The primary reason for the ineffectiveness of aggressive monetary response to induce economic recovery is that the large quantity of new money created by central banks has been channeled into a global banking system terminally infested with a fatal financial virus in the form of a gigantic debt bubble. The world’s central banks all belong to a powerful ideological fraternity that subscribes to the group-think of bankrupt doctrines of monetarism promoted by the US Federal Reserve.

Since the onset of the 2008 credit crisis, central banks have morphed from their original role of being lenders of last resort to prevent cyclical panic bank runs from turning into a systemic crisis of no confidence in the financial system under their separate jurisdiction, to a new controversial role of being market-makers of last resort in a hopelessly dysfunctional economic world order infested with an extreme case of financial moral hazard and an unstable financial market structure flooded with unmarketable troubled assets left by a collapsed giant price bubble created earlier by excessive debt made available by misguided central bank monetary laxative.

The world’s under-capitalized, debt-infested, essentially insolvent  commercial banks of systemic significance have used the new, basically cost-free money from central banks to avoid insolvency through deleverage - unloading at face value their large holdings of overpriced illiquid troubled asset with fallen market value onto the balance sheets of central banks that have unlimited power to create money out of thin air to drop as if from helicopters, not on the economy at large as needed, but into the under-funded reserve accounts these insolvent banks are required to keep at the electronic vaults of central banks.

Thus central bank quantitative easing (QE) programs have not provided macroeconomic stimulus and liquidity to the needy productive sectors of the economy to kick start and accelerate economic recovery from a debt-induced recession by moving the ailing economy towards full employment with living wages to boost necessary consumer demand to soak up the excess productive capacity that had been financed by excess debt over past decades.

Instead, central bank QE measures have merely bailed out the under-capitalized, insolvent banks from their heavily discounted debt overload, leaving overcapacity in the economy in a worse state by default. This overcapacity is exacerbated by central bank insistence on a balanced government fiscal budget not from revenue growth in a robust economy but by austerity fiscal measures to further dampen demand.  

The now more than five-years-old global recession caused by the financial crisis that first broke out in earnest in 2008 after an abrupt seizure of credit markets in mid 2007, triggered a new tradition of Group of Twenty (G20) Leaders Summits which was initiated on November 14-15, 2008 by outgoing US President George W Bush (Republican) near the end of his second and final term, ten days after Barack Obama (Democrat) won the 2008 presidential election to become President Elect, to be inaugurated two-and-a-half months later on January 20, 2009.

 
The first G20 Leaders Summit on Financial Markets and the World Economy called by the White House tried to forge a coordinated global response by separate sovereign nations to an impending melt-down of the world financial system and to revive the seriously impaired world economy. The financial crisis elevated the G20 from a perfunctory debating society between rich and poor countries to a recognized international institution of real promise, albeit by default.

 
On the occasion of the First G20 Leaders Summit of 2008, Paul Davidson and I co-authored an Open Letter to World Leaders dated November 7, a week before the White House meeting. The Open Letter was co-signed by a large number of other supportive economists worldwide. The Open Letter recommended a new international financial architecture based on an updated 21st century version of the Keynes Plan originally proposed at Bretton Woods in 1944.

For an economy subject to business cycles, the lower the present rate of interest, the larger, ceteris paribus, would be a future rise, the larger the expected capital loss on securities, and the higher, therefore, the preference for liquid cash balances. As an extreme possibility, Keynes envisaged the case in which even the smallest decline in interest rates would produce a sizable switch into cash balances, which would make the demand curve for cash balances virtually horizontal. This limiting case became known as a liquidity trap.

In his two-asset world of cash and government bonds, Keynes argues that a liquidity trap would arise if market participants believed that interest rates had bottomed out at a “critical” interest rate level, and that rates should subsequently rise, leading to capital losses on bond holdings.  The inelasticity of interest rate expectations at a critical rate would imply that the demand for money would become highly or perfectly elastic at this point, implying both a horizontal money-demand function and LM (liquidity preference/money supply) curve. 

The monetary authority, then, would not be able to reduce interest rates below the critical rate, as any subsequent monetary expansion would lead investors to increase their demand for liquidity and become net sellers of government bonds. Money-demand growth, then, should accelerate when interest rates reach the critical level. Of course, Keynes did not anticipate that central banks would resort to as unconventional measures as quantitative easing to buy up all the government bonds the market participants would sell.

Keynes argued that there were three reasons why market participants hold money. They hold cash for pending transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money market participants would want to hold should be inversely related to the rate of interest. Market participants will want to hold more money (liquidity) when interest rates are low than when they are higher, despite a loss of interest income.

