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The coming trade war and global depression

Many historians have suggested that the 1929 stock market crash was not the cause of the Great Depression. If anything, the 1929 crash was the technical reflection of the inevitable fate of an overblown bubble economy. Yet stock market crashes can recover within a relatively short time with the help of effective government monetary measures, as demonstrated by the crashes of 1987 (23% drop, recovered in nine months), 1998 (36% drop, recovered in three months) and 2002 (37% drop, recovered in two months).

There was no quick recovery after the 1929 crash. Structurally, what made the Great Depression last for more than a decade from 1929 until the US entry into World War II in 1941 were the 1930 Smoot-Hawley tariffs, which put world trade into a tailspin from which it did not recover until the war began. While the US economy finally recovered through war mobilization after the Japanese attack on Pearl Harbor, Hawaii, on December 7, 1941, most of the world's market economies sank deeper into war-torn distress and did not fully recover until the Korean War boom in 1951.

Barely five years into the 21st century, with a globalized neo-liberal trade regime firmly in place in a world where market economy has become the norm, trade protectionism appears to be fast re-emerging and developing into a new global trade war of complex dimensions. The irony is that this new trade war is being launched not by the poor economies that have been receiving the short end of the trade stick, but by the US, which has been winning more than it has been losing on all counts from globalized neo-liberal trade, with the European Union following suit in lockstep. Japan, of course, has never let up on protectionism and never taken competition policy seriously. The rich nations need to recognize that their efforts to squeeze every last drop of advantage out of already unfair trade will only plunge the world into deep depression. History has shown that while the poor suffer more in economic depressions, the rich, even as they are financially cushioned by their wealth, are hurt by political repercussions in the form of either war or revolution, or both.

Cold War and moral imperative

During the Cold War, there was no international free trade. The economies of the two contending ideology blocs were completely disconnected. Within each bloc, economies interacted through foreign aid and memorandum trade from their respective superpowers. The competition was not for profit but for the hearts and minds of the people in the two opposing blocs, as well as those in the non-aligned nations in the Third World. The competition between the two superpowers was to give rather than to take from their separate fraternal economies.

The population of the superpowers worked hard to help the poorer people within their separate blocs, and convergence toward equality was the policy aim even if not always the practice. The Cold War era of foreign aid and memorandum trade had a better record of poverty reduction in both camps than post-Cold War globalized neo-liberal trade dominated by one single superpower. The aim was not only to raise income and increase wealth, but also to close income and wealth disparity between and within economies. Today, income and wealth disparity is rationalized as a necessity for capital formation. The New York Times reports that from 1980 to 2002, the total income earned by the top 0.1% of earners in the United States more than doubled, while the share earned by everyone else in the top 10% rose far less and the share of the bottom 90% declined.

For all its ill effects, the Cold War achieved two formidable ends: it prevented nuclear war and it introduced development as a moral imperative into superpower geopolitical competition with rising economic equality within each bloc. In the years since the end of the Cold War, nuclear terrorism has emerged as a serious threat and domestic development is preempted by global trade, even in the rich economies, while income and wealth disparity has widened everywhere.

Since the end of the Cold War some 15 years ago, world economic growth has shifted to rely exclusively on globalized neo-liberal trade engineered and led by the US as the sole remaining superpower, financed with the US dollar as the main reserve currency for trade and anchored by the huge US consumer market made possible by the high wages of US workers. This growth has been sustained by knocking down national tariffs everywhere around the world through supranational institutions such as the World Trade Organization (WTO), and financed by a deregulated foreign-exchange market working in concert with a global central-banking regime independent of local political pressure, lorded over by the supranational Bank of International Settlement (BIS) and the International Monetary Fund (IMF).

Redefining humanist morality, the United States asserts that world trade is a moral imperative and as such trade promotes democracy, political freedom and respect for human rights in trade participating nations. Unfortunately, income and wealth equality is not among the benefits promoted by trade. Even if the validity of this twisted ideological assertion is not questioned, it clearly contradicts the US practice of trade embargo against countries Washington deems undemocratic, lacking in political freedom and deficient in respect for human rights. If trade promotes such desirable conditions, the practice of linking trade to freedom is tantamount to denying medicine to the sick.

US President George W Bush defends his free-trade agenda in moralistic terms. "Open trade is not just an economic opportunity, it is a moral imperative," he declared in a May 7, 2001, speech. "Trade creates jobs for the unemployed. When we negotiate for open markets, we're providing new hope for the world's poor. And when we promote open trade, we are promoting political freedom." Such claims remain highly controversial when tested by actual data.

Phyllis Schlafly, a syndicated conservative columnist, responded three weeks later in an article "Free trade is an economic issue, not a moral one". In it, she noted that while conservatives should be happy finally to have a president who added a moral dimension to his actions, "the Bible does not instruct us on free trade and it's not one of the Ten Commandments. Jesus did not tell us to follow Him along the road to free trade ... Nor is there anything in the US constitution that requires us to support free trade and to abhor protectionism. In fact, protectionism was the economic system believed in and practiced by the framers of our constitution. Protective tariffs were the principal source of revenue for our federal government from its beginning in 1789 until the passage of the 16th Amendment, which created the federal income tax, in 1913. Were all those public officials during those hundred-plus years remiss in not adhering to a "moral obligation" of free trade?" Hardly, argued Schlafly, whose views are noteworthy because US politics is currently enmeshed in a struggle between strict-constructionist paleo-conservatives and moral-imperialist neo-conservatives. Despite the ascendance of neo-imperialism in US foreign policy, protectionism remains strong in US political culture, particularly among conservatives and in the labor movement.

