Wages and profits

And neo-classical economics does not allow the prospect of employers having an objective of raising wages, as Henry Ford did, instead of minimizing wages as current corporate management, such as the Ford Motor Co, routinely practices. Henry Ford raised wages to increase profits by selling more cars to workers, while the Ford Motor Co today cuts wages to maximize profit while adding to overcapacity. Therein resides the cancer of market capitalism: falling wages will lead to the collapse of an overcapacity economy.

This is why global wage arbitrage is economically destructive unless and until it is structured to raise wages everywhere rather than to keep prices low in the developed economies. That is done by not chasing after the lowest price made possible by the lowest wages, but by chasing after a bigger market made possible by rising wages. The terms of global trade need to be restructured to reward companies that aim at raising wages and benefits globally through internationally coordinated transitional government subsidies, rather than the regressive approach of protective tariffs to cut off trade that exploits wage arbitrage. This will enable the low-wage economies to begin to be able to afford the products they produce and to import more products from the high wage economies to move toward balanced trade.

Eventually, certainly within a decade, wage arbitrage will cease to be the driving force in global trade as wage levels around the world equalize. When the population of the developing economies achieves per capita income that matches that in developed economies, the world economy will be rid of the modern curse of overcapacity caused by the flawed neoclassical economics of scarcity. When top executives are paid tens of million of dollars in bonuses to cut wages and worker benefits, it is not fair reward for good management; it is legalized theft. Executives should only receive bonuses if both profit and wages in their companies rise as a result of their management strategies.

Sovereign credit and dollar hegemony

In an economy that can operate on sovereign credit, free from dollar hegemony, private savings are needed only for private investment that has no clear socially redeeming purpose or value.

Savings are deflationary without full employment, as savings reduce current consumption to provide investment to increase future supply. Savings for capital formation serve only the purpose of bridging the gap between new investment and new revenue from rising productivity and increased capacity from the new investment. With sovereign credit, private savings are not needed for this bridge financing. Private savings are also not needed for rainy days or future retirement in an economy that has freed itself from the tyranny of the business cycle through planning.

Say's Law of supply creating its own demand is a very special situation that is operative only under full employment, as eminent post-Keynesian economist Paul Davidson has pointed out. Say's Law ignores a critical time lag between supply and demand that can be fatal to a fast-moving modern economy without demand management. Savings require interest payments, the compounding of which will regressively make any financial system unsustainable by tilting it toward overcapacity caused by overinvestment. Religions forbade usury for very practical reasons. Yet interest on money is the very foundation of finance capitalism, held up by the neo-classical economic notion that money is more valuable when it is scarce. Aggregate poverty, then, is necessary for sound money. This was what US president Ronald Reagan meant when he said that there are always going to be poor people.

The Bank for International Settlements (BIS) estimated that as of the end of 2004, the notional value of global OTC (over the counter) interest-rate derivatives is about US$185 trillion, with a market risk exposure of more than $5 trillion, which is almost half of 2004 US GDP. Interest-rate derivatives are by far the largest category of structured finance contracts, taking up $185 trillion of the total $250 trillion of notional values. The $185 trillion notional value of interest-rate derivatives is 41 times the outstanding value of US Treasury bonds. This means that interest-rate volatility will have a disproportioned impact of the global financial system in ways that historical data cannot project.

Fiat money issued by government is now legal tender in all modern national economies since the 1971 collapse of the Bretton Woods regime of fixed exchange rates linked to a gold-backed US dollar. Chartalism holds that the general acceptance of government-issued fiat currency rests fundamentally on government's authority to tax. Government's willingness to accept the currency it issues for payment of taxes gives the issuance currency within a national economy. That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government, known as fiat money. When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment.

A central banking regime operates on the notion of government-issued fiat money as sovereign credit. That is the essential difference between central banking with government-issued fiat money, which is a sovereign-credit instrument, and free banking with privately issued specie money, which is a bank IOU that allows the holder to claim the gold behind it.