Keynes’ introduction of interest rate into the demand for money has survived in modern finance, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss except under hyperinflation in which there would be a loss of purchasing power; and bonds, which earned interest but which were not as liquid and which has a risk of capital loss. If one thinks not in terms of a two-asset world, but in terms of the range of assets which actually exist in the current financial world, there is no reason to hold cash balances for either precautionary or speculative purposes. These are assets that are both very liquid and interest bearing, such as money market accounts and Treasury bills, plus all forms of options in structured finance.

Though Keynes’ two-asset-class explanation of why interest rates influence the demand for money is outdated by developments, his other explanations are still sound. Money held for transactions purposes is much like inventory which businesses hold. A rise in interest rates will decrease the optimal amount of money as inventory, and a rise in the cost of re-monetizing will increase the optimal amount. Modern management has introduced just-in-time inventory which renders this argument mute. Most chief financial officers have also perfected just-in-time cash management schemes. The exception is that holders of money can live on it, which is not true for holders of most other inventories.

This new international financial architecture proposed in the Open Letter will aim to create:
1) a new global monetary regime that operates without national currency hegemony, 2) global trade relationships that support rather than retard domestic development and 3) a global economic environment that provides incentives for each and every nation to promote full employment and rising wages for its labor force.

At that first G20 Leaders Summit hosted by out-going US President George Bush in 2008, leaders of member sovereign states agreed to a hastily drafted action plan based on orthodox macroeconomic doctrines to try to stabilize the precarious global market economy and to prevent recurrent crises in the future, resulting in the premier international forum that acquired its current name and significance.

G20 leaders in 2008 reached general agreement on cooperation in key areas to strengthen sustainable economic growth, and to deal with the on-going global financial crisis that had first broken out in New York in mid 2007. with focus on three key objectives: 1) Restoring global economic growth through globalized free trade; 2) Strengthening the international financial system of global market capitalism; 3) Reforming supranational financial institutions to give more voice to the emerging economy countries.

Objectives 1 and 2 were emergency Band-Aid solutions to deal with the painful symptoms but not the dilapidating disease of dysfunctional economic interactions that had caused the current financial crisis.

Neoliberal globalization has promoted the myth that the current terms of international trade lead to win-win transactions for all participating nations, based on a panglossian distortion of the Ricardian notion of comparative advantage, win-win transactions in international trade. In recent decades, international trade has been conducted primarily through cross-border wage arbitrage, driving down wages in both advanced and developing economies. Around the world, unemployment has been the weapon of choice with which to fight inflation induced by continuous central bank monetary easing.

Yet without global full employment with rising wages, Ricardian comparative advantage is merely Say’s Law internationalized. Say’s Law states that “supply creates its own demand”, but only under full employment, a pre-condition supply-siders conveniently ignore.

After two decades of substituting wage increases with consumer debt in order to maximize return on capital by tilting the distributional balance between capital and labor against labor to the benefit of capital, and the detriment of demand, overlooking the structural wage-price dynamics of Fordism that built the US middle class, this win-win illusion of comparative advantage in international trade without the prerequisite of global full employment with rising wages has been shattered by concrete data: relative poverty has increased worldwide and global wages, already low to begin with, have declined since the Asian financial crisis of 1997, and by 45% in some emerging market economies, such as that of Indonesia. As wages failed to grow, demand was kept high by debt unsustainable by low wages.

Under dollar hegemony, export to US markets is merely an arrangement in which the exporting economies, in order to earn dollars to buy needed commodities denominated in dollars and to service dollar loans and  direct investments, are forced to finance the US consumption beyond the level supported by US wages, and by the need to invest their trade surplus dollars in dollar assets as foreign-exchange reserves, giving the US a rising capital account surplus to finance its rising current account deficit.

Furthermore, the trade surpluses are achieved not by any advantage in the terms of trade, but by sheer self-denial of basic domestic needs and critical imports necessary for domestic development. Not only are the exporting nations debasing the market value of their labor and the exchange value of their currencies, degrading their environment and depleting their natural resources for the privilege of running on the poverty treadmill, they are enriching the dollar economy and strengthening dollar hegemony in the process, and causing harm also to the US economy.

Thus the exporting nations allow themselves to be robbed of needed capital for critical domestic development in such vital areas as education, health and other social infrastructure, by assuming heavy debt denominated in foreign currencies to finance export, while they beg for even more foreign investment in the export sector by offering still more exorbitant returns, lower wages and generous tax exemptions, putting increased social burden on the underdeveloped domestic economy. Yet many small economies around the world have no option but to continue to serve dollar hegemony like a drug addiction by hoping to develop their domestic economies through export.

