The Real Interest Rate Conundrum
By
Henry C.K. Liu

This article appeared in AToL on June 12, 2007, one month before the implosion of the financial crisis rhat started in New York


Suddenly this summer, all eyes are trained on rising interest rates around the globe. The prospect of central banks tightening to ward off impending inflation has abruptly interrupted the spectacular rise of all stock markets driven by abnormally ample liquidity, but has yet to precipitate a market crash. Under normal conditions, rising rates lowers bond prices as well as equity prices. But in the current liquidity boom that has produced a persistently inverted yield curve, high short-term interest rates have crashed bonds but have left equity prices higher than market fundamentals could justify.

Yet even as rising interest rates will eventually reduce liquidity to reverse the rise of stock markets, it will not arrest the real decline of the dollar as otherwise expected. The anomalous combination of rising interest rates and overpriced stocks is explosive enough by itself; but adding to it the shocking impotence of rising interest rates to arrest the declining value of the dollar, we have an unstable mixture of deadly financial dynamite waiting to be detonated by even seemingly unrelated minor events.

Normally, high interest rates should lift the exchange value of a currency to reduce import prices to constrain inflation which is one of the offsetting benefits of a tight monetary policy that otherwise slows down the domestic economy. Increased global capital inflow would also be attracted by high interest rates.

But the dollar is not a normal currency. It is a fiat currency that can be produced at will by the US, not backed by anything of intrinsic value, yet assuming the role of a reserve currency for international trade and finance. This unique characteristic is what lies behind dollar hegemony.

The US dollar is the head of the world’s fiat currencies snake. As the fiat dollar declines in value over the long term, as expressed by its dwindling purchasing power, all other fiat currencies decline with it because of dollar hegemony within the current international finance architecture, even though some currencies may decline faster temporarily due to varying local conditions such as different interest rates and inflation rates, in which case the market registers the dollar as rising in exchange value against these currencies, while in reality, all currencies are following the dollar in steady net decline against real assets. Market cheerleaders then mislabel the persistent rise in asset prices from the steady decline in currency value as the sign of a healthy business boom in an allegedly dynamic global economy led by the liquidity boom in the US.

Concurrently, some currencies may decline slower in purchasing power than the dollar, causing the market to view these currencies as rising in exchange value against the dollar while in reality they are also declining in real value. The temporary divergence or convergence of exchange values between and among currencies caused sometimes by market inefficiency or other times by market overshoots are what make currency arbitrage profitable, albeit with corresponding risk of loss.

This global trend of declining currency value has been going on in the current international finance architecture for several decades and has distorted the historical and conventional relationship of interest rates to inflation and economic growth. This distortion has sent central bankers looking desperately for, if not new, at least newly rediscovered economic theories to construct improved algorithms to guide their deliberation on monetary policy in the new paradigm.

A New Guru for the Fed

The Wall Street Journal (WSJ) on Oct 3, 2000 reported that the Federal Reserve, the US central bank then under Alan Greenspan, had of late fallen under the influence of the views of Swedish economist Johan G. K. Wicksell (1851-1926) on the relationship between interest rates, inflation and economic growth. Wicksell argues that monetary policy works best at containing inflation by pegging interest rates not to the level of money supply as mandated by textbook neoclassical economics theory, but to the rate of return on investment (ROI). Some critics described the Fed’s new fad as asking for advice from dead men who never had a chance to analyze present-day data. Wicksell died three years before the 1929 crash.

Greenspan made his famous “irrational exuberance” speech at the conservative American Enterprise Institute in Washington DC on December 5, 1996, when the Dow Jones Industrial Average (DJIA) was at 6,442, already more than twice the pre-1987-crash high of 2,722.  Less than a year earlier, on January 31, 1996, the Fed had lowered Fed Funds Rate (FFR) target 25 basis points from 5.5% to 5.25% to add liquidity to the very same irrational exuberance Greenspan later warned against. The Fed did not raise the FFR target again until four months after Greenspan’s warning and then only by 25 basis points back to 5.5% on March 25, 1997.

Not surprisingly, the market kept rising despite the Greenspan warning and on January 14, 2000, with the FFR target still at 5.5%, the DJIA peaked at a hyper-irrational level of 11,723, rising another 83% over Greenspan’s warning level. But the Gross Domestic Product (GDP) only rose from $7.8 trillion in 1996 to $9.8 trillion in 2000, or 25.6%.  The DJIA climbed three times more than the GDP in the four-year period after Greenspan’s warning of irrationality. One can only conclude that the dollar had declined in value by 57.4% in that time.

Two months later, after some secular bull market corrections in which each down closing was erased by subsequent gains, the DJIA scored on March 16, 2000 its largest one-day point gain in history, 499.19 points, to close at 10,630.60.  On April 14, 2000, 22 trading days later, the DJIA plummeted 617.78 points, closing at 10,305.77, its steepest point decline in a single day historically so far, but the DJIA was still 50% higher than the 6,442 that prompted Greenspan’s irrational exuberance warning more than 4 years earlier. This volatility came purely from speculative forces operating in a liquidity bubble. The real economy did not change in 22 trading days.

