shadows of the real economy. The shape and fidelity of the shadows are affected by the position and intensity of the light source that comes from market sentiments on the future performance of the economy, and by the fluctuating ideological surface on which the shadow is cast. The institutional character of the Fed over the decades has since developed more allegiance to the soundness of the financial-market system than to the health of the real economy, let alone the welfare of all the people. Granted, conservative economists argue that a sound financial-market system ultimately serves the interest of all. But the economy is not homogenous throughout or even neatly hierarchical. In reality, some sectors of the economy and segments of the population, through no fault of their own, may not, and often do not, survive the down cycles to enjoy the long-term benefits, and even if they survive are permanently put in the bottom heap of perpetual depression. The late John Kenneth Galbraith said famously about trickling down economics: “When you feed the horse enough oats, the sparrows will eventually benefit.” The corollary is that the sparrows can survive very well without the horse being overfed.

Periodically, the Fed has failed to distinguish a healthy growth in the financial markets from a speculative debt bubble. Under Greenspan, this failure is accepted as a policy initiative, equivalent to “when rape is inevitable, relax and enjoy it”. Debt is accepted as the financial magic cure for all ills economic.

The Reagan administration by its second term discovered an escape valve from Volcker's independent domestic policy of stable-valued money. In an era of growing international trade among allies in the Western block, with the mini-globalization to include the emerging developing countries before the final collapse of the Soviet bloc, a booming market for foreign exchange had been developing since Nixon's abandonment of the gold standard and the Bretton Woods regime of fixed exchange rates in 1971. The exchange value of the dollar thus became a matter of national security and as such fell within the authority of the president that required the Fed's patriotic support.

Martin Feldstein and Disciples

Council of Economic Advisers chairman Martin Feldstein, a highly respected conservative economist from Harvard with a reputation for intellectual honesty, had advocated a strong dollar in Reagan's first term, arguing that the loss suffered by US manufacturing for export was a fair cost for national financial strength. But such views were not music to the ears of the nationalistic Reagan White House and the Treasury under Donald Reagan, former head of Merrill Lynch, whose roster of clients included all major manufacturing giants which had not caught on to the escape valves of outsourcing labor intensive manufacturing to low-wage countries and that it was more profitable to import low price-goods from overseas than to export high-priced goods overseas. Feldstein, given the brush-off by the White House, went back to Harvard to continue his quest for truth in theoretical global geo-economics after serving two years in the Reagan White House, where voodoo economics reigned.

Feldstein went on to train many influential economists who later would hold key positions in government, including Lawrence Summers, treasury secretary under president Bill Clinton and later failed president of Harvard University; Lawrence Lindsey, dismissed Presidential Economic Advisor to President George W. Bush; and Gregory Mankiew, Chairman of the Bush White House Council of Economic Advisers, who sparked an uproar by saying, in the same intellectual tradition: “Outsourcing is a growing phenomenon, but it's something that we should realize is probably a plus for the [US] economy in the long run.” Whether that is true depends of course on which part of the US economy one is housed.

Nearly 2.8 million factory jobs have been lost since President George W Bush took office in 2000. Democrats seized on Mankiew’s comments as evidence that the Bush White House is insensitive to the plight of the unemployed and the underemployed, who are likely to be active voters, notwithstanding that the Clinton economic team held in essence the same views. Senate Minority Leader Tom Daschle called Mankiew’s assessment “Alice in Wonderland economics.”

Since the press frequently fails to ask sophisticated technical questions of economics, government economists can usually give a carefully formulated sentence that appears to be consistent with White House policy that is not literally false technically. Mankiew’s immediate predecessor, Glenn Hubbard, signed on to the White House position that “interest rates don’t move in lockstep with budget deficits”, despite having written, as Mankiew also did, a popular textbook with a standard model linking interest rates to budget deficits.  But because the sentence as qualified with “lockstep” can be true, Hubbard remained within the bounds of fidelity in economic science, preserving his credibility in the profession.