Bush also said China, which reached a trade agreement with the United States at the close of the administration of his predecessor Bill Clinton, and became a member of the WTO in late 2001, would benefit from political changes as a result of liberalized trade policies. This pronouncement gives clear evidence to those in China who see foreign trade as part of an anti-China "peaceful evolution" strategy first envisaged by John Forster Dulles, US secretary of state under president Dwight Eisenhower in the 1950s. It is a strategy of inducing through peaceful trade the Chinese Communist Party (CCP) to reform itself out of power and to eliminate the dictatorship of the proletariat in favor of bourgeois liberalization. Almost four decades later, Deng Xiaoping criticized CCP chairman Hu Yaobang and premier Zhao Ziyang for having failed to contain bourgeois liberalization in their implementation of China's modernization policy. Deng warned in November 1989, five months after the Tiananmen incident: "The Western imperialist countries are staging a third world war without guns. They want to bring about the peaceful evolution of socialist countries towards capitalism." Deng's handling of the Tiananmen incident prevented China from going the catastrophic route of the USSR, which dissolved in 1991.

Hostility in the name of 'freedom'

Yet it is clear that political freedom is often the first casualty of a garrison-state mentality and such mentality inevitably results from hostile economic and security policy toward any country the US deems as not free. Whenever the US pronounces a nation to be not free, that nation will become less free as a result of US policy. This has been repeatedly evident in China and elsewhere in the Third World. Whenever US policy toward China turns hostile, as it currently appears to be heading, political and press freedoms inevitably face stricter curbs. For trade mutually and truly to benefit the trading economies, three conditions are necessary: 1) the de-linking of trade from ideological/political objectives, 2) maintenance of equality in the terms of trade and 3) recognition that global full employment at rising, living wages is the prerequisite for true comparative advantage in global trade.

The developing rupture between the sole superpower and its traditionally deferential allies lies in mounting trade conflicts. The United States has benefited from an international financial architecture that gives the US economy a structural monetary advantage over those of the EU and Japan, not to mention the rest of the world. Trade issues range from government-subsidy disputes between Airbus and Boeing to those regarding bananas, sugar, beef, oranges and steel, as well as disputes over fair competition associated with mergers and acquisition and financial services. If either government is found to be in breach of WTO rules when these disputes wind through long processes of judgment, the other will be authorized to retaliate. The US could put tariffs on other European goods if the WTO rules against Airbus and vice versa. So if both governments are found in breach, both could retaliate, leading to a cycle of offensive protectionism. When the US was ruled to have unfairly supported its steel industry, tariffs were slapped by the EU on Florida oranges to make a political point in a politically important state in US politics.

Trade competition between the EU and the US is spilling over into security areas, allowing economic interests to conflict with ideological sympathy. Both of these production engines, saddled with serious overcapacity, are desperately seeking new markets, which inevitably leads them to Asia in general and China in particular, with its phenomenal growth rate and its 1.2 billion eager consumers bulging with rapidly rising disposable income. The growth of the Chinese economy will lift all other economies in Asia, including Australia, which has only recently begun to understand that its future cannot be separated from its geographic location and that its prosperity is interdependent with those of other Asia-Pacific economies. Australian iron ore and beef and dairy products are destined for China, not the British Isles. The EU is eager to lift its 15-year-old arms embargo on China, much to the displeasure of the US. Israel, with its close relations with the US, faces a similar dilemma on military sales to China.

Even the US defense establishment has largely come around to the view that the US arms industry must export, even to China, to remain on top. It was reported recently that US Defense Secretary Donald Rumsfeld tried to sell to Thailand F-16 warplanes capable of firing advanced medium-range air-to-air missiles two days after he lashed out in Singapore at China for upgrading its own military when no neighboring nations are threatening it (see Rumsfeld pitches in for F-16s, June 9). The sales pitch was in competition with Russian-made Sukhoi Su-30s and Swedish JAS-39s. The open competition in arms export had been spelled out for the US Congress years earlier by Donald Hicks, a leading Pentagon technologist in the administration of president Ronald Reagan. "Globalization is not a policy option, but a fact to which policymakers must adapt," he said. "The emerging reality is that all nations' militaries are sharing essentially the same global commercial-defense industrial base." The boots and uniforms worn by US soldiers in Afghanistan and Iraq were made in China.

The widening wealth gap

The WTO is the only global international organization dealing with the rules of trade among its 148 member nations. At its heart are the WTO agreements, known as the multilateral trading system, negotiated and signed by the majority of the world's trading nations and ratified in their parliaments. The stated goal is to help producers of goods and services, exporters and importers conduct their business, with the dubious assumption that trade automatically brings equal benefits to all participants. The welfare of the people is viewed only as a collateral aim based on the doctrinal fantasy that "balanced" trade inevitably brings prosperity equally to all, a claim that has been contradicted by facts produced by the very terms of trade promoted by the WTO itself.

Two decades of neo-liberal globalized trade have widened income and wealth disparity within and between nations. Free trade has turned out not to be the win-win game promised by neo-liberals. It is very much a win-lose game, with heads, the rich economies win, and tails, the poor economies lose. Domestic development has been marginalized as a hapless victim of foreign trade, dependent on trade surplus for capital. Foreign trade and foreign investment have become the prerequisite engines for domestic development. This trade model condemns those economies with trade deficits to perpetual underdevelopment. Because of dollar hegemony, all foreign investment goes only to the export sector where US dollars can be earned. Even the economies with trade surpluses cannot use their dollar trade earnings for domestic development, as they are forced to hold huge dollar reserves to support the exchange rate of their currencies.