Interest Rates and Elections

The fed in its board meeting on October 3, 2000, the same day of the WSJ report on Wicksell, with the DJIA closing at 10,719.74, left the FFR target unchanged at 6.5%, keeping inflation-adjusted real short-term interest rate at historical high. This decision left the DJIA in the historical high range, but left the Democrats with an anemic economy despite a Clinton fiscal surplus and robust corporate earnings in the crucial months before the presidential election in November. Though a rate reduction had been warranted by conventional wisdom over weak economic data and ominous leading economic indicators, the DJIA stayed high because the market believed the Fed would have to cut rates soon to prevent a sharp market correction.

As it turned out, the Fed did not lower the FFR target until its January 3, 2001 board meeting, after the Supreme Court snatched a near victory from the jaws of Democratic candidate Al Gore and delivered a bitterly-contested White House to Republican George W. Bush. The Fed then lowered the FFR target by larger-than-usual 50 basis points to 6% to commence a long downward rate cycle with 13 more cuts in 30 months to bottom at 1% on June 25, 2003, pushing short-term rate below neutral, meaning below inflation rate, feeding a multi-year credit bubble.

Belated Epiphany on Inflation Threats

Only five days after the FFR hitting a historical low of 1%, the Fed, in a belated epiphany on rediscovering inflation threats that had been glaringly visible for some time, reversed course and raised the FFR target by 25 basis points, followed by a “measured pace” of 18 more upward moves to 5.25% on June 29, 2006 and kept it there unchanged for over 11 months up to now, with no signs of ending the cautious interest rate “pause”, extending a liquidity boom that creates an interest rate “conundrum”.

Conundrum is Just Another Word for Denial

Maestro Greenspan confessed publicly that with all his acknowledged wisdom, he could not understand why long-term rates stayed low despite a high FFR while the flat or inverted yield curve had been obviously caused by the Fed’s own earlier actions of releasing too much credit into the system. This easy credit fueled a trade deficit which due to dollar hegemony was recycled as a capital account surplus in US Treasuries, pushing long-term rates down. This trend is still going on and is exacerbated by endogenous liquidity generated internally by debt securitization and hedging through derivatives. What determines long-term interest rates is sustained monetary liquidity or excess money already in the system from previous short-term rates staying too low and too long which the Fed’s subsequent gradualism in short-term rate hikes would not be able to stop the momentum effectively and quickly.

Timed for Elections

On Tuesday November 9, 2004, the election day for Bush’s second term, the FFR target was still at a below-neutral 1.75%, with the DJIA closing at a bullish 10,386.37, giving Bush a temporary bull market, if not quite a sustainable strong economy, to achieve an easy win over challenger John Kerry, all the while with the Fed keeping a straight face about itself being an apolitical institution that operates on scientific monetary principles. The Fed raised the FFR target to 2% in its meeting the day after the 2004 presidential election when it was politically safe to raise rates and kept it going upward to its current 5.25%.

The DJIA closed at 10,719.74 on the same day of the WSJ-Wicksell report on October 3, 2000, having broken the psychological 10,000 for the first time in history on March 19, 1999. The DJIA had risen 50% from its previous low of 7,161.15 recorded on October 27 1997, when it suffered a big one-day fall of 554.26 points, or 7.2%, from contagion from the Asian Financial Crisis. On Monday, June 4, 2007, defying persistent news of a slowing economy, the key index rose 91% higher than its 1997 low to close at an all-time high of 13,673.

Wicksell: Link Interest Rates to Return on Investment

Monetarists who dominate the Fed throughout most of its history subscribe to the theory that inflation can only be prevented either by high interest rates to reduce growth by reducing the growth of money supply, or by high unemployment to depress wages, which are two faces of the same coin. Wicksell argues that monetary policy works best at containing inflation by pegging interest rates to investment returns rather than money supply.

Wicksell’s theory was given credence empirically in 1980 by then Fed Chairman Paul Volcker’s brief experiment with targeting the monetary base with automatic interest rate adjustments by his “new operating procedure”. The disastrous and damaging result of violent fluctuation of the FFR forced the Fed to drop Volcker’s misguided approach after about six months.

Volcker’s Blood-letting Experiment

The “new operating procedure" was adopted on October 6, 1979 by the Fed under Paul Volcker as a therapeutic shock-treatment for Wall Street, which had been conditioned by former Fed Chairman Arthur Burns’ brazen political opportunism during the Nixon era in the 1970s to lose faith in the Fed’s political will to control inflation. The new operating procedure, by concentrating on monetary aggregates, and letting it dictate FFR swings within a range from 13-19%, to be authorized by the Fed Open Market Committee (FOMC), was an exercise in “creative uncertainty” to shock the financial market out of its complacency about the Fed’s traditional policy of interest-rate stability and gradualism.