Presidents and their Economic Advisors

President Lyndon B. Johnson rejected the advice of his CEA chairman Gardner Ackley that the war in Vietnam could not be pursued simultaneously with Johnson’s ambitious Great Society domestic spending programs without inflationary consequences unless taxes were raised. In 1971, Richard Nixon imposed wage and price controls, considered a cardinal sin by CEA chairmen Paul McCracken and Herb Stein. In 1983-84, Martin Feldstein, Ronald Reagan's CEA chairman, publicly predicted protracted record-high budget and trade deficits, upsetting the White House, notwithstanding that the prediction came true. Michael Boskin, CEA chairman under George HW Bush tried in vain to warn his president about a developing weak economy, contrary to the “Be Happy” tune Bush projected. The 1988 Bush presidential campaign used as its theme the popular song “Don’t Worry, Be Happy” by jazz composer Bobby McFerrin as its theme until McFerrin objected.

It’s the Economy, Stupid

James Carville, candidate Bill Clinton campaign strategist coined four famous words that became political lore: “It's the economy, stupid”, with which an unknown from Arkansas defeated an incumbent president fresh from victory in foreign war. Three weeks before the 1992 election, as a desperate Bush campaign moved to demonstrate that the president saw the light, the White House tried to blame the economic troubles on Boskin and the sitting economic team by announcing that if re-elected Bush would appoint a fresh new team. A “kill the messenger” attitude was also displayed by George W. Bush in December 2002, in the unceremonious manner in which the departures of Paul O'Neill, Treasury secretary, and Larry Lindsey, economic adviser, were announced. Their replacements quickly learned to tote the White House line, at least in public.

Some advisers did resign over policy but almost none in protest, with the exception of perhaps O’Neill. McCracken considered leaving when Nixon rejected his advice on wage-price controls but postponed the resignation for four months to minimize negative publicity. Murray Weidenbaum, Reagan’s first CEA chairman, unhappy over the issue of Reagan’s rhetoric against government spending made empty by his actual irresponsible fiscal policy that produced historically high budget deficits, resigned but not in protest.

James Baker and the Plaza Accord

By Reagan's second term, it became undeniable that the US policy of a strong dollar was doing much damage to the manufacturing sector of the US economy and threatening the Republicans with the loss of political support from key industrial states, not to mention the unions, which the Republican Party was trying to woo with a theme of Cold War patriotism. Treasury secretary James Baker and his deputy Richard Darman, with the support of manufacturing corporate interest, then adopted an interventionist exchange-rate policy to push the fundamentally overvalued dollar down. A truce was called between the Fed and the Treasury, though each continued to work quietly toward opposite policy aims, much like the situation in 2000 on interest rates, with the Greenspan Fed raising the short-term Fed funds rate while the Summers Treasury pushed down long-term rates by buying back 30-year bonds with its budget surplus, resulting in an inverted rate curve, a classical signal for recession down the road, while expensive talk of the End of the Business Cycle was extravagantly entertained in the same vein as Francis Fujiyama’s “End of History”.

Thus, a deal was struck to allow Volcker to continue his battle against domestic inflation with high interest rates while the overvalued dollar would be pushed down by the Treasury through the Plaza Accord of 1985 with a global backing-off of high interest rates. Notwithstanding the subsequent Louvre Accord of 1987 to halt the continued decline of the dollar started by the Plaza Accord only two years earlier, the cheap-dollar trend did not reverse until 1997, when the Asian financial crisis brought about a rise of the dollar by default, through the panic devaluation of Asian currencies. The paradox is that in order to have a stable-valued dollar domestically, the Fed had to permit a destabilizing appreciation of the foreign-exchange value of the dollar internationally. For the first time since end of World War II, foreign-exchange consideration dominated the Fed's monetary-policy deliberations, as the Fed did under Benjamin Strong after World War I. The net result was the dilution of the Fed's power to dictate to the globalized domestic economy and a blurring of monetary and fiscal policy distinctions. The high foreign-exchange value of the dollar had to be maintained because too many dollar-denominated assets were held by foreigners or to be more precise, non-domestic entities, which could be subsidiaries of US companies. A fall in the dollar would trigger sell-offs as it did after the Plaza/Louvre Accords of 1985 and 1987, which contributed to the 1987 stock market crash.

Robert Rubin and Dollar Hegemony

It was not until Robert Rubin became special economic assistant to President Clinton in 1992 that the US would figure out its strategy of dollar hegemony through the promotion of unregulated globalization of financial markets. Rubin, a consummate international bond trader at Goldman Sachs who earned $60 million the year he left to join the White House, figured out how the US was able to have its monetary cake and eat it too, by controlling domestic inflation with cheap imports bought with a strong dollar, and having its trade deficit financed by a capital account surplus made possible by the same strong dollar. Thus dollar hegemony was born.