In the fifth WTO ministerial conference held in Cancun, Mexico, in September 2003, the richer countries rejected the demands of poorer nations for radical reform of agricultural subsidies that have decimated Third World agriculture. Failure to get the Doha Round back on track after the collapse of Cancun runs the danger of a global resurgence of protectionism, with the US leading the way. Larry Elliott reported on October 13, 2003, in The Guardian on the failed 2003 Cancun ministerial meeting: "The language of globalization is all about democracy, free trade and sharing the benefits of technological advance. The reality is about rule by elites, mercantilism and selfishness." Elliot noted that the process is full of paradoxes: why is it that in a world where human capital is supposed to be the new wealth of nations, labor is treated with such contempt?

Sam Mpasu, Malawi's commerce and industry minister, asked at Cancun for his comments about the benefits of trade liberalization, replied dryly: "We have opened our economy. That's why we are flat on our back." Mpasu's comments summarized the wide chasm that divides the perspectives of those who write the rules of globalization and those who are powerless to resist them.
Exports of manufactures by low-wage developing countries have increased rapidly over the past three decades due in part to falling tariffs and declining transport costs that enable outsourcing based on wage arbitrage. It grew from 25% in 1965 to nearly 75% over three decades, while agriculture's share of developing-country exports has fallen from 50% to less than 10%. Many developing countries have gained relatively little from increased manufactures trade, with most of the profit going to foreign capital. Market access for their most competitive manufactured export, such as textiles and apparel, remains highly restricted, and recent trade disputes threaten further restrictions. Still, the key cause of unemployment in all developing economies is the trade-related collapse of agriculture, exacerbated by the massive government subsidies provided to farmers in rich economies. Many poor economies are predominantly agriculturally based and a collapse of agriculture means a general collapse of the whole economy.

The Doha Development Agenda negotiations, sponsored by the WTO, collapsed in Cancun over the question of government support for agriculture in rich economies and its potential impacts on causing more poverty in developing countries. Negotiations since Cancun have focused on the need to understand better the linkages between trade policies, particularly those of the rich economies, and poverty in the developing world. While poverty reduction is now more widely accepted by establishment economists as a necessary central focus for development efforts and has become the main mission of the World Bank and other development institutions, very few effective measures have been forthcoming.

The UN Millennium Development Goals (UNMDG) commit the international community to halving world poverty by 2015, a decade from now. With current trends, that goal is likely to be achievable only through the death of half of the poor by starvation, disease and local conflicts. The UN Development Program warns that 3 million children will die in sub-Saharan Africa alone by 2015 if the world continues on its current path of failing to meet the UNMDG agreed to in 2000. Several key avenues to this goal supposedly lie in international trade, but the record of poverty reduction has been exceedingly poor, if not outright negative. The fundamental question whether trade can replace or even augment socio-economic development remains unasked, let alone answered. Until such issues are earnestly addressed, protectionism will re-emerge in the poor countries. Under such conditions, if democracy expresses the will of the people, democracy will demand protectionism more than government by elite.

While tariffs in the past decade have been coming down like leaves in autumn, flexible exchange rates have become a form of virtual countervailing tariff. In the current globalized neo-liberal trade regime operating in a deregulated global foreign-exchange market, the exchanged value of a currency is regularly used to balance trade through government intervention in currency-market fluctuations against the world's main reserve currency - the US dollar, as the head of the international monetary snake.

Purchasing power parity (PPP) measures the disconnection between exchange rates and local prices. PPP contrasts with the interest rate parity (IRP) theory, which assumes that the actions of investors, whose transactions are recorded on the capital account, induce changes in the exchange rate. For a dollar investor to earn the same interest rate in a foreign economy with a PPP of four times, such as the purchasing power parity between the US dollar and the Chinese yuan, local wages would have to be at least four times (75%) lower than US wages. PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy.

The law of one price says that identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. But the law of one price does not apply to the price of labor. Price arbitrage is the opposite of wage arbitrage in that producers seek to make their goods in the lowest wage locations and to sell their goods in the highest price markets. This is the incentive for outsourcing, which never seeks to sell products locally at prices that reflect PPP differentials. What is not generally noticed is that price deflation in an economy increases its PPP, in that the same local currency buys more. But the cross-border one-price phenomenon applies only to certain products, such as oil, thus for a PPP of four times, a rise in oil prices will cost the Chinese economy four times the equivalent in other goods, or wages, than in the US. The larger the purchasing power parity between a local currency and the dollar, the more severe is the tyranny of dollar hegemony on forcing down wage differentials.

The origins and effects of dollar hegemony
Ever since 1971, when US president Richard Nixon, under pressure from persistent fiscal and trade deficits that drained US gold reserves, took the dollar off the gold standard (at US$35 per ounce), the dollar has been a fiat currency of a country of little fiscal or monetary discipline. The Bretton Woods Conference at the end of World War II established the dollar, a solid currency backed by gold, as a benchmark currency for financing international trade, with all other currencies pegged to it at fixed rates that changed only infrequently. The fixed-exchange-rate regime was designed to keep trading nations honest and prevent them from running perpetual trade deficits. It was not expected to dictate the living standards of trading economies, which were measured by many other factors besides exchange rates. Bretton Woods was conceived when conventional wisdom in international economics did not consider cross-border flow of funds necessary or desirable for financing world trade, precisely for this reason. Since 1971, the dollar has changed from a gold-backed currency to a global reserve monetary instrument that the US, and only the US, can produce by fiat. At the same time, the US has continued to incur both current-account and fiscal deficits.

That was the beginning of dollar hegemony. With deregulation of foreign-exchange and financial markets, many currencies began to free-float against the dollar, not in response to market forces but to maintain export competitiveness. Government interventions in foreign-exchange markets became a regular last-resort option for many trading economies for preserving their export competitiveness and for resisting the effect of dollar hegemony on domestic living standards.