With the fall of the Union of Soviet Socialist Republics, the US attitude toward the rest of the world changed. It now no longer needs to compete for the hearts and minds of the masses of the Third and Fourth Worlds. So trade has replaced aid. The US has embarked on a strategy to use cheap Third/Fourth World labor and non-existent environmental regulation to compete with its former Cold War allies, now industrialized rivals in trade, taking advantage of traditional US anti-labor ideology to outsource low-paying jobs, playing against the strong pro-labor tradition of social welfare in Europe and Japan. In the meantime, the US pushed for global financial deregulation based on dollar hegemony and emerged as a 500-pound gorilla in the globalized financial market that left the Japanese and Europeans in the dust, playing catch-up in an unwinnable game. In the game of finance capitalism, those with capital in the form of fiat money they can print freely will win hands down.

The tool of this US strategy is the privileged role of the dollar as the key reserve currency for world trade, otherwise known as dollar hegemony. Out of this emerges an international financial architecture that does real damage to the actual producer economies for the benefit of the financier economies. The dollar, instead of being a neutral agent of exchange, has become a weapon of massive economic destruction (WMED) more lethal than nuclear bombs and with more blackmail power, which is exercised ruthlessly by the International Monetary Fund (IMF) on behalf of the Washington Consensus. Trade wars are fought through volatile currency valuations. Dollar hegemony enables the United States to use its trade deficits as the bait for its capital account surplus.

Foreign direct investment under dollar hegemony has changed the face of the international economy. Since the early 1970s, FDI has grown along with global merchandise trade and is the single most important source of capital for developing countries, not net savings or sovereign credit. FDI is mostly denominated in dollars, a fiat currency that the US can produce at will since 1971, or in dollar derivatives such as the yen or the euro, which are not really independent currencies. Thus FDI is by necessity concentrated in exports-related development, mainly destined for US markets or markets that also sell to US markets for dollars with which to provide the return on dollar-denominated FDI. US economic policy is shifting from trade promotion to FDI promotion. The US trade deficit is financed by the US capital account surplus which in turn provides the dollars for FDI in the exporting economies. A trade spat with the EU over beef and bananas, for example, risks large US investment stakes in Europe. And the suggestion to devalue the dollar to promote US exports is misleading for it would only make it more expensive for US affiliates to do business abroad while making it cheaper for foreign companies to buy dollar assets. An attempt to improve the trade balance, then, would actually end up hurting the FDI balance. This is the rationale behind the slogan: a strong dollar is in the US national interest.

Between 1996 and 2003, the monetary value of US equities rose around 80% compared with 60% for Europeans and a decline of 30% for Japanese. The 1997 Asian financial crisis cut the values of Asian equities by more than half, some as much as 80% in dollar terms even after drastic devaluation of local currencies. Even though the United States has been a net debtor since 1986, its net income on the international investment position has remained positive, as the rate of return on US investments abroad continues to exceed that on foreign investments in the US. This reflects the overall strength of the US economy, and that strength is derived from the US being the only nation that can enjoy the benefits of sovereign-credit utilization while amassing external debt, largely due to dollar hegemony.

In the US, and now also increasingly so in Europe and Asia, capital markets are rapidly displacing banks as both savings venues and sources of funds for corporate finance. This shift, along with the growing global integration of financial markets, is supposed to create promising new opportunities for investors around the globe. Neo-liberals even claim that these changes could help head off the looming pension crises facing many nations. But so far it has only created sudden and recurring financial crises like those that started in Mexico in 1982, then in the United Kingdom in 1992, again in Mexico in 1994, in Asia in 1997, and Russia, Brazil, Argentina and Turkey subsequently.