With his vast experience in evolving globalization of financial markets, Rubin helped Clinton, developed an economic policy based on global open markets, and investments in education, training and the environment. This program helped to spark and sustain the longest economic expansion in the nation’s history to date, transforming the nation’s budgetary position from deficit to surplus, and produce the lowest national rates of unemployment in decades. As Treasury Secretary, Rubin faced threats to the nation’s creditworthiness and to the stability of the global financial system. He used statutory authority to safeguard the Federal government’s finances and make timely payments of the Federal debt when the Congress did not raise the debt limit during an extensive budgetary confrontation. During his tenure, financial crises flared in Mexico and Asia posing real risks to global financial stability. Rubin led efforts–with the IMF, Federal Reserve and others–that contained both disruptions, stopping both crises from overwhelming the global financial system, protecting US economic expansion, and spurring Mexico and Asia toward economic recovery.  Upon Rubin’s retirement, President Clinton called him the “greatest secretary of the Treasury since Alexander Hamilton.”  It was no exaggeration.

The US economy grew at an unprecedented rate with the wholesale and permanent export not of US goods, but manufacturing jobs from the rust belt to low-wage economies, with the added bonus of reining in the unruly domestic labor unions. The Japanese and the German manufacturers, later joined by their counterparts in the Asian tigers and Mexico, were delirious about US willingness to open its domestic market for invasion by foreign products, not realizing until too late that their national wealth was in fact being steadily transferred to the dollar economy through their exports, for which they got only dollars that the US could print at will but that foreigners could not spend in their own respective non-dollar economies. By then, the entire structure of their economies, and in fact the entire non-dollar global economy, was enslaved to export, condemning them to permanent economic servitude to the US dollar. The central banks of these countries with non-dollar economies competed to keep the exchange values of their currencies low in relation to the dollar and to one another so that they can transfer more wealth to the dollar economy via export while the dollars they earned from export had no choice but to go back to the US to finance the restructuring of the dollar economy toward new modes of finance capitalism and new generations of high-tech research and development through US defense spending.

The Greenspan Era

Reagan replaced Volcker with Alan Greenspan as Fed chairman in the summer of 1987, over the objection of supply-side partisans, most vocally represented by Wall Street Journal assistant editor Jude Wanniski, a close associate of former football star and presidential potential Jack Kemp, Congressman from New York. Wanniski, who died  unexpectedly earlier this year, derived many of his economics ideas from Robert Mundell, who was to be the recipient of the Nobel Prize for economics in 1999 on his theory on exchange rates, not without help from the persistent promotion of the Wall Street Journal. Wanniski later accused Greenspan of having caused the 1987 crash, with Greenspan, in his new role as Fed chairman, telling Fortune magazine in the summer of 1987 that the dollar was overvalued. Wanniski also maintained that there was no liquidity problem in the banking system in the 1987 crash, and “all the liquidity Greenspan provided after the crash simply piled up on the bank ledgers and sat there for a few days until the Fed called it back”. Wanniski blamed the 1986 Tax Act, which, while sharply lowering marginal tax rates, nevertheless raised the capital gains tax to 28 percent from 20 percent and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns, according to Wanniski.

On Monday, October 19, 1987, the value of stocks plummeted on markets around the world, with the Dow Jones Industrial Average (DJIA, the main index measuring market activity in the United States) falling 508.32 points to close at 1,738.42, a 22.6% fall, the largest one-day decline since 1914. The magnitude of the 1987 stock-market crash was much more severe than the 1929 crash of 12.8%. The loss to investors amounted to $500 billion, about 10% of 1987 gross domestic product (GDP). Over the four-day period leading up to the October 19 crash the market fell by more than 30%. By peak value in January 2000, this would translate into the equivalent of an almost 4,000-point drop in the Dow. However, while the 1929 crash is commonly believed to have led to the Great Depression, the 1987 crash only caused pain to the real economy and not the collapse of its financial system. It is widely accepted that Greenspan's timely and massive injection of liquidity into the banking system saved the day. The events launched the super-central-banker cult of Greenspan, notwithstanding Winniski's criticism.