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

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

The adverse effect of this type of globalization on the US economy is also becoming clear. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a debt bubble that thrives on conspicuous consumption and fraudulent accounting. The unsustainable and irrational rise of US equity and real-estate prices, unsupported by revenue or profit, has meant a de facto devaluation of the dollar. Ironically, the recent fall in US equity prices from their 2004 peak and the anticipated fall in real-estate prices reflect a trend to an even stronger dollar, as the same amount of dollars can buy more deflated shares and properties. The rise in the purchasing power of the dollar inside the United States impacts its purchasing-power disparity with other currencies unevenly, causing sharp price instability in the economies with freely exchangeable currencies and fixed exchange rates, such as Hong Kong and until recently Argentina. For the US, a falling exchange rate of the dollar actually causes asset prices to rise. Thus with a debt bubble in the US economy, a strong dollar is not in the US national interest. Debt has turned US policy on the dollar on its head.

The setting of exchange values of currencies is practiced not only by sovereign governments on their own currencies as a sovereign right. The US, exploiting dollar hegemony, usurps the privilege of dictating the exchange value of all foreign currencies to support its own economic nationalism in the name of global free trade. And the US position on exchange rates has not been consistent. When the dollar was rising, as it did in the 1980s, the US, to protect its export trade, hailed the stabilizing wisdom of fixed exchange rates. When the dollar falls as it has been in recent years, the US, to deflect blame for its trade deficit, attacks fixed exchange rates as currency manipulation, as it now targets China's currency, which has been pegged to the dollar for more than a decade. How can a nation manipulate the exchange value of its currency when it is pegged to the dollar at the same rate over long periods? Any manipulation came from the dollar, not the yuan.

Economic nationalism

The recent rise of the euro against the dollar, the first appreciation wave since its introduction on January 1, 2002, is the result of an EU version of the 1985 Plaza Accord on the Japanese yen, albeit without a formal accord. The strategic purpose is more than merely moderating the US trade deficit. The record shows that even with a 30% drop of the dollar against the euro, the US trade deficit continued to climb. The strategic purpose of driving up the euro is to reduce it to the status of the yen, as a subordinated currency to dollar hegemony. The real effect of the Plaza Accord was to shift the cost of support for the dollar-denominated US trade deficit, and the socio-economic pain associated with that support, from the United States to Japan. What is happening to the euro now is far from being the beginning of the demise of the dollar. Rather, it is the beginning of the reduction of the euro into a subservient currency to the dollar to support the US debt bubble.

Six and a half years since the launch of the European Monetary Union, the eurozone is trapped in an environment in which monetary policy of sound money has in effect become destructive and supply-side fiscal policy unsustainable. National economies are beginning to refuse to bear the pain needed for adjustment to globalization or the EU's ambitious enlargement. The European nations are beginning to resist the US strategy to make the euro economy a captive supporter of a rising or falling dollar as such movements fit the shifting needs of US economic nationalism.

It is the modern-day monetary equivalent of the brilliant Roman strategy of making a dissident Jew a Christian god to preempt Judaism's rising cultural domination over Roman civilization. Roman law, the foundation of the Roman Empire, gained in sophistication from being influenced by, if not directly derived from, Jewish Talmudic law, particularly on the concept of equity - an eye for an eye. The Jews had devised a legal system based on the dignity of the individual and equality before the law four centuries before Christ. There was no written Roman law until two centuries before Christ. The Roman law of obligatio was not conducive to finance as it held that all indebtedness was personal, without institutional status. A creditor could not sell a note of indebtedness to another party and a debtor did not have to pay anyone except the original creditor. Talmudic law, on the other hand, recognized impersonal credit, and a debt had to be paid to whoever presented the demand note. This was a key development of modern finance. With the Talmud, the Jews under the Diaspora had an international law that spanned three continents and many cultures.

The Romans were faced with a dilemma. Secular Jewish ideas and values were permeating Roman society, but Judaism was an exclusive religion that the Romans were not permitted to join. The Romans could not assimilate the Jews as they did the Greeks. Early Christianity also kept its exclusionary trait until Paul, who opened Christianity to all. Historian Edward Gibbon (1737-94) noted that Rome recognized the Jews as a nation who as such were entitled to religious peculiarities. The Christians, on the other hand, were a sect and, being without a nation, subverted other nations. The Roman Jews were active in government and, when not resisting Rome against social injustice, fought side by side with Roman legionnaires to preserve the empire. Roman Jews were good Roman citizens. By contrast, the early Christians were social dropouts, refused responsibility in government and civic affairs and were conscientious objectors and pacifists in a militant culture. Gibbon noted that Rome felt that the crime of a Christian was not in what he did, but in being who he was.

Christianity gained control of Roman culture and society long before Constantine, who in AD 324 sanctioned it with political legitimacy and power after recognizing its power in helping to win wars against pagans, as pope Urban II in 1095 used the Crusade to prolong papal temporal power. When early Christianity, a secular Jewish dissident sect, began to move up from the lower strata of Roman society and began to find converts in the upper echelons, the Roman polity adopted Christianity, the least objectionable of all Jewish sects, as a state religion. Gibbon estimated that Christians killed more of their own members over religious disputes in the three centuries after coming to secular power than did the Romans in three previous centuries. Persecution of the Jews began in Christianized Rome. The disdain held by early Christianity for centralized government gave rise to monasticism and contributed to the fall of the Roman Empire.