The introduction of the euro has accelerated the growth of the EU financial markets. For the current 25 members of the European Union, the common currency nullified national requirements for pension and insurance assets to be invested in the same currencies as their local liabilities, a restriction that had long locked the bulk of Europe's long-term savings into domestic assets. Freed from foreign-exchange transaction costs and risks of currency fluctuations, these savings fueled the rise of larger, more liquid European stock and bond markets, including the recent emergence of a substantial euro junk bond market. These more dynamic capital markets, in turn, have placed increased competitive pressure on banks by giving corporations new financing options and thus lowering the cost of capital within euroland. How this will interact with the euro-dollar market is still indeterminate. Euro-dollars are dollars outside of US borders everywhere and not necessarily Europe, generally pre-taxed and subject to US taxes if they return to US soil or accounts. The term also applies to euro-yen and euro-euros. But the idea of French retirement accounts investing in non-French assets is both distasteful and irrational for the average French worker, particularly if such investment leads to decreased job security in France and jeopardizes the jealously guarded 35-hour work-week with 30 days of paid annual vacation that has been part of French life.

Take the Japanese economy as an example, the world's largest creditor economy. It holds more than $800 billion in dollar reserves. The Bank of Japan (BOJ), the central bank, has bought more than 300 billion dollars with yen from currency markets in the past two years in an effort to stabilize the exchange value of the yen, which continued to appreciate against the dollar. Now, the BOJ is faced with a dilemma: continue buying dollars in a futile effort to keep the yen from rising, or sell dollars to try to recoup yen losses on its dollar reserves. Japan has officially pledged not to diversify its dollar reserves into other currencies, so as not to roil currency markets, but many hedge funds expect Japan to run out of options soon.

Now if the BOJ sells dollars at the rate of $4 billion a day, it will take some 200 trading days to get out of its dollar reserves. After the initial two days of sale, the remaining unsold $792 billion reserves would have a market value of 20% less than before the sales program began. So the BOJ would suffer a substantial net yen paper loss of $160 billion. If the BOJ continues its sell-dollar program, every day 400 billion yen will leave the yen money supply to return to the BOJ if it sells dollars for yen, or the equivalent in euros if it sells dollars for euros. This will push the dollar further down against the yen or euro, in which case the value of its remaining dollar reserves will fall even further, not to mention a sharp contraction in the yen money supply, which will push the Japanese economy into a deeper recession.

If the BOJ sells dollars for gold, two things may happen. There may not be enough sellers because no one has enough gold to sell to absorb the dollars at current gold prices. Instead, while the price of gold will rise, the gold market may simply freeze, with no transactions. Gold holders will not have to sell their gold; they can profit from gold derivatives on notional values. Also, the reverse market effect that faces the dollar would hit gold. After two days of Japanese gold buying, everyone would hold on to his gold in anticipation of still-higher gold prices. There would be no market makers. Part of the reason central banks have been leasing out their gold in recent years is to provide liquidity to the gold market.

The second thing that may happen is that the price of gold will skyrocket in currency terms, causing a great deflation in gold terms. The US national debt as of June 1 was $7.787 trillion. US government gold holding is about 261 million ounces. The price of gold required to pay back the national debt with US-held gold is $29,835 per ounce. At that price, an ounce of gold would buy a car. Meanwhile, the market price of gold as of June 4 was $423.50 per ounce. Gold peaked at $850 per ounce in 1980 and bottomed at $252 in 1999 when oil was below $10 a barrel. At $30,000 per ounce, governments would have to make gold trading illegal, as US president Franklin Roosevelt did in 1930, and we would be back to Square 1. It is much easier for a government to outlaw the trading of gold within its borders than it is for it to outlaw the trading of its currency in world markets. It does not take much to conclude that anyone who advises any strategy of long-term holding of gold will not get to the top of the class.

Heavily indebted poor countries need debt relief to get out of virtual financial slavery. Some African governments spend three times as much on debt service as they do on health care. Britain has proposed a half-measure that would have the International Monetary Fund (IMF) sell about $12 billion worth of its gold reserves, which have a total current market value of about $43 billion, to finance debt relief. The United States has veto power over gold decisions in the IMF. Thus the US Congress holds the key. However, the mining-industry lobby has blocked a vote. In January, a letter opposing the sale of IMF gold was signed by 12 US senators from western mining states, arguing that the sale could drive down the price of gold. A similar letter was signed in March by 30 members of the House of Representatives. Lobbyists from the National Mining Association and gold-mining companies such as Newmont Mining and Barrick Gold Corp persuaded the congressional leadership that the gold proposal would not pass in Congress, even before it came up for debate.