There had been a traditional expectation in the market that even if the Fed were to raise rates it would do so gradually so as to not permit the market to be volatile. The banks could continue to lend as long as they could profitably manage the gradual rise in rates. Under the new operating procedure, the banks would be exposed to risks that interest rates might suddenly and drastically go against even their short-term credit positions. Also, banks had been seeking higher earnings by expanding new loans beyond the growth of deposits, by borrowing shorter term funds at lower interest rates. This practice was given the benign name of “managed liability” by regulators, allowing banks to profit from interest-rate spreads over the yield curve, which had seldom if ever been allowed by the Fed to stay inverted, that is with short-term rates higher than longer-term rates, at least for long. This practice of interest rate arbitrage later came to be known as “carry trade” in bank parlance, and when internationalized, eventually led to the Asian financial crisis of 1997 when interest-rate and exchange-rate volatility became the new paradigm that could roil equity and currency markets.

The Fed’s new operating procedure would greatly increase the banks’ risk exposure, at least before the widespread practice of loan securitization shifting individual bank risk to systemic risk for the entire financial market. On top of it all, Volcker also set an additional 8% reserve on bank borrowed funds for lending. The new operating procedure violated the traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, which meant smooth, gradual changes in interest rates which in turn would keep money supply fluctuation moderate and gradual so that prices would not be detached excessively from market fundamentals. The new operating procedure was a policy to induce the threat of severe short-term pain to stabilize long-term inflation expectations.

Most economists agree that when money growth slows, market interest rates go up. The trouble with the use of the FFR target to control money supply is that it has to be set by fiat, which exposed the Fed to political pressure to keep a liquidity boom going forever. A case can be made, and is frequently made, that the Fed’s FFR targets tend to be self-fulfilling prophecies rather than a device to manage future trends. High FFR targets deflate while low targets inflate, and there is little argument about that relationship, at least before the age of structured finance when virtual money can be created within the system circularly outside of the Fed’s control. Under structured finance, high FFR targets can actually inflate because they raise the cost of money needed for protection through hedging and for profiteering through financial arbitrage.

But there is plenty of argument about the Fed’s projection ability on the economy. History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection that at times borders on blind denial of clear data. The new operating procedure would let the monetary aggregates set the FFR targets scientifically and provide political cover for the Fed Open Market Committee (FOMC) members if the FFR target needs to go to double digits. This amounts to monetarism through the back door, not by heroic intellectual confidence in scientific truth, but by political cowardice.

The Federal Advisory Council (FAC) of the Federal Reserve Board is unique in that it is a big-bank lobby composed of twelve representatives of the banking industry that officially advises the Fed, itself a peculiar institution: an all powerful public institution mandated by law, but owned by private banks. The FAC meets in secrecy four times a year with Fed officials to give the banking industry an inside track on influencing Fed deliberation, if not decisions. The since-declassified minutes of the FAC show that four weeks before the Volcker Fed announced its “new” operating procedure on October 6, 1979, the FAC had recommended to the Fed a review of its “traditional” operating procedure, before even the President was alerted of the Fed’s deliberation and final decision to adopt a “new” operating procedure. Initially, the FAC was concerned that political pressure was likely to push FFR down, not anticipating that money supply would turn volatile to create extreme interest rate volatility.  Carter, preoccupied with the Iran hostage crisis, was totally in the dark about the impending volatile high-interest-rate policy with which the Fed under Volcker, a Republican, was going to hit Carter’s Democrat administration running for a second term within a year.

To stabilize money supply, the Fed announced on March 14, 1980 a program of Emergency Credit Controls. The program affected not only commercial banks, but also money-market mutual funds and retail companies that issue credit cards. Banks would be limited to a 9% credit growth instead of the 17% in February. By April, the Fed was shocked by data showing money disappearing from the financial system at an alarmingly rapid rate. The last two weeks in March saw more than $17 billion vanish, representing an annualized shrinkage of 17%, yielding a 34% change. Money was evaporating from the banking system as credit dried up and borrowers paying off their debts in response to Carter’s moralistic jawboning to save the nation from hyper-inflation through personal restraint on consumption. Another cause was the shift from bank deposits to three-month T-bills that were paying 15%, causing money to exit the market back into the Fed’s vault.

Volcker’s new operating procedure adopted six months earlier now faced a critical test. According to monetarist theory, the Fed now must pump up new bank reserves to stop the money supply shrinkage. But in practice, Volcker and the FOMC were applying monetarism, which by definition must be a long-term proposition, to short-term turbulence, and in the process undermined their own earlier efforts to fight hyper-inflation and, worse, destabilized the economy unnecessarily. When mortals play god, other mortals die unnecessarily.