By allowing a trade surplus denominated in dollars to be accumulated by non-dollar economies such as the yen, euro, or now the Chinese yuan, the cost of supporting the appropriate value of the US dollar to sustain perpetual economic growth in the dollar economy is then shifted to these non-dollar economies, which manifest themselves in perpetual relative low wages and weak domestic consumption. For the already high-wage EU and Japan, the penalty is the reduction of social-welfare benefits and job security traditional to these economies. China, now the world's second-largest creditor nation, it is reduced to having to ask the US, the world's largest debtor nation, for capital denominated in dollars the US can print at will to finance its export trade to a US running recurring trade deficits.

Market impotence against trade imbalance

The IMF, which has been ferocious in imposing draconian fiscal and monetary "conditionalities" on all debtor nations everywhere in the decade after the Cold War, is nowhere to be seen on the scene in the world's most fragrantly irresponsible debtor nation. This is because the US can print dollars at will and with immunity. The dollar is a fiat currency not backed by gold, not backed by US productivity, not backed by US export prowess, but backed by US military power. The US military budget request for Fiscal Year 2005 is $420.7 billion. For Fiscal Year 2004, it was $399.1 billion; for 2003, $396.1 billion; for 2002, $343.2 billion; and for 2001, $310 billion. In the first term of George W Bush's presidency, the US spent $1.5 trillion on its military. That is more than the entire gross domestic product of China in 2004. The US trade deficit is about 6% of its GDP, while it military budget is about 4%. In other words, the trading partners of the US are paying for one and a half times the cost of a military that can some day be used against any one of them for any number of reasons, including trade disputes. The anti-dollar crowd has nothing to celebrate about the recurring US trade deficit.

It is pathetic that Rumsfeld tries to persuade the world that China's military budget, which is less that one-tenth of that of the United States, is a threat to Asia, even when he is forced to acknowledge that Chinese military modernization is mostly focused on defending its coastal territories, not on force projection for distant conflicts, as is US military doctrine. While Rumsfeld urges more political freedom in China, his militant posture toward China is directly counterproductive toward that goal. Ironically, Rumsfeld chose to make his case about political freedom in Singapore, the bastion of Confucian authoritarianism.

Normally, according to free-trade theory, trade can only stay unbalanced temporarily before equilibrium is re-established or free trade would simply stop. When bilateral trade is temporarily unbalanced, it is generally because one trade partner has become temporarily uncompetitive, inefficient or unproductive. The partner with the trade deficit receives more goods and services from the partner with the trade surplus than it can offer in return and thus pays the difference with its currency that someday can buy foods produced by the deficit trade partner to re-established balance of payments. This temporary trade imbalance can be due to a number of socio-economic factors, such as terms of trade, wage levels, return on investment, regulatory regimes, shortages in labor or material or energy, trade-supporting infrastructure adequacy, purchasing power disparity, etc. A trading partner that runs a recurring trade deficit earns the reputation of being what banks call a habitual borrower, ie, a bad credit risk, one that habitually lives beyond its means. If the trade deficit is paid with its currency, a downward pressure results in the exchange rate. A flexible exchange rate seeks to remove or moderate a temporary trade imbalance while the productivity disparities between trading partners are being addressed fundamentally.

Dollar hegemony prevents US trade imbalance from returning to equilibrium through market forces. It allows a US trade deficit to persist based on monetary prowess. This translates over time into a falling exchange rate for the dollar even as dollar hegemony keeps the fall at a slow pace. But a below-par exchange rate over a long period can run the risk of turning the temporary imbalance in productivity into a permanent one. A continuously weakening currency condemns the issuing economy into a downward economic spiral. This has happened to the United States in the past decade. To make matters worse, with globalization of deregulated markets, the recurring US trade deficit is accompanied by an escalating loss of jobs in sectors sensitive to cross-border wage arbitrage, with the job-loss escalation climbing up the skill ladder. Discriminatory US immigration policies also prevent the retention of low-paying jobs within the US and exacerbate the illegal-immigration problem.

Regional wage arbitrage within the US in past decades kept its economy lean and productive internationally. Labor-intensive US industries relocated to the low-wage south of the country through regional wage arbitrage, and despite temporary adjustment pains from the loss of textile mills, the northern economies managed to upgrade their productivity, technology level, financial sophistication and output quality. The economies in the southern US also managed to upgrade these factors of production and in time managed to narrow the wage disparity within the national economy. This happened because the jobs stayed within the nation. With globalization, it is another story. Jobs are leaving the United States mercilessly. According to free-trade theory, the US trade deficit is supposed to cause the dollar to fall temporarily against the currencies of its trading partners, causing export competitiveness to rebalance, thereby removing or reducing the US trade deficit. Jobs that have been lost temporarily are then supposed to return to the US.

But the persistent US trade deficit defies trade theory because of dollar hegemony. The broad trade-weighted dollar index stays in an upward trend, despite selective appreciation of some strong currencies, as highly indebted emerging market economies attempt to extricate themselves from dollar-denominated debt through the devaluation of their currencies. While the aim is to subsidize exports, this ironically makes dollar debts more expensive in local-currency terms. The moderating impact on US price inflation also amplifies the upward trend of the trade-weighted dollar index despite persistent US expansion of monetary aggregates, also known as monetary easing or money printing.

Adjusting for this debt-driven increase in the exchange value of dollars, the import volume into the US can be estimated in relationship to expanding monetary aggregates. The annual growth of the volume of goods shipped to the United States has remained around 15% for most of the 1990s, more than five times the average annual GDP growth. The US enjoyed a booming economy when the dollar was gaining ground, and this occurred at a time when interest rates in the US were higher than those in its creditor nations. This led to the odd effect that raising interest rates actually prolonged the boom in the US rather than threatened it, because it caused massive inflows of liquidity into the US financial system, lowered import-price inflation, increased apparent productivity and prompted further spending by American consumers enriched by the wealth effect despite a slowing of wage increases. Returns on dollar assets stayed high in foreign-currency terms.