The Bank for International Settlements (BIS) reports that gold derivatives took up 26% of the world's commodity derivatives market, yet gold only composes 1% of the world's annual commodity production value, with 26 times as many derivatives structured against gold as against other commodities, including oil. The Bush administration, at first apparently unwilling to take on a congressional fight, began in April to oppose gold sales outright. But President George W Bush and British Prime Minister Tony Blair announced on June 7 that the US and UK are "well on their way" to a deal that would provide 100% debt cancellation for some poor nations to the World Bank and African Development Fund as a sign of progress in the Group of Eight (G8) debate over debt cancellation.

Jude Wanniski, a former editor of the Wall Street Journal, commenting in his "Memo on the margin" on the Internet on June 15, on the headline of Pat Buchanan's syndicated column of the same date, "Reviving the foreign-aid racket", wrote:
This not a bailout of Africa's poor or Latin American peasants. This is a bailout of the IMF, the World Bank and the African Development Bank ... The second part of the racket is that in exchange for getting debt relief, the poor countries will have to spend the money they save on debt service on "infrastructure projects", to directly help their poor people with water and sewer lines, etc, which will be constructed by contractors from the wealthiest nations ... What comes next? One of the worst economists in the world, Jeffrey Sachs, is in charge of the United Nations scheme to raise mega-billions from Western taxpayers for the second leg of this scheme. He wants $25 billion a year for the indefinite future, as I recall, and he has the fervent backing of the New York Times, which always weeps crocodile tears for the racketeers. It was Jeffrey Sachs, in case you forgot, who with the backing of the NY Times persuaded Moscow under Mikhail Gorbachev to engage in "shock therapy" to convert from communism to capitalism. It produced the worst inflation in the history of Russia, caused the collapse of the Soviet federation, and sank the Russian people into a poverty they had never experienced under communism.
The dollar cannot go up or down more than 20% against any other major currencies within a short time without causing a major global financial crisis. Yet, against the US equity markets, the dollar appreciated about 40% in purchasing power in the 2000-02 market crash. And against real-estate prices between 2002 and 2005, the dollar has depreciated 60% or more. According to Greenspan's figures, the Fed can print $8 trillion more fiat dollars without causing inflation. The problem is not the money-printing. The problem is where that $8 trillion is injected. If it is injected into the banking system, then the Fed will have to print $3 trillion every subsequent year just to keep running in place. If the $8 trillion is injected into the real economy in the form of full employment and higher wages, the US will have a very good economy, and much less need for paranoia against Asia or the EU. But US wages cannot rise as long as global wage arbitrage is operative. This is one of the arguments behind protectionism. It led Greenspan to say on May 5 he feared what appeared to be a growing move toward trade protectionism, saying it could lessen the ability of the US and the world economy to withstand shock. Yet if democracy works in the US, protectionism will be unstoppable as long as free trade benefits the elite at the expense of the voting masses.

Fiat money is sovereign credit

Money is like power: use it or lose it. Money unused (not circulated) is defunct wealth. Fiat money not circulated is not wealth but merely pieces of printed paper sitting in a safe. Gold unused as money is merely a shiny metal good only as an ornamental gift for weddings and birthdays. The usefulness of money to the economy is dependent on its circulation, like the circulation of blood to bring oxygen and nutrients to the living organism. The rate of money circulation is called velocity by monetary economists. A vibrant economy requires a high velocity of money. Money, like most representational instruments, is subject to declaratory definition. In semantics, a declaratory statement is self-validating. For example: "I am king" is a statement that makes the declarer king, albeit in a kingdom of one citizen. What gives weight to the declaration is the number of others accepting that declaration. When sufficient people within a jurisdiction accept the kingship declaration, the declarer becomes king of that jurisdiction instead of just his own house. When an issuer of money declares it to be credit it will be credit, or when he declares it to be debt it will be debt. But the social validity of the declaration depends on the acceptance of others.