On May 6, 1980, with the New York Fed’s Open Market Desk furiously trying to reverse a raging money-supply shrinkage, pumping in money to the system by buying government securities and depositing the funds in banks to create new additional “high power” money by increasing bank reserves for lending, interest rates fell sharply and abruptly. The FFR dropped 500 basis points in two weeks, from 18 to 13%, the bottom of the FOMC range in the new operating procedure, and was actually trading below the low FOMC target range at one point.

Telling the Monetary Train to go in Opposite Directions Simultaneously

The Fed was in danger of losing control of its FFR target to the market and jeopardizing it own credibility. The New York Fed notified the FOMC that it could continue to follow the new operating procedure by injecting more bank reserves to let the FFR fall below the low limit set by the FMOC or to tighten up the supply of bank reserves to get the FFR back up to the 13% set by it, but it could not do both, any more than a train could go in opposite directions simultaneously.

Volcker opted for continuing the new operating procedure and staged an emergency telephone conference of the FOMC to authorize a new low FFR target of 10.5%, down from 13%, way below the inflation rate of over 12%.

Market conditions were such that interest rate falling below 10% would mean below-neutral negative interest rate after inflation adjustment, which would start another borrowing binge to exacerbate further inflation. The fundamental fault of monetarism was being exposed by real life. The claim that stabilizing the money supply would also stabilize interest rates was shown to be inoperative by events. In reality, attempts to stabilize the money supply actually destabilized interest rates and pushed them down in a fast-reacting dynamic market in an environment of shrinking liquidity.

Desperate, the Fed under Volcker, with concurrence from an even more panic-stricken Carter White House, started to dismantle Emergency Credit Controls as fast as administratively doable, so that demand for credit would not be artificially shut down, in hope of making market interest rates rise from more borrowing. Still it took until July 1980 before the last of the credit controls were lifted. Back in April, the New York Fed had injected additional reserves into the banking system at an annualized rate of 14% and in May at 48% annualized rate in non-borrowed reserves, pushing interest rates down and lay the ground for future inflation.

It was obvious Volcker panicked, spooked by the sudden economic collapse set off by his own credit-control program to slow the rise in money supply. By the last week of July, the FFR fell below the 13% discount rate and hit 8.5% down from 20% in late March. For one trading day, it dipped to 7.5% and for a time the Fed lost control. The short-term rate that monetary policy regulates most directly was free-floating down on its own, unhinged from FFR target. With the FFR below the discount rate, the FFR could fall to zero by banks responding to market forces. So the pressure to lower the discount rate was overwhelming. The financial markets had never seen anything like it. The money market became a game in which the guards had thrown in the towel and the inmates were running the asylum.

Correcting one Overshoot with another Overshoot

The FFR dropped from 20% in April to 8.5% in 10 weeks, effectively banishing interest rate gradualism out to the wilderness. In the autumn of 1979, the Fed had seized the initiative to push the price of money up 100% to fight inflation. Now, barely seven months later, the Fed allowed the price of money to fall even more rapidly to reverse the money-supply shrinkage, with “damn the inflation torpedo - full speed ahead in the sea of liquidity” frenzy. The recession abruptly ended by the Fed’s overreaction and Volcker, the self-ordained slayer of the inflation dragon, became overnight a breeder of baby dragons of even more aggressive inflationary DNA and the economy was facing a worse, and more interest-rate immune inflation problem than when he first became Fed chairman in July 1979 less than a year ago.

Many businesses that were profitable under a steady interest rate regime went bankrupt during this brief period of sudden Fed-manufactured volatility in liquidity, but the banks were dancing in the street with windfall profits and excess cash to lend.  Volcker’s “new operating procedure” experiment put the Fed back on its traditional path: focusing on interest rates and not money-supply numbers and vowing again to focus only on the long term. Yet for the long term, money supply was the correct barometer, while for the short term, interest rate was the appropriate tool. The Fed did not seem to have learned anything, despite having made the nation and the world pay a very costly tuition.

Volcker’s high interest rate policy caused the dollar to rise in the foreign exchange market, making US exports less competitive, but US investment overseas less expensive. The rise in import prices was moderated by lower profit margins made affordable to foreign importers whose dollar earning now was worth more in local currencies.

Instead of restructuring the US economy and to reform the terms of globalized trade to address a mounting structural US trade deficit, Treasury Secretary James Baker under President Reagan took the easy way out and engineered the Plaza Accord on September 22, 1985 to push the dollar down by coordinated intervention by the central banks of US, Japan and Germany, France and Britain. Two weeks earlier, on September 6, the Fed had raised the Fed Funds Rate target 25 basis points to 8% from 7.75% set mid-July, putting upward pressure on the dollar as the Treasury was trying to push the dollar down.

The Plaza Accord when finally put in place pushed the Japanese yen down by over 50% against the dollar with central bank intervention. But it had little discernable effect on the US trade deficit. It did allow the US to export deflation to Japan to use the dollar’s low exchange rate to boost up US asset value nominally. The Plaza Accord decoupled dollar interest rates from the exchange value of the dollar and also decoupled the traditional link between rising interest rates and falling equity prices.