This was precisely what Greenspan did in the 1990s in the name of preemptive measures against inflation. Dollar hegemony enabled the US to print money to fight inflation, causing a debt bubble of asset appreciation. These data substantiated the view of the US as Rome in a New Roman Empire with an unending stream of imports as the free tribute from conquered lands. This was what Greenspan meant by US "financial hegemony".

The Fed Funds Rate (FFR)target has been lifted eight times in steps of 25 basis points from 1% in mid-2004 to 3% on May 3, 2005. If the same pattern of "measured pace" continues, the FFR target would be at 4.25% by the end of 2005. Despite Fed rhetoric, the lifting of dollar interest rates has more to do with preventing foreign central banks from selling dollar-denominated assets, such as US Treasuries, than with fighting inflation. In a debt-driven economy, high interest rates are themselves inflationary. Raising interest rates to fight inflation could become the monetary dog chasing its own interest-rate tail, with rising rates adding to rising inflation, which then requires more interest-rate hikes. Still, interest-rate policy is a double edged sword: it keeps funds from leaving the debt bubble, but it can also puncture the debt bubble by making the servicing of debt prohibitively expensive.

To prevent this last adverse effect, the Fed adds to the money supply, creating an unnatural condition of abundant liquidity with rising short-term interest rates, resulting in a narrowing of interest spread between short-term and long-term debts, a leading indication for inevitable recession down the road. The problem of adding to the money supply is what John Maynard Keynes called the liquidity trap, that is, an absolute preference for liquidity even at near-zero interest-rate levels. Keynes argued that either a liquidity trap or interest-insensitive investment draft could render monetary expansion ineffective in a recession. It is what is popularly called pushing on a credit string, where ample money cannot find creditworthy willing borrowers. Much of the new low-cost money tends to go to refinancing existing debt taken out at previously higher interest rates. Rising short-term interest rates, particularly at a measured pace, would not remove the liquidity trap while long-term rates stay flat because of excess liquidity.

The debt bubble in the US is clearly having problems, as evident in the bond market. With just 14 deals worth $2.9 billion, May 2005 was the slowest month for high-yield bond issuance since October 2002. The late-April downgrades of the debt of General Motors and Ford Motor to junk status roiled the bond markets. The number of high-yield, or junk-bond, deals fell 55% in the March-to-May 2005 period compared with the same three months in 2004. They were also down 45% from the December-through-February period. In dollar value, junk-bond deals totaled $17.6 billion in the March-to-May 2005 period, compared with $39.5 billion during the same three months in 2004 and $36 billion from December 2004 through February 2005. There were 407 deals of investment-grade bond underwriting during the March-to-May 2005 period, compared with 522 in the same period 2004 - a decline of 22%. In dollar volume, some $153.9 billion of high-grade bonds were underwritten from March to May 2005, compared with $165.5 billion in the same period in 2004 - a 7% decline.

Oil at $50 a barrel, along with astronomical asset-price appreciation, particularly in real estate, is giving the debt bubble additional borrowed time. But this game cannot go on forever and the end will likely be triggered by a new trade war's effect on reduced trade volume. The price of a reduced US trade deficit is the bursting of the US debt bubble, which could plunge the world economy into a new depression. Given such options, the United States has no choice but to ride the trade-deficit train for as long as the traffic will bear, which may not be too long, particularly if protectionism begins to gather force.

The transition to offshore outsourced production has been the source of the productivity boom of the "New Economy" in the US in the past decade. The productivity increase not attributable to the importing of other nations' productivity is much less impressive. While published government figures of the productivity index show a rise of nearly 70% since 1974, the actual rise is between zero and 10% in many sectors if the effect of imports is removed from the equation. The lower productivity values are consistent with the real-life experience of members of the blue-collar working class and the white-collar middle class who have been spending the equity cash-outs from the appreciated market value of their homes. World trade has become a network of cross-border arbitrage on differentials in labor availability, wages, interest rates, exchange rates, prices, saving rates, productive capacities, liquidity conditions and debt levels. In some of these areas, the US is becoming an underdeveloped economy.

The Bush administration continues to assure the US public that the state of the economy is sound while in reality the country has been losing entire sectors of its economy, such as manufacturing and information technology, to foreign producers, while at the same time selling off part of the nation to finance its rising and unending trade deficit. Usually, when unjustified confidence crosses over to fantasized hubris on the part of policymakers, disaster is not far ahead.

The Clinton legacy

To be fair, the problems of the US economy started before the administration of George W Bush. The Clinton administration's annual economic report for 2000 claimed that the longest economic expansion in US history could continue "indefinitely" as long as "we stick to sound policy", according to chairman Martin Baily of the Council of Economic Advisers (CEA) as reported in the Wall Street Journal. A New York Times report differed somewhat by quoting Baily as saying: "stick to fiscal policy." Putting the two newspaper reports together, one got the sense that the Clinton administration thought its fiscal policy was the sound policy needed to put an end to the business cycle. Economics high priests in government, unlike the rest of us mortals who are unfortunate enough to have to float in the daily turbulence of the market, can afford to focus aloofly on long-term trends and their structural congruence to macro-economic theories. Yet outside of macro-economics, "long-term" is increasingly being redefined in the real world. In the technology and communication sectors, "long-term" evokes periods lasting less than five years. For hedge funds and quant shops, long-term can mean a matter of weeks.