Anyone can issue money, but only sovereign government can issue legal tender for all debts, public and private, universally accepted with the force of law within the sovereign domain. The issuer of private money must back that money with some substance of value, such as gold, or the commitment for future service, etc. Others who accept that money have provided something of value for that money, and have received that money instead of something of similar value in return. So the issuer of that money has given an instrument of credit to the holder in the form of that money, redeemable with something of value on a later date.
When the state issues fiat money under the principle of Chartalism, the something of value behind it is the fulfillment of tax obligations. Thus the state issues a credit instrument, called (fiat) money, good for the cancellation of tax liabilities. By issuing fiat money, the state is not borrowing from anyone. It is issuing tax credit to the economy.

Even if money is declared as debt assumed by an issuer who is not a sovereign who has the power to tax, anyone accepting that money expects to collect what is owed him as a creditor. When that money is used in a subsequent transaction, the spender is parting with his creditor right to buy something of similar value from a third party, thus passing the "debt" of the issuer to the third party. Thus no matter what money is declared to be, its function is a credit instrument in transactions. When one gives money to another, the giver is giving credit and the receiver is incurring a debt unless value is received immediately for that money. When debt is repaid with money, money acts as a credit instrument. When government buys back government bonds, which is sovereign debt, it cannot do so with fiat money it issues unless fiat money is sovereign credit.

When money changes hands, there is always a creditor and a debtor. Otherwise there is no need for money, which stands for value rather than being value intrinsically. When a cow is exchanged for another cow, that is bartering, but when a cow is bought with money, the buyer parts with money (an instrument of value) while the seller parts with the cow (the substance of value). The seller puts himself in the position of being a new creditor for receiving the money in exchange for his cow. The buyer exchanges his creditor position for possession of the cow. In this transaction, money is an instrument of credit, not a debt.

When private money is issued, the only way it will be accepted generally is that the money is redeemable for the substance of value behind it based on the strong credit of the issuer. The issuer of private money is a custodian of the substance of value, not a debtor. All that is logic, and it does not matter how many mainstream monetary economists say money is debt.

Economist Hyman P Minsky (1919-96) observed correctly that money is created whenever credit is issued. He did not say money is created when debt is incurred. Only entities with good credit can issue credit or create money. Debtors cannot create money, or they would not have to borrow. However, a creditor can only be created by the existence of a debtor. So both a creditor and a debtor are needed to create money. But only the creditor can issue money, the debtor accepts the money so created, which puts him in debt.

The difference with the state is that its power to levy taxes exempts it from having to back its creation of fiat money with any other assets of value. The state when issuing fiat money is acting as a sovereign creditor. Those who take the fiat money without exchanging it with things of value are indebted to the state; and because taxes are not always based only on income, a taxpayer is a recurring debtor to the state by virtue of his citizenship, even those with no income. When the state provides transfer payments in the form of fiat money, it relieves the recipient of his tax liabilities or transfers the exemption from others to the recipient to put the recipient in a position of a creditor to the economy through the possession of fiat money. The holder of fiat money is then entitled to claim goods and services from the economy. For things that are not for sale, such as political office, money is useless, at least in theory. The exercise of the fiat money's claim on goods and services is known as buying something that is for sale.

There is a difference between buying a cow with fiat money and buying a cow with private IOUs (notes). The transaction with fiat money is complete. There is no further obligation on either side after the transaction. With notes, the buyer must either eventually pay with money, which cancels the notes (debt), or return the cow. The correct way to look at sovereign-government-issued fiat money is that it is not a sovereign debt, but a sovereign-credit good for canceling tax obligations. When the government redeems sovereign bonds (debt) with fiat money (sovereign credit), it is not paying off old debt with new debt, which would be a Ponzi scheme.