By January 1989, 15 months after the crash, the market had fully recovered, but not the US economy, which remained in recession for several more years. When the recession finally hit in full force, three years after the crash, it was blamed on excessive financial borrowing, not the stock market, notwithstanding the fact that excessive financial borrowing itself was made possible by the stock-market bubble. The Tuesday after the crash on Black Monday on October 19, 1987, Alan Greenspan issued a one-sentence assurance that the Federal Reserve would provide the system with necessary credit. John D Rockefeller had made a somewhat similar declaration in 1929 - but failed to buoy the market. Rockefeller was rich, but his funds were finite. Greenspan succeeded because he controlled unlimited funds with the full faith and credit of the nation. The 1987 crash marked the hour of his arrival as central banker par excellence, the beginning of his status as a near-deity on Wall Street. The whole world now hums the mantra: In Alan We Trust (an update of the slogan "In God We Trust" printed on every Federal Reserve note, known as the dollar bill). It was the main reason for his third-term reappointment by President Clinton. Greenspan is the man who will show up with more liquor when the partying hits a low point, rather than the traditional central-banker role of taking the punch bowl away when the party gets going. Greenspan could be relied upon to keep the financial system liquid until after the 2004 election. It remains to be seen if Bernanke will do the same for the 2008 presidential election.

Reportedly, George H W Bush was miffed by Greenspan's handling of interest rates, which led to a brief economic downturn shortly before the 1992 election, when Bush lost to Clinton despite victory in a foreign war. By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured. The DJIA was below 4,000 in 1994 and rose steadily to a bubble of near 12,000 while Greenspan raised the Fed funds rate (FFR) seven times from 3% to 6% between February 4, 1994, and February 1, 1995, to try to curb "irrational exuberance", and kept it above 5% until October 15, 1998. When the DJIA started its slide downward after peaking in January 2001, the Fed lowered the FFR from 6.5% on January 3, 2001, to 1% set on June 25, 2003. A years later, when the DJIA rebounded to above 10,500, the Fed started raising FFR in 25 basis point increments on June 30, 2004 16 times to the current 5% on May 10, 2006.

Greenspan and George W
The current president recognized Greenspan’s importance from the beginning. In his first trip to Washington as president-elect in 2000, the first person Bush visited was Greenspan. The central-bank chairman, with a sensitive ear to the shifting pitches of politics, later gave a qualified endorsement of Bush’s $1.35 trillion tax cut in 2001. But later, the chairman told the Senate Banking Committee that Bush's new tax-cut proposal was premature since the economy might be in the midst of a recovery without it. He endorsed Bush’s dividend-tax exemption proposals but said any revenue loss would have to be offset with spending cuts and tax increases. And, he said, the deficit raises long-term interest rates, contrary to White House economic theory. Greenspan confessed to a “conundrum” that the Fed had been tightening credit for a year, raising short-term interest rates by 2 percentage points - and yet long-term rates continue low by historic standards.

The largest fall in rates through a modern election year occurred in 1960, when a sagging economy and high unemployment caused the Fed to cut rates from 4 percent to 2.4 percent, and helped challenger John F Kennedy defeat Richard Nixon. The second-largest easing of monetary policy happened in 1992, when Bill Clinton ousted George Bush Sr amid a strong, rebounding economy and falling interest rates. This runs counter to the perceived wisdom about the 1992 election among Democrats, who believe it was a lousy economy that delivered them the White House when, in fact, by the time of the poll, the economy was growing strongly, and among Republicans, who still blame the Greenspan-led Fed for bringing down the first Bush with unaccommodating monetary policy through 1992. “It's the economy, stupid” was a great slogan, but perhaps not quite as relevant in hindsight as it seemed at the time.

When Greenspan was appointed by Ronald Reagan in 1987, the year before Bush Sr was first elected, the economy was gliding along at a 2.9 percent clip, with 6.2 percent unemployment. This was good performance at the time, though weak by recent standards. However, inflation stood at a "horrific" 3.1% and Greenspan did not want to be known as the man who threw away Volcker's heroic "victory" against inflation. He mercilessly cranked interest rates up from 6.7 percent in 1987 to 9.2 percent in 1989. The economy continued to grow for a while, but by 1991 unemployment began to rise, and reached a peak of 7.5% of the labor force in 1992 and cost Bush the father his 1992 re-election. Historical data suggest it takes about two years for policy maneuvers to slow the economy.