Two factors were identified by the Clinton CEA Year 2000 economic report as contributing to the "good" news - technology-driven productivity and neo-liberal trade globalization. Even with somewhat slower productivity and spending growth, the CEA believed the economy could continue to expand perpetually. As for the huge and growing trade deficit, the CEA expected global recovery to boost demand for US exports, not withstanding the fact that most US exports are increasingly composed of imported parts.

Yet the United States has long officially pursued a strong-dollar policy that weakens world demand for US exports. The high expectation on e-commerce was a big part of optimism, which had yet to be substantiated by data. In 2000, the CEA expected the business to business (B2B) portion of e-commerce to rise to $1.3 trillion by 2003 from $43 billion in 1998. Goldman Sachs claimed in 1999 that B2B e-commerce would reach $1.5 trillion by 2004, twice the size of the combined 1998 revenues of the US auto industry and the US telecom sector. Others were more cautious. Jupiter Research projected that companies around the globe would increase their spending on B2B e-marketplaces from US$2.6 billion in 2000 to only $137.2 billion by 2005 and spending in North America alone would grow from $2.1 billion to only $80.9 billion. North American companies accounted for 81% of the total spending in 1998, but by 2005, that figure was expected to drop to 60% of the total. The fact of the matter is that Asia and Europe are now faster growth markets for communication and technology.
Reality proved disappointing. A 2004 UN Conference on Trade and Development (UNCTAD) report said that in the United States, e-commerce between enterprises, which in 2002 represented almost 93% of all e-commerce, accounted for 16.28% of all commercial transactions between enterprises. While overall transactions between enterprises (e-commerce and non e-commerce) fell in 2002, e-commerce B2B grew at an annual rate of 6.1%. As for business-to-consumer (B2C) e-commerce, UNCTAD reported that sales in the first quarter of 2004 amounted to 1.9% of total retail sales, a proportion nearly twice as large as that recorded in 2001. The annual rate of growth of retail e-commerce in the US in the year to the end of the first quarter of 2004 was 28.1%, while the growth of total retail in the same period was only 8.8%. Dow Jones reported on May 20, 2005, that first-quarter retail e-commerce sales in the US rose 23.8% compared with the year-ago period to $19.8 billion from $16 billion, according to preliminary numbers released by the Department of Commerce. E-commerce sales during the first quarter rose 6.4% from the fourth quarter, when they were $18.6 billion. Sales for all periods are on an adjusted basis, meaning the Commerce Department adjusts them for seasonal variations and holiday and trading-day differences but not for price changes.

E-commerce sales accounted for 2.2% of total retail sales in the first quarter of 2005, when those sales were an estimated $916.9 billion, according to the Commerce Department. Wal-Mart, the low-priced retailer that imports outsourced goods from overseas, grew only 2%, indicating spending fatigue on the part of low-income US consumers, while Target Stores, the upscale retailer that also imports outsourced goods, continued to grow at 7%, indicating the effects of rising income disparity.

The CEA 2000 report did not address the question of whether e-commerce was merely a shift of commerce or a real growth. The possibility exists for the new technology to generate negative growth. It happened to IBM - the increased efficiency (lower unit cost of calculation power) of IBM big frames actually reduced overall IBM sales, and most of the profit and growth in personal computers went to Microsoft, the software company that grew on business that IBM, a self-professed hardware manufacturer, did not consider worthy of keeping for itself. The same thing happened to Intel, where in 1965 company co-founder Gordon Moore observed an exponential growth in the number of transistors per integrated circuit and predicted that this trend would continue the doubling of transistors every couple of years. But what this so-called Moore's Law did not predict was that this growth of computing power per dollar would cut into company profitability. As the market price of computer power continues to fall, the cost to producers to achieve Moore's Law has followed the opposite trend: research and development, manufacturing, and test costs have increased steadily with each new generation of chips. As the fixed cost of semiconductor production continues to increase, manufacturers must sell larger and larger quantities of chips to remain profitable. In recent years, analysts have observed a decline in the number of "design starts" at advanced process nodes. While these observations were made in the period after the year 2000 economic downturn, the decline may be evidence that the long-term global market cannot economically sustain Moore's Law. Is the Google bubble a replay of the AOL fiasco?

Joseph Alois Schumepter's creative destruction theory, while revitalizing the macro-economy with technological obsolescence in the long run, leaves real corporate bodies in its path, not just obsolete theoretical concepts. Financial intermediaries and stock exchanges face challenges from electronic communication networks (ECNs), which may well turn the likes of the New York Stock Exchange (NYSE) into sunset industries. ECNs are electronic marketplaces that bring buy/sell orders together and match them in virtual space. Today, ECNs handle roughly 25% of the volume in Nasdaq stocks. The NYSE and the Archipelago Exchange (ArcaEx) announced on April 20 that they had entered a definitive merger agreement that will lead to a combined entity, NYSE Group Inc, becoming a publicly held company. If approved by regulators, NYSE members and Archipelago shareholders, the merger will represent the largest-ever among securities exchanges and combine the world's leading equities market with the most successful totally open, fully electronic exchange. Through Archipelago, the NYSE will compete for the first time in the trading of Nasdaq -listed stocks; it will be able to indirectly capture listings business that otherwise would not qualify to list on the NYSE. Archipelago lists stocks of companies that do not meet the NYSE's listing standards.