Government does not become a debtor by issuing fiat money, which in the US is a Federal Reserve note, not an ordinary banknote. The word "bank" does not appear on US dollars. Zero maturity money (ZMM), which grew from $550 billion in 1971, when president Richard Nixon took the dollar off gold, to $6.63 trillion as of May 30, 2005, is not a federal debt. It is a federal credit to the economy acceptable for payment of taxes and as legal tender for all debts, public and private. Anyone refusing to accept dollars within US jurisdiction is in violation of US law. One is free to set market prices that determine the value, or purchasing power, of the dollar, but it is illegal on US soil to refuse to accept dollars for the settlement of debts. Instruments used for settling debts are credit instruments. When fiat money is used to buy sovereign bonds (debt), money cannot be anything but an instrument of sovereign credit. If fiat money is sovereign debt, there is no need to sell government bonds for fiat money. When a sovereign government sells a sovereign bond for fiat money issues, it is withdrawing sovereign credit from the economy. And if the government then spends the money, the money supply remains unchanged. But if the government allows a fiscal surplus by spending less than its tax revenue, the money supply shrinks and the economy slows. That was the effect of the Bill Clinton surplus, which produced the recession of 2000. While runaway fiscal deficits are inflationary, fiscal surpluses lead to recessions. Conservatives who are fixated on fiscal surpluses are simply uninformed on monetary economics.

For euro-dollars, meaning fiat dollars outside the United States, the reason those who are not required to pay US taxes accept them is dollar hegemony, not because dollars are IOUs of the US government. Everyone accepts dollars because dollars can buy oil and all other key commodities. When the Fed injects money into the US banking system, it is not issuing government debt; it is expanding sovereign credit that would require higher government tax revenue to redeem. But if expanding sovereign credit expands the economy, tax revenue will increase without changing the tax rate. Dollar hegemony exempts the US dollar, and only the US dollar, from foreign-exchange implication on the State Theory of Money. To issue sovereign debt, the Treasury issues Treasury bonds. Thus under dollar hegemony, the United States is the only nation that can practice and benefit from sovereign credit under the principle of Chartalism.

Money and bonds are opposite instruments that cancel each other. That is how the Fed Open Market Committee (FOMC) controls the money supply, by buying or selling government securities with fiat dollars to set a Fed Funds Rate target. The Fed Funds Rate is the interest rate at which US banks lend to each other overnight. As such, it is a market interest rate that influences market interest rates throughout the world in all currencies through exchange rates. Holders of a government bond can claim its face value in fiat money at maturity, but the holder of a fiat dollar can only claim a fiat-dollar replacement at the Fed. Holders of fiat dollars can buy new sovereign bonds at the Treasury, or outstanding sovereign bonds in the bond market, but not at the Fed. The Fed does not issue debts, only credit in the form of fiat money. When the FOMC buys or sells government securities, it does so on behalf of the Treasury. When the Fed increases the money supply, it is not adding to the national debt. It is increasing sovereign credit in the economy. That is why monetary easing is not deficit financing.

Money and inflation

It is sometimes said that war's legitimate child is revolution and war's bastard child is inflation. World War I was no exception. The US national debt multiplied 27 times to finance the nation's participation in that war, from $1 billion to $27 billion. Far from ruining the United States, the war catapulted the country into the front ranks of the world's leading economic and financial powers. The national debt turned out to be a blessing, for government securities are indispensable as anchors for a vibrant credit market.

Inflation was a different story. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead. In response, the Federal Reserve Board raised the discount rate in quick succession, from 4% to 7%, and kept it there for 18 months to try to rein in inflation. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - the discount window. The result was that in 1921, 506 banks failed. Deflation descended on the economy like a perfect storm, with commodity prices falling 50% from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, adding 4 million to the jobless count. The economy came to a screeching halt. From the Fed's perspective, declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained.