Time Magazine reported on January 26, 1987 that John Makin, director of fiscal-policy studies at Washington’s American Enterprise Institute, argued that the value of the dollar was “totally irrelevant. If the budget deficit isn’t going to improve very much, the trade deficit isn’t either.” Sidney Jones, an economist at the Brookings Institution, also warned of a danger if the dollar’s exchange rate continued to serve as the main instrument for altering the trade balance: the risk that the US inflation rate, about 2% in 1986, would flare up. “Once those import prices do go up, then you can get away with increasing domestic prices. That's probably a greater inflation risk than simply the increase in the price of imported goods,” Jones was quoted as saying. Yet the House passed a highly restrictive omnibus trade bill, but it stalled in the pro-trade Republican-controlled Senate.

China Enters the Trade Picture

Predictably the same passion play over trade with Japan two decades ago is now being reenacted with China. And if China yield to US pressure as Japan did to revalue its currency upward against the dollar, China will face decades of deflation as Japan did. China launched its economic reform and “open to the outside” policy in 1978 and a good part of the excess global liquidity resulting from the recycling of oil revenue after the 1973 oil crisis went into China after 1978, and to other economies in Asia to fund the newly industrialized countries (NICs), known as Asian Tigers, eager to trade with and invest in China. For almost three decades, China has been riding on a liquidity boom created by the US Fed’s stealth devaluation of the purchasing power of the dollar.

Ironically, pundits of all colors have since applauded China for its “wisdom” in adopting market capitalism as a path out of poverty, while the whole world has become addicted to easy money denominated in dollars of falling value that actually makes everyone poorer in real terms, only that some become poorer more and faster by comparison.  Pathetically, neo-liberal economists fell over each other hailing the poverty eradication powers of market fundamentalism.

The Income Equality Hoax

J. Bradford DeLong, an economic professor at the University of California at Berkley and former official in the Clinton White House, attracted mainstream attention by claiming in a February 2001 article (The World’s Income Distribution: Turning the Corner?) that global income distribution has been trending towards equality through globalization. Such claims not only fly in the face of World Bank data on the gini coefficient which measures income equality in economies, they ignore the fact that all wages were falling in purchasing power globally even if rising nominally, improving statistical equality as nominal wages in poor economies rise at the faster rate because they started from a lower base both nominally and in real terms.

Neo-liberal ideology asserts that inequality is the result of poverty and that as poverty is relieved, inequality recedes.  This assertion neglects the possibility that inequality itself causes poverty, not as calculations in a zero sum game, but as a damper on consumer demand in a global economy plagued by overcapacity. Globalized trade, rather than domestic development, has been hailed by neo-liberal economists as the solution to both inequality and poverty.  Opposition to globalization by the world’s poor has been labeled misguided by the neo-liberal mainstream that holds monopolistic sway in the media in defiance of glaring conditions of poverty on the ground.

The Harrod-Domar Model of Development

Neo-liberal economists point to the Harrod-Domar model of economic growth to argue that unequal distribution of income promotes faster economic growth and greater employment because the rich save more than the poor so that a greater volume of domestic savings will increase the supply of capital available for investment; and the accelerated capital formation will raise gross domestic product and resulting incomes, a virtuous cycle feeding back into greater savings. Thus, income inequality, even with widespread poverty, is regarded as good for development, not merely as a transitional compromise but as a permanent structural necessity. This is essentially the IMF/WTO model of market fundamentalism since discredited by factual data.

Even Deng Xiao-ping, paramount leader of China’s economic reform, fell for this fallacy and accepted the need to “let some people get rich first.” Predictably, the word “first” soon disappeared in Chinese economic policy deliberations until it was too late. Finally, the new leadership in China is at long last addressing the problem of income disparity both between people and between regions, but the task is made more Herculean by the two-decade-long solidification of a political and bureaucratic superstructure imbedded with powerful resistance of special interests of those who had gotten rich first and want to stay more rich permanently.

Notwithstanding that the Harrod-Domar model may not be operative in a world plagued by overcapacity from over-investment and insufficient demand as a result of income inequality, the model neglects the fact that under globalized finance capitalism, even the savings of the rich in the poor economies are siphoned off to US capital markets, draining the local economy of desperately needed capital.  The global dollar glut in the context of dollar hegemony that Fed Chairman Ben Bernanke mistook for a global savings glut is the living evidence against the validity of the Harrod-Domar model of economic growth. Income inequality in the economies that export to the US provides capital formation only to the US by financing a US capital account surplus with the current account surpluses these economies earn from trade.