On fiscal policy, US government spending, including social programs and defense, declined as a share of the economy during the eight years of the Clinton watch. This in no small way contributed to a polarization of both income and wealth, with visible distortions in both the demand and supply sides of the economy. This was the opposite of the Roosevelt administration's record of increasing income and wealth equality by policy. The wealth effect tied to bloated equity and real-estate markets could reverse suddenly and did in 2000, bailed out only by the Bush tax cut and the deficit spending on the "war on terrorism" after 2001. Private debt kept hitting all-time highs throughout the 1990s and was celebrated by neo-liberal economists as a positive factor. Household spending was heavily based on expected rising future earnings or paper profits, both of which might and did vanish on short notice. By election time in November 1999, the Clinton economic miracle was fizzling. The business cycle had not ended after all, and certainly not by self-aggrandizing government policies. It merely got postponed for a more severe crash later. The idea of ending the business cycle in a market economy was as much a fantasy as the assertion by the current vice president, Richard Cheney, in a speech before the Veterans of Foreign Wars in August 26, 2002, that "the Middle East expert Professor Fouad Ajami predicts that after liberation, the streets in Basra and Baghdad are sure to erupt in joy ..."

In their 1991 populist campaign for the White House, Bill Clinton and Al Gore repeatedly pointed out the obscenity of the top 1% of Americans owning 40% of the country's wealth. They also said that if you eliminated home ownership and only counted businesses, factories and offices, then the top 1% owned 90% of all commercial wealth. And the top 10%, they said, owned 99%. It was a situation they pledged to change if elected. But once in office, president Clinton and vice president Gore did nothing to redistribute wealth more equally - despite the fact that their two terms in office spanned the economic joyride of the 1990s that would eventually hurt the poor much more severely than the rich. On the contrary, economic inequality only continued to grow under the Democrats. Reagan spread the national debt equally among the people while Clinton gave all the wealth to the rich.

Rising resistance to globalization

Geopolitically, trade globalization was beginning to face complex resistance worldwide by the second term of the Clinton presidency. The momentum of resistance after Clinton would either slow further globalization or force the terms of trade to be revised. The Asian financial crises of 1997 revived economic nationalism around the world against US-led neo-liberal globalization, while the North Atlantic Treaty Organization (NATO) attack on Yugoslavia in 1999 revived militarism in the EU. Market fundamentalism as espoused by the United States, far from being a valid science universally, was increasingly viewed by the rest of the world as merely US national ideology, unsupported even by US historical conditions. Just as anti-Napoleonic internationalism was in essence anti-French, anti-globalization and anti-moral-imperialism are in essence anti-US. US unilateralism and exceptionalism became the midwife for a new revival of political and economic nationalism everywhere. The Bush Doctrine of monopolistic nuclear posture, preemptive wars, "either with us or against us" extremism, and no compromise with states that allegedly support terrorism pours gasoline on the smoldering fire of defensive nationalism everywhere.

Alan Greenspan in his October 29, 1997, congressional testimony on "Turbulence in World Financial Markets" before the Joint Economic Committee said that "it is quite conceivable that a few years hence we will look back at this episode [Asian financial crisis of 1997] ... as a salutary event in terms of its implications for the macro-economy". When one is focused only on the big picture, details do not make much of a difference: the Earth always appears more or less round from space, despite that some people on it spend their whole lives starving and cities get destroyed by war or natural disasters. That is the problem with macro-economics. As Greenspan spoke, many around the world were waking up to the realization that the turbulence in their own financial markets was viewed by the US central banker as having a "salutary effect" on the US macro-economy. Greenspan gave anti-US sentiments and monetary trade protectionism held by participants in these financial markets a solid basis and they were no longer accused of being mere paranoia.

Ironically, after the end of the Cold War, market capitalism has emerged as the most fervent force for revolutionary change. Finance capitalism became inherently democratic once the bulk of capital began to come from the pension assets of workers, despite widening income and wealth disparity. The monetary value of US pension funds is more than $15 trillion, the bulk of which belongs to average workers. A new form of social capitalism emerged that would gladly eliminate the worker's job in order to give him or her a higher return on his or her pension account. The capitalist in the individual is exploiting the worker in the same individual. A conflict of interest arises between a worker's savings and his or her earnings. As Pogo used to say: "The enemy: they are us." This social capitalism, by favoring return on capital over compensation for labor, produces overinvestment, resulting in overcapacity. But the problem of overcapacity can only be solved by high-income consumers. Unemployment and underemployment in an economy of overcapacity decrease demand, leading to financial collapse. The world economy needs low wages the way the cattle business needs foot-and-mouth disease.

The nomenclature of neo-classical economics reflects, and in turn dictates, the warped logic of the economic system it produces. Terms such as money, capital, labor, debt, interest, profits, employment, market, etc have been conceptualized to describe synthetic components of an artificial material system created by the power politics of greed. It is the capitalist greed in the worker that causes the loss of his or her job to lower-wage earners overseas. The concept of the economic man who presumably always acts in his self-interest is a gross abstraction based on the flawed assumption of market participants acting with perfect and equal information and clear understanding of the implication of his actions. The pervasive use of these terms over time disguises the artificial system as the logical product of natural laws, rather than the conceptual components of the power politics of greed.

Just as monarchism first emerged as a progressive force against feudalism by rationalizing itself as a natural law of politics and eventually brought about its own demise by betraying its progressive mandate, social capitalism today places return on capital above not only the worker but also the welfare of the owner of capital. The class struggle has been internalized within each worker. As people facing the hard choice of survival in the present versus well-being in the future, they will always choose survival, and social capitalism will inevitably go the way of absolute monarchism, and make way for humanist socialism.

............. TO BE CONTINUED .................

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If you prick us, do we not bleed?
If you tickle us, do we not laugh?
If you poison us, do we not die?
And if you wrong us, shall we not revenge?"

William Shakespeare, "The Merchant of Venice

[B]Wages and profits[/B]

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.

[B]Sovereign credit and dollar hegemony[/B]

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.

[B]Fiat money is sovereign credit[/B]

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.

[B]Money and inflation[/B]

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.

[B]Money and gold[/B]

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