Ironically, the second-largest increase in interest rates through a modern presidential-election year happened in 1988, when a booming economy saw the Fed fund rate rise from 6.7% to 8.4% through the year. Even so, the first Bush won a resounding victory over the liberal Democrat Michael Dukakis. There were no complaints from Republicans about a biased Fed that year. The largest election-year increase in Fed fund rates happened in 1980, when Ronald Reagan resoundingly defeated Jimmy Carter amid soaring inflation and high unemployment. But the Fed's 2-percentage-point increase in rates that year was triggered by inflation reaching 13%.

Reagan left the nation with the highest budget deficit as a percentage of GDP (6 percent) in history with tax cuts and increased military spending. Clinton left the nation with massive trade deficits by pushing deregulated financial globalization. The current account deficit is financed by a capital account surplus through dollar hegemony created by an international finance architecture that requires foreign central banks to hold dollar reserves to prevent attacks on their own respective currencies, notwithstanding the dollar being a fiat currency of an economy inflated with debt.

George W Bush won the 2000 election along with the bursting of the Clinton debt bubble. Nine months into office, Bush faced spectacular terrorist attacks in the heart of the financial sector. The Fed poured billions of dollars into the US banking system to keep it from seizure, and left un-sterilized funds created through a $90 billion special swap arranged that week with the foreign central banks. True to supply-side economics, Bush pushed through a tax cut to ward off the Clinton recession, but stock prices fell like rocks.

The stock market recovery in 2003, with the DJIA rising by 25% from its low in March, and the Nasdaq rising a phenomenal 50%, and the S&P 500 rising 26% and the Russell 2000 rising 45%, fits into the Presidential Election Cycle Theory, even though it was a jobless recovery. The rise in equity prices was tempered by the dollar falling 20% against the euro, 10% against the yen, despite Bank of Japan intervention, and a whopping 34% against the Australian dollar, a commodities currency. When a dollar buys less stock, it is not viewed as inflation by the Fed because higher equity prices can support more debt, which in turn causes the dollar to buy even less stock, which causes equity prices to rise even more. Yet no one seems to be worried about this bubble. The market takes comfort in Greenspan's recent claim that the Fed correctly focuses policies on trying to mitigate probable damage after the eventual bursting of a bubble of stock-market speculation rather than taking measures to prevent the bubble itself. Irrational exuberance is now the name of the game and the rule of the game, to paraphrase Keynes, is that markets can stay irrationally exuberant longer than investors can afford to stay liquid on the sideline.

Bernanke’s False Starts

In a speech to a conference on June 5 in Washington, Bernanke gave hint that future rate increases should be expected because price inflation had reached a danger zone even as the US economy is showing signs of slowing down, pointing to slowing consumer spending, the cooling housing market and slower job growth. Bernanke left little doubt that he was more worried about rising inflation than slowing growth, and possibly stagflation by calling them “unwelcome developments”. The DJIA promptly plunged 200 points, and fell another 150 points by week’s end. What the markets heard was that rate increases might extend beyond the next expected bump up to 5.25 percent at the Fed's June 28 and 29 meeting, until inflation pressures ease. Unlike Greenspan, Bernanke came into office determined to tell the nation how he sees about the economy. He is learning that there is a price to be paid for telling the truth.

Why Paulson Accepts the Treasury Job

It is possible that Henry Paulson sees Goldman profitability going forward an up-hill drive in the next few years as the economy slows.  Paulson has made enough money in the good years and may see leaving Goldman at the peak of the market a smart option. It's no fun to run an investment bank in a down market. Paulson is a banker. Bankers are interested in the state of the market, not the economy per se. In two and a half years, a Treasury Secretary can, with the full power of the Treasury behind him, have a chance of saving the market from imminent collapse from its current structural imbalances.

The Game Plan to Save the Markets

The formula is to accelerate the crash for a fast recovery later. The prospect of Paulson engineering a sharp correction in the equity market right after the mid-term Congressional election is almost certain.  The strategy is to remove the structural bottlenecks and to weed out the weaknesses and have the market resume its upward path by June 2008. It is do-able with a heavy dose of government intervention, but it needs a crash to create an emergency to making government intervention patriotic, possibly including massive bailouts of several troubled giants such as GM, GE and Fanny Mae and the big money-center banks that are up to their necks with credit derivative exposures.