At this point, a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interest, pre-eminent influence over the Federal Reserve Board in Washington, the composition of which represented a more balanced national interest. The initial operation of the Fed did not use the open-market operation of purchasing or selling government securities to set interest-rate policy as a method of managing the money supply. The Fed could not simply print money to buy government securities to inject money into the money supply because the dollar was based on gold and the amount of gold held by the government was relatively fixed. Money in the banking system was created entirely through the discount window at the regional Federal Reserve banks. Instead of buying or selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the "real bills" doctrine to maintain the gold standard. The regional Feds bought government securities not to adjust money supply, but to enhance their separate operating profit by parking idle funds in interest-bearing yet super-safe government securities, the way institutional money managers do today.

Bank economists at that time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macroeconomic implications of injecting "high power" money into the banking system, with which commercial banks could create more money in multiple by lending recycles based on the partial reserve principle. When the government sold bonds, the reverse would happen. When the Fed made open-market transactions, interest rates would rise or fall accordingly in financial markets. And when the regional Feds did not act in unison, the credit market could become confused or disaggregated, as one regional Fed might buy while another might sell government securities in its open-market operations.

Benjamin Strong, first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds formed an Open Market Investment Committee, to be run by the New York Fed for the purpose of maximizing overall profit for the whole system. This committee became dominated by the New York Fed, which was closely linked to big-money central-bank interests, which in turn were closely tied to international financial markets. The Federal Reserve Board approved the arrangement without full understanding of its implication: that the Fed was falling under the undue influence of the New York internationalist bankers. For the United States, this was the beginning of financial globalization. This fatal flaw would reveal itself in the Fed's role in causing and its impotence in dealing with the 1929 stock market crash.

The deep 1920-21 depression eventually recovered by the lowering of the Fed discount rate into the Roaring Twenties, which, like the New Economy bubble of the 1990s, left some segments of the US economy and the population in them lingering in a depressed state. Farmers remained victimized by depressed commodity prices and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30% of their membership because of high unemployment in boom times. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression. Historical data showed that when New York Fed president Strong leaned on the regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest. It is an issue of debate that continues in the US Congress today. Like Greenspan, Strong argued that it was preferable to deal with post-crash crisis management by adding liquidity than to pop a bubble prematurely with preventive measures of tight money. It is a strategy that requires letting a bubble pop only inside a bigger bubble.

The speculative boom of easy credit in the 1920s attracted many to buy stocks with borrowed money and used the rising price of stocks as new collateral for borrowing more to buy more stocks. Brokers' loans went from under $5 million in mid-1928 to $850 million in September of 1929. The market capitalization of the 846 listed companies of the New York Stock Exchange was $89.7 billion, at 1.24 times 1929 GDP. By current standards, a case could be built that stocks in 1929 were in fact technically undervalued. The 2,750 companies listed in the New York Stock Exchange had total global market capitalization exceeding $18 trillion in 2004, 1.53 times 2004 GDP of $11.75 trillion.

On January 14, 2001, the Dow Jones Industrial Average reached its all-time high to date at 11,723, not withstanding Greenspan's warning of "irrational exuberance" on December 6, 1996, when the DJIA was at 6,381. From its August 12, 1982, low of 777, the DJIA began its most spectacular bull market in history. It was interrupted briefly only by the abrupt and frightening crash on October 19, 1987, when the DJIA lost 22.6% on Black Monday, falling to 1,739. That represented a 1,021-point drop from its previous peak of 2,760 reached less than two months earlier on August 21. But Greenspan's easy-money policy lifted the DJIA to 11,723 in 13 years, a 674% increase. In 1929 the top came on September 4, with the DJIA at 386. A headline in the New York Times on October 22, 1929, reported highly respected economist Irving Fisher as saying, "Prices of stocks are low." Two days later, the stock market crashed, and by the end of November, the New York Stock Exchange shares index was down 30%. The index did not return to the September 3, 1929, level until November 1954. At its worst level, the index dropped to 40.56 in July 1932, a drop of 89%. Fisher had based his statement on strong earnings reports, few industrial disputes, and evidence of high investment in research and development (R&D) and in other intangible capital. Theory and supportive data not withstanding, the reality was that the stock-market boom was based on borrowed money and false optimism. In hindsight, many economists have since concluded that stock prices were overvalued by 30% in 1929. But when the crash came, the overshoot dropped the index by 89% in less than three years.