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

Japan has seen its sovereign credit rating lowered by international rating agencies while it remains the world’s biggest creditor nation unless China overtook it in that dubious honor in a few more years. Moody’s Investor Service downgraded Japanese government bonds (JGB) by two notches in 2004 to A2, or one grade below Botswana’s, not to mention Chile and Hungary. Japan in 2004 had the world’s largest foreign-exchange reserves: $819 billion in July 2004; the world’s biggest domestic savings: $11.4 trillion (US gross domestic product was $11 trillion in 2003); and $1 trillion in overseas investment. And 95% of its sovereign debt is held by Japanese nationals, which rules out risk of default similar to Argentina, or any eurozone country. Japan has given Botswana, where half of the population is infected with the AIDS virus, $12 million in grants and $102 million in loans.

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

The Asia-Pacific trading system has been structured to serve markets outside of Asia by providing low-wage manufacturing and extracting natural resources at high environmental abuse to service US markets paid in dollars. This enables the US to consume more without high inflation and more than depressed domestic wages can afford. The bulk of the trade surpluses accumulated by the Asian economies have ended up financing the US debt bubble, which is not even good for the US economy in the long run as events since mid-2007 have demonstrated.

Low-price imports made by outsourcing to low-wage economies allow the US to keep domestic wages low without dampening consumer demand. Low wages in the US are compensated by high consumer debt to keep demand high.

These terms of international trade contribute to a rising disparity of both income and wealth around the world and within the US where purchasing power comes increasingly from debt-supported spending. High return on capital is achieved by cross-border wage arbitrage to reward investment offshore, while keeping domestic wages from rising. The result is that when the equity bubble of inflated price-earning ratio finally bursts, wages are too low to keep the economy from crashing from a collapse of the wealth effect of the asset price bubble.

After continuously impoverishing the Asian economies by unregulated financial manipulation of crisis proportions masked as innovative “creative destruction”, dollar hegemony now works to penetrate the remaining Asian markets that have stayed relatively closed: notably domestic market in Japan, China and South Korea. Control of foreign access to its emerging markets has been Asia’s principal defensive strategy for its sub-optimized trade advantage based on low wages, high pollution and distorted low-tech, labor-intensive industrial development. This strategy had been practiced successfully first by Japan and copied in various degree of success by the Asian Tigers.

Economic nationalism, which neoliberals label derogatorily as protectionism, has been  rising in many Asian economies long after formal accession by these economies to the World Trade Organization (WTO), particularly in the finance sector. Once free from dollar hegemony, China will be able to finance its domestic development without depending on foreign loans or capital. The Chinese economy will then no longer be distorted by excessive reliance on export merely to earn dollars that by definition must be invested in dollar assets, not yuan assets. The more dollars the Chinese export sector earns, the more will China become a financial colony of dollar hegemony.

The aim of development is to raise wage levels, not to push wages down to achieve predatory export competitiveness. Yet export under dollar hegemony requires the export sector to keep wages low, a prerequisite that condemns an economy to perpetual underdevelopment. Terms such as “openness” need to be reconsidered away from the distorted meanings assigned to them by neoliberal cultural hegemony. The contradiction between globalizing and territory-based national social and political forces is framed in the context of past, present and future world orders.

 
Globalization is not a new trend. It is the natural policy for all empire building. Globalization under modern capitalism began with the British Empire, marked by the repeal of the Corn Laws in 1846, five years after Britain’s Opium War with China, and two years before the Revolutions of 1848. Great Britain embarked on a systemic promotion of free trade beginning around the mid 19th century and chose to depend on imported food to free up resources and energy for international trade. This national choice provided a survivalist justification to economic empire.

France adopted free trade in 1860 and within 10 years was faced with the revolutionary Paris Commune, which was suppressed ruthlessly by the French bourgeoisie, who put to death 20,000 workers and peasants, including children.

Despite a backlash movement toward protective tariffs in Britain, Holland and Belgium, the global economy of the 19th century was characterized by high mobility of goods across political borders. As Europe adopted political nationalism, international economic liberalism developed in parallel, until 1914. World War I, the 1929 Depression and World War II caused a temporary halt of free trade. 

The US “Open Door” policy for pre-revolutionary China, proclaimed by John Hay in 1899, was part of a globalization scheme to preserve US commercial interests by preventing the partition of China into spheres of influence by European powers and Japan, after the US became a late-comer Far Eastern power through the acquisition of the Philippines after the Spanish-American War in the 1898 Treaty of Paris. The Open Door policy was rooted in the “most-favored-nation” clause in the unequal treaties imposed on China by Western imperialist powers.