China, World’s Biggest Creditor, is Starved for Capital

This increases the cost of capital for the exporting economies which have to offer returns drastically higher than the return they get from US sovereign debt merely to induce their own capital to come back home. And even then, capital flows only to the export sector to earn even more dollars to pay foreign capital denominated in dollars, putting these economies in a perpetual competitive disadvantage for global capital. China is a perfect example of a booming economy caught in this trap. To look for better returns than what its dollar reserves get from US Treasuries, China is beginning to pursue so-called “alternative investment” in higher risk private equity firms while China is continues to face capital shortage in its rural regions and most non-export sectors.

The GDP Growth Mirage

By the mid-1960s, the theory equating domestic development with GDP (gross domestic product) growth was already not empirically supported by evidence. GDP attributes profits to the country where factories or mines or financial institutions are located, regardless of ownership nationality, even though profit and investment may not stay there permanently. The accounting shift from GNP which measures total value added from both domestic and foreign sources claimed by residents of a country, to GDP has turned many struggling, exploited economies into statistical boomtowns, while seducing local leaders to embrace a global economy while their countries slide into further poverty.

The Perverse Logic of Economics

But such micro evidence has been systemically dismissed by mainstream economics because it goes against the prevalent macro paradigm of trade globalization, which is deemed intellectually uncontestable and ideologically correct. Moreover, the evidence goes against powerful economic interests of the rich economies and is dismissed as the result of a democracy deficit. By making the rules of development treat capital as more scarce compared to labor and thus is the more valuable factor of production, owners of capital are logically justified in receiving a larger share of the benefits from development.

Lawrence Summers as chief economist of the World Bank used a similar economic argument for dumping pollution from advanced economies onto developing economies to achieve an overall lower cost globally.

The only problem with this perverted cost-benefit approach to welfare economics is that it is not true. Optimum development requires capital and labor to be assigned fair and equitable value so that supply and demand can be balanced and for all human lives to be treated with equality because as many around the world have since recognized, global warming recognized no economic or national borders.

Foreign Central Banks are Captured Buyers of US Sovereign Debt

In 1995, after the Federal Reserve started to hike the FFR target in 1994 and sharply curtailed its own purchase of Treasury bills, triggering the Mexico peso crisis and a subsequent US slowdown, the Bank of Japan initiated a program to use its foreign reserves to buy $100 billion of US treasuries.  China bought $80 billion. Hong Kong and Singapore bought $22 billion each.  Korea, Malaysia, Thailand, Indonesia and the Philippines bought $30 billion.  The Asian purchase totaled $260 billion from 1994 to 1997, the entire increase in foreign-held US dollar reserves.  In 1995, East Asia claimed 47% of capital flows to all low-and-middle-income countries. In 1996 alone, about $100 billion flowed into East Asia, which Asian central banks had to buy up with local currencies and invest the dollars in US Treasuries. But in 1997, $150 billion flowed out in the three months after July, exacerbating the Asian Financial Crisis by draining foreign reserves held by Asian central banks. These recycled dollars pushed up stock prices in the US both before and after the Asian Financial Crisis.

Structured Finance Renders Interest Rate Gradualism Inoperative

Volcker’s new operating procedure was in 1980, some 27 years ago. Nowadays, with structured finance, which can add endogenous liquidity created internally by risk management schemes to protect against a liquidity crunch, a new dimension has been added. That new dimension is that in stabilizing the money supply, instead of sending interest rates down, it will send interest rate skyward due to a fierce competition for money by market participants addicted to an endless supply of cheap money, turning the liquidity boom into a liquidity bust. When the market anticipates money getting tight, everyone wants to borrow before money dries up.  Money becomes easy only if there are fewer borrowers than money available for lending. When everybody wants more easy money, including lenders who must borrow money in order to lend, money becomes hard to get very fast.

It is now generally recognized that the most effective way for the Fed to stabilize the monetary system is through a consistent, gradual “steady as she goes” interest rate policy without surprises or sudden reversals.  The credit market has grown accustomed to gradual interest rate policies. That is the rationale for a soft landing to cushion the adverse effects of the previous bubble. The problem with gradualism is that the approach is increasingly out of step with a fast-paced financial world driven by structured finance with all manners of financial derivatives that tend to create sudden super systemic volatility even though the financial instruments employed have been designed to ensure stability for individual market participants. High volatility has become profit opportunities for hedge funds and banks and traders.

Chinese Gradualism Under Attack

Ironically, China’s gradualism in financial reform and exchange rate adjustment has been vehemently attacked by impatient US officials and politicians, notwithstanding the Fed’s own traditional preference for monetary gradualism. Ironically, gradualism works in a controlled capital market which China still has, but not in a de-controlled global capital market led by the US.

Wicksell Provides Greenspan with Scientific Cover

Wicksell’s theory of linking interest rate to the rate of return on investment (ROI) provided a timely scientific cover for Greenspan’s high interest rate policy in the face of an economic slowdown as the 2000 presidential election approached. Interest rates could stay high with theoretical justification because US investment offshore was getting good returns even though the domestic economy was showing clear signs of stagnation.