Money and gold

When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central bank. No responsible government will voluntarily let the market set the exchange value of its currency, market fundamentalism notwithstanding. Yet central bankers tend to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set by someone to reflect the underlying economic conditions at the time of its setting. Therein lies the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy temporarily out of sync with that fixed rate. It seldom occurs to central bankers that the fixed rate was the problem, not the dynamic economy. When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency.

The return to the gold standard in war-torn Europe in the 1920s was engineered by a coalition of internationalist central bankers on both sides of the Atlantic as a prerequisite for postwar economic reconstruction. Lenders wanted to make sure that their loans would be repaid in money equally valuable as the money they lent out, pretty much the way the IMF deals with the debt problem today. President Strong of the New York Fed and his former partners at the House of Morgan were closely associated with the Bank of England, the Banque de France, the Reichsbank, and the central banks of Austria, the Netherlands, Italy and Belgium, as well as with leading internationalist private bankers in those countries. Montagu Norman, governor of the Bank of England from 1920-44, enjoyed a long and close personal friendship with Strong as well as an ideological alliance. Their joint commitment to restore the gold standard in Europe and so to bring about a return to the "international financial normalcy" of the prewar years was well documented. Norman recognized that the impairment of British financial hegemony meant that, to accomplish postwar economic reconstruction that would preserve prewar British interests, Europe would "need the active cooperation of our friends in the United States".

Like other New York bankers, Strong perceived World War I as an opportunity to expand US participation in international finance, allowing New York to move toward coveted international-finance-center status to rival London's historical pre-eminence, through the development of a commercial paper market, or bankers' acceptances in British finance parlance, breaking London's long monopoly. The Federal Reserve Act of 1913 permitted the Federal Reserve Banks to buy, or rediscount, such paper. This allowed US banks in New York to play an increasingly central role in international finance in competition with the London market.

Herbert Hoover, after losing his second-term US presidential election to Franklin D Roosevelt as a result of the 1929 crash, criticized Strong as "a mental annex to Europe", and blamed Strong's internationalist commitment to facilitating Europe's postwar economic recovery for the US stock-market crash of 1929 and the subsequent Great Depression that robbed Hoover of a second term. Europe's return to the gold standard, with Britain's insistence on what Hoover termed a "fictitious rate" of US$4.86 to the pound sterling, required Strong to expand US credit by keeping the discount rate unrealistically low and to manipulate the Fed's open market operations to keep US interest rate low to ease market pressures on the overvalued pound sterling. Hoover, with justification, ascribed Strong's internationalist policies to what he viewed as the malign persuasions of Norman and other European central bankers, especially Hjalmar Schacht of the Reichsbank and Charles Rist of the Bank of France. From the mid-1920s onward, the United States experienced credit-pushed inflation, which fueled the stock-market bubble that finally collapsed in 1929.

Within the Federal Reserve System, Strong's low-rate policies of the mid-1920s also provoked substantial regional opposition, particularly from Midwestern and agricultural elements, who generally endorsed Hoover's subsequent critical analysis. Throughout the 1920s, two of the Federal Reserve Board's directors, Adolph C Miller, a professional economist, and Charles S Hamlin, perennially disapproved of the degree to which they believed Strong subordinated domestic to international considerations.

The fairness of Hoover's allegation is subject to debate, but the fact that there was a divergence of priority between the White House and the Fed is beyond dispute, as is the fact that what is good for the international financial system may not always be good for a national economy. This is evidenced today by the collapse of one economy after another under the current international finance architecture that all central banks support instinctively out of a sense of institutional solidarity. The same issue has surfaced in today's China where regional financial centers such as Hong Kong and Shanghai are vying for the role of world financial center. To do this, they must play by the rules of the international financial sy

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