Like the United States now, Britain, the predominant economic power in the 19th century, was a predominantly importing economy by the close of the 18th century. Despite the Industrial Revolution’s expanded export of manufacturing goods, British import of raw material, food and consumer amenities grew faster in value than export of manufacturing goods and coal. The key factor that sustained this trade imbalance was the predominance of the British pound, as it is today with the US dollar and its effect on trade finance.

British hegemony of sea transportation and financial services (cross-currency trade finance and insurance) earned Britain vast amounts of foreign currencies that could be sold in the London money markets to importers of Argentine meat, Canadian bacon and Chinese tea and silk. International credit and capital markets were centered in London. British export of financial services and capital produced factor income that served as hidden surplus to cushion the trade deficit. To enhance financial hegemony, the British maintain separate dependent currencies in all parts of the empire under pound-sterling hegemony. Currencies of the colonies were pegged to the pound-sterling at fixed exchange rates, depriving the colonies of the prerogative of sovereign credit.

This financial hegemony is now centered on New York with the dollar as the reserve currency. When the Asian tigers export to the United States, all they get in return are US Treasury bills and corporate bonds, not money they can spend in their domestic economy. Asian labor in fact is working at low wages, the “surplus value” of which go mainly to finance the expansion of the global dollar economy, not their own domestic economies.

Market fundamentalism, a modern euphemism of capitalism, is thus made necessary by the finance architecture imposed on the world by the hegemonic financial power, first 19th-century Great Britain, now the United States.

When the developing economies call for a new international finance architecture, this is what they are really driving at. Foreign-exchange markets ensure that the endless demand for dollar capital by the poor exporting nations will never be fully met. British economist John A Hobson identified the surplus of capital in the core economies and the need for its export to the impoverished parts of the world as the material basis of imperialism. For neo-imperialism of the 21st century, this remains fundamentally true.

Then as now, the international economy rested on an international money system. Britain adopted the gold standard in 1816, with Europe and the US following in the 1870s. Until 1914, the exchange rates of most currencies were highly stable, except in victimized, semi-colonial economies such as Turkey and China. The gold standard, while greatly facilitating free trade, was hard on economies that produced no gold, and the gold-based monetary regime was generally deflationary (until the discovery of new gold deposits in South Africa, California and Alaska), which favored capital.

William Jenning Bryan spoke for the world in 1896 when he declared that mankind should not be “crucified upon this cross of gold”. But the 50-year lead time of the British gold standard firmly established London as the world’s financial center. The world’s capital was drawn to London to be redistributed to investments of the highest return around the world. Borrowers around the world were reduced to playing a game of “race to the bottom” to compete for capital.

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

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

This process increased the power of banks and other financial institutions and brought forth finance capitalism as the new core of the economy. Cartels and trusts emerged, using vertical and horizontal integration to eliminate competition and to manipulate markets and prices for entire sectors of the economy.

Middle-class membership was mainly concentrated in salaried management workers of corporations, while working class members were hourly wage earners in factories. The 1848 Revolutions were the first proletariat revolutions in modern time. This was the time when Marx and Engle wrote the Communist Manifesto. The creation of an integrated world market, the financing and development of economies outside of Europe and the rising standards of living for Europeans were triumphs of the 19th-century system of unregulated capitalism. In the 20th century, the process continued, with the center shifting to the US after two world wars.

Friedrich List, in his National System of Political Economy (1841), asserted that political economy as espoused in England at that time, far from being a valid science universally, was merely British national opinion, suited only to English historical conditions. List’s institutional school of economics asserted that the doctrine of free trade was devised to keep England rich and powerful at the expense of its trading partners and that it had to be fought with protective tariffs and other devices of economic nationalism by the weaker countries.

List’s economic nationalism influenced Asian leaders, including Sun Yatsen of China, who proposed industrial policies financed with sovereign credit. List was also the influence behind the Meiji Reform Movement of 1868 in Japan.  Alexander Hamilton, by proposing the US Treasury using tax revenue to assume and pay off all public debts incurred by the Confederation in his 1791 Report on Public Debt, through the establishment of a national bank, provided the new nation with sovereign credit in the form of paper money for development.

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

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

Yet neoliberals policy makers in developing economies continue to ignore the insights of Friedrich List on the limitation of international trade as a venue for national development, thus denying their domestic economy the benefits of using sovereign credit instead of foreign capital.

Next: G20 as the Prime Forum