Global money supply continues to expand through the effect of Fed policy under dollar hegemony which permits the US trade deficit to finance the US capital account surplus, keeping dollar long-term rates low even as the Fed kept FFR high. The flat yield curve, at times inverted, meaning long-term rates falling below short-term rates, no longer automatically bring on recessions because liquidity is kept high by the circular flow from the trade deficit back into the capital account surplus, with inflation kept low by outsourced low wages and asset prices kept high by excess money that steadily loses purchasing power.

Trade-off Between Global Growth and Domestic Growth

This was the point when US economic policy began to make the macro trade-off in seeking benefits from globalization at the expense of the US domestic economy. This trade off became possible because of dollar hegemony in which global trade and finance are denominated in fiat dollars that the US, and only the US, can print at will with little short-term penalty.

Capital is permitted to milk labor in all economies, including labor in the US, so that global ROI can stay high. The tradition of lowering short-term interest rates in response to a slowing US economy has been preempted by the need to keep short-term interest rates high to attract capital inflow and to compensate for the continuing devaluation of the dollar independent of short-term exchange rate fluctuations. High dollar interest rates are needed to sustain the capital account surplus. With the help of the Fed, the US Treasury has become a major player in the “carry trade” business, paying low interest rate in Treasury bonds to lend the proceeds to US banks at higher rate which in turn lend to corporate and private borrowers as even higher rates.

While this trade-off had been fully understood by the Clinton economic team led by Robert Robin, a bond trader par excellence from Goldman Sachs prior to joining the Clinton White House, the public, particular labor, had been completely oblivious until too late to an impending fate that would cause them to lose the shirts off their backs made by the Ladies Garment Workers Union members to be replaced by cheaper ones made in low-wage Asia, particularly China.

Bond Market Crash

Pimco’s Total Return Bond Fund manager William H. Gross, a highly respected veteran bond fund manager with an impressive record for profitably managing over $100 billion of bond funds, the world’s largest, admitted publicly recently he made “a big mistake” betting on the Fed lowering interest rate to offset a slowing US economy caused by collapse of the housing sector due to a sub-prime mortgage meltdown. As a bond investor, Gross understandably sets his sight single-dimensionally on interest rates movements since the price of bonds moves in the opposite direction of interest rates.

While Gross accurately predicted a slowing economy, he failed to realize that the Fed was pegging interest rate to high nominal corporate global earnings boosted by a regime of universal currency devaluation, but with the dollar devaluing at a faster rate than many other currencies, thus increasing overseas earnings in dollars terms. Pimco bond portfolios lost on two levels from its bad interest rate call: from a collapse in nominal bond prices as rates stay high and from a net long-term decline in the real purchasing power of the dollars its bonds hold after persistent devaluation against real assets.

Strong Dollar is in the US National Interest

Of course, the Treasury, which by law requires the Fed to support its exchange rate policy as a matter of national security, has repeatedly declared that a strong dollar is in the US national interest. And a strong dollar in the existing international finance architecture requires high dollar interest rates.  Now, in addition to national security and national interest justifications, a respectable scientific theory has been resurrected to support Greenspan’s high interest rate policy required by his liquidity bubble.

With globalization of trade and finance, field data have since demolished the conventional wisdom that unemployment below structural level of 6% causes inflation because US consumer prices are held down by import costs kept low by global wage arbitrage and by low-wage illegal immigrant workers, despite a global decline in the purchasing power of all currencies led by dollar hegemony.  Greenspan called his high rates “equilibrium interest rates.” But a strong dollar is only in relation to other key currencies, while all currencies continue to devalue against real assets in a global weak currency trend led by the dollar.  Despite rhetoric, the US has not had a real strong dollar policy for decades.

The Politics of Economics

The Fed, notwithstanding its intellectual pretense and self-proclaimed political independence, has always been a political institution.  The politics of monetary economics repeatedly resurrects from the intellectual wasteland, the theoretical Siberia as it were, new gurus to support its latest ideological interpretation of an ever-changing economy.  Nobel winners are proponents of theories that explain “scientifically” the latest wave of political expediency.

The list includes the most politically-contested joint-award to Gunar Myrdal and Friedrich August von Hayek (1974, Myrdal for interdependence of economic, social and institutional phenomena in contrast to Hayek for theory of money, economic fluctuations and market fundamentalism) that led Myrdal to call for the abolition of the prize on moral grounds.  Others on the list were: Milton Friedman (1976, monetary history and monetarism theory and stabilization policy), Theodore W. Schultz and Arthur Lewis (1979, economic development of developing countries), James Tobin (1981, financial markets and expenditure decisions, employment, production and prices), George J Stigler (1982, industrial structures, functioning of markets and causes and effects of public regulation), Franco Modigliani (1985, saving and of financial markets), Robert M Solow (1987, economic growth), Robert Lucas (1995, rational expectation), Amartya Sen (1998, welfare economics), Robert C Merton and Myron S Scholes (1997, precise valuation of options/derivatives), Robert A Mundell (1999, exchange rate regimes), George A Ackerlof, A Michael Spence and Joseph E Stiglitz (2001, markets with asymmetric information), etc, etc.