Strong Dollar is the Key

The key is to restore the dollar’s strong exchange rate, despite all the talk of the need for a lower dollar to reduce the trade deficit by predictable free trade economists such as C. Fred Bergsten of the Institute of International Economics whose views are distorted by their seeing trade as the entire economy rather than just one aspect of the global economy. If China refuses to revalue the yuan against the dollar in the near-term, as it most likely will, Paulson can bring up the dollar along with the yuan against the yen and the euro without adding to the US trade deficit which is mostly with China and oil which is denominated in dollars. The way to strengthen the dollar is to raise Fed Funds rates.  Paulson can be expected to apply all the pressure he can muster to force Bernanke to raise FFR, continuing a gradual pace of 25 basis points on June 25 but sharply immediately after the November elections to bring on a massive correction in the markets. FFR can rise to 9 or 10% in the name of national security to save the dollar. The recession will be prepackaged, and relatively short, from Q4 2006 to Q1 2008 with a sharp recovery in Q2 2008, providing buying opportunities for those who are smart enough to have cash on hand.

Just like Robert Rubin, Paulson firmly believes that a strong dollar is in America’s national interest.  Rubin did it by making the current account deficit finance the capital account surplus. Paulson will do it by further erasing national borders in global finance, thus making the US current account deficit meaningless as long as it is denominated in dollars.  The US has transcended the US national economy by operating on the dollar economy which is not location dependent. The name of the globalization game is making money where money can be made most easily.  America will prosper as the place where the world’s rich will come to spend money made elsewhere, leaving behind the pollutions and labor disputes and all the dirty business of making money offshore.  Paulson will try to make China an economic colony of the US and thus remove bilateral economic conflicts.

The Fed Will Follow a Strong Treasury

Bernanke, not yet a force with confidence, will go along because it is the Fed’s duty to support national security aim and also because a Fed Chairman needs a crash to show his wizardry, as Greenspan did in 1987. Besides, no one has opposed Hank the Hammer and survived.

Congress and China the Wild Cards

The wild card is the parochial Congress. If the Democrats regain the House after the mid-term election of 2006, Paulson will have a tough task ahead. The other problem is that China is going through a heated debate internally about the wisdom of its economic policy based on export. Any change in Chinese economic strategy will throw a monkey wrench in Paulson’s strategy. Paulson can count on his close link to Tsinghua University in Beijing where he helped start a business school with several of his Goldman Sachs colleagues. Tsinghua has become in recent decades a hot bed of neo-liberal free trade market fundamentalism more doctrinaire than Stanford. As a sign of its rejection of progressive correctness, the revisionist institution even refused to use the pin-yin spelling (Qinghua) for its name in preference to the Wade-Gilles spelling of the Western imperialist era.

There is no guarantee that Paulson will succeed in his possible game plan. The War in Iraq and the pending war over Iran are big uncertainties.  In fact, the worst is a gradual steady deterioration of the Iraq quagmire.  If Iraq were to go very badly suddenly, say 3,000 US troops got killed over one disastrous week, it would be easier for Bush.  This slow bleeding in prolonged occupation is truly deadly for US interests. Paulson cannot save the economy but he has a chance to create a recovery in time for the 2008 election. After that whoever rules from the White House would have to face the real music.

Dollar Hegemony Requires a Strong Dollar

While I have been pointing out since 2002 (http://www.atimes.com/global-econ/DD11Dj01.html)
the mechanics of how dollar hegemony works, I am not of the opinion that dollar hegemony will die a natural death easily.  I coined the term to mean the use of the US trade deficit to finance the US capital account surplus, both denominated in a fiat currency, thus eliminating any balance of payments problem for the US and depriving the trade surplus economies of needed domestic capital.  Under dollar hegemony, the exporting economies ship real goods produced with low wages to the US in exchange for dollars that must by definition be reinvested in dollar assets, not assets denominated in domestic currencies. This is what is hegemonic about the dollar since the emergence of globalization late 1990s, not seigniorage, which is not hegemonic by nature because seigniorage is merely a fair fee for services rendered.