It is not difficult to see that many economic concepts honored by the Nobel Committee, while usually for work done decades earlier, were concepts much in vogue at the time the prizes were awarded, soon to be followed by real life disasters caused by the unquestioning, widespread applications of these very same admired concepts. The latest example is Stiglitz, who, very much part of the economics establishment that promoted market fundamentalism, summarized by the Washington Consensus, despite his early work on asymmetrical market information, only belatedly raised questions about the claim of market fundamentalism as the god-sent solution for the post Cold War economic order. Like the Nobel Peace Price, the Prize for Economics is highly politicized.

Wicksell provides an intellectually respectable cover for Greenspan to abdicate his responsibility as Chairman of the most powerful central bank in the world, by pretending to follow the flow of the market, to treat interest rate as the price of money set by market forces, and not as a monetary authority with a mandate to promote full employment and balanced growth for the world’s interconnected economies.  The embarrassing question is never asked why a central bank is even needed if financial markets are on self-adjusting auto pilot.

Everyone Has an Income Policy

The fact is that monetarists at the Fed are fervently and ceaselessly intervening in the financial and currency markets, the only difference between them and Keynesians is that they intervene to favor capital as expressed by the nominal value of money while Keynesians intervene to protect labor from structural unemployment and below-inflation wages deemed necessary by monetarists for fighting inflation.  As post-Keynesian economist Paul Davidson insightfully said: “everyone has an income policy; they just don't like the other fellow’s income policy but claiming their own is ‘free’ market determined.” Extending their distaste for inept bureaucracy, neo-conservatives monetarists reject the policy imperative of government while neo-liberal monetarists reject government responsibility for the welfare of all citizens by favoring an income policy favoring the rich.

A New Guru

The installation of a new guru at the Fed stimulates rethinks on Wall Street.  Traders and investors now have to reverse their traditional knee-jerk reaction to sell when the Fed raised short-term interest rates. Even as real corporate earnings fall amid rising rates, such falls are disguised nominally as rising profit by across-the-board currency devaluation.

Wicksell, born in Stockholm, Sweden, published his book: Value, Capital and Rent (1893) in Swedish, which was not translated into English until 1954. His two-volume Lectures on Political Economy (1901-6,) and Selected Papers on Economic Theory (1958) were read only by professionals. Wicksell did rigorous work on marginal theory of price and distribution and on monetary theory. The Lectures on Political Economy has been aptly called a “textbook for professors”. In an unusually volatile career, including brief imprisonment for exercising free speech rights, he wrote and lectured tirelessly on radical issues, which did not figure among the attitudes admired by Greenspan, a disciple of Ayn Rand’s cultish objectivism of extreme individualism.

Wicksell was an advocate of social and economic reforms of all sorts, most notably neo-Malthusian population controls. He extended Ricardo’s concept of uneven income distribution based on the iron law of wages, asserting that a totally free economy does not naturally equalize wealth distribution, as wealth created by growth would be distributed in greater share to those who already had wealth. Wicksell defended government intervention to improve national and public welfare through equitable distribution of the benefits of growth.

Wicksell’s theory of interest, published in his 1898 book, Interest and Prices, distinguishes the natural rate of interest from the money rate of interest. The money rate of interest, or nominal rate, is merely the interest rate in the capital markets while the natural rate of interest is the interest rate that is neutral to prices in the real market, or rather, the interest rate at which supply and demand in the real market are at equilibrium. Economic growth takes place when the natural rate of interest is higher than the market rate; a view shared by the Austrian School, despite the difference Austrian individualism has with the institutionalism of Wicksell.

In his later years, Wicksell was admired by a new generation of economists who became known as the Stockholm School whose members include Nobel laureates Gunnar Myrdal (1974-institutional interdependence) and Bertil Ohlin (1977-trade theory). They developed Wicksell’s ideas on the cumulative process into a dynamic theory of monetary macroeconomics simultaneously with but independently of the Keynesian revolution.

Greenspan’s selective use of other people’s idea is notorious.  His fondness of Schumpetrean “creative destruction” which he cites in practically every speech, always leaves out the second half of Schumpeter’s world view: that “creative destruction” leads to monopolies (a la Microsoft) and accelerates the coming of socialism, the worst possible nightmare for Greenspan and his fellow central bankers.

Joseph A. Schumpeter (1883-1950) writes in his Capitalism, Socialism and Democracy (1942 Chapter 3): “Economic progress in capitalist society means turmoil.” And in Chapter 13, sect. 2, he writes: “Capitalism inevitably and by virtue of the very logic of its civilization creates, educates and subsidizes a vested interest in social unrest.” Keynesianism aims to save capitalism by taming its internal contradiction with a moderate dose of socialist prescription.

 Next: Currency Devaluation Depresses Wages Globally