Dollar hegemony is the most sophisticate financial regime in history.  It is the first time in human financial affairs that currency hegemony is imposed by a fiat currency through floating exchange rates and free convertibility made possible by globalized financial markets. The British Empire was built around the pound sterling but all local currencies within the vast empire had fixed exchange rates with respect to the pound sterling. After World War II, when the US took over the British Empire, Bretton Woods was a fixed exchange rate regime based on a gold-backed currency - the dollar, a regime in which cross-border flow of funds were restricted because mainstream economic theory at that time did not consider cross border flows necessary for trade or desirable for development.

After 1971, when Nixon took the dollar off gold because of the drain of gold from recurring US trade deficits, dollar hegemony still did not arise because cross-border flow of funds were still restricted. After World War II, euro-dollars came into existence because of US military overseas spending, dollar-denominated war debts from both allies and former enemies paid to offshore US accounts and foreign aid, but the US was still running a trade surplus and euro-dollars stayed outside the US, mostly in Germany and Japan. It was during the Vietnam War that the US began to run a recurring trade deficit, at first purposely to prevent Germany and Japan from turning communist. The US allowed Germany and Japan to build up their auto and steel sectors for exporting to US markets to keep their economies capitalistic but kept the advanced high-tech sectors for itself.  Since it takes several thousand cars to buy one commercial airliner, it was no great loss to lose market share in the auto sector. It did create the Rusk Belt in the Mid-West, but domestic political power was shifting to the West and South West where a new aerospace sector was flourishing.

Dollar hegemony did not come into being until after the end of the Cold War, when the global market was suddenly open to US companies and financial institutions and cross-border flow of funds became routine.  Dollar hegemony came into existence with the deregulation of financial markets and unimpeded cross-border flow of funds.  It was Robert Rubin under Clinton that dollar hegemony became formal US policy in the form of “a strong dollar is in the US national interest” even with a rising and recurring trade deficit.  Rubin advanced the notion that the US trade deficit is benign because it is neutralized by the US capital account surplus. A trade deficit is never a problem as long as it is denominated in the country’s fiat currency.  Dollar hegemony is a regime in which a fiat currency issued by one government becomes a super-national currency. Dollar hegemony is the device for globalization of finance to tear down national boundaries and to reduce the authority of sovereign nation states.

Resistance to Dollar Hegemony from Economic Nationalism

The problem with dollar hegemony is not that it will be resisted by other governments. This is because the dollar is now a super-national fiat monetary unit accepted by all who owns capital, not just US citizens. All other fiat currencies are now derivatives of the dollar. In every foreign government, from Japan to Germany, from China to Russia, there are powerful forces that see supporting a strong dollar as serving factional, if not national interests. This is because the dollar economy is increasingly detached from US economy, not completely but selectively.  The resistance to dollar hegemony is from a revival economic nationalism, including US economic nationalism against global trade, particularly in finance where the game of economic control is being played.  This conflict is being waged in the domestic politics of every country, with those who need jobs to make a living pit against those who make money by the manipulation of capital, known popularly as investing. US big business is allied with foreign state capitalism with US official policy support.  Democracy in Latin America is ushering a parade of radical socialist leaders against dollar hegemony; and the democratic process in the US is also turning against dollar hegemony. The wars waged by the US to secure oil for its economy have created $70 oil and $3.50 gas for the US consumer, and the worst is yet to come. The double digit returns on US pension funds come from investment in companies that ship US jobs overseas and stealth inflation that produced $700 gold.  Dollar hegemony to the US economy is turning out to be like the computer HAL in the movie 2001: A Space Odyssey.

Paulson’s Challenge

The problem Henry Paulson will face is right here at home in the US, not in Beijing or Moscow or even Caracas.  He will have to explain to an ever increasing number of US voters how globalized financial markets and super-national economic policy has benefited them or will benefit them in the future.

Conflict of interest in policy-making is unavoidable in a complex financial system. It is not surprising nor unreasonable that those have done well in the private finance sector should be natural candidates to manage the finances of the public sector. And it can be argued that in a system such as the US’s, the private and public sectors are two complementary rings of the national economy circus. Conflicts are tolerable if the management of the public sector by private interests produces a strong economy for all of the general public. When the economy falters, conflict of interest between private and public becomes a critical issue because it is always the general public that bears most of the pain.  An economic downturn in the US will produce populist government by representatives of the general public rather than elitist government by the rich and powerful.

Henry C.K. Liu

June 12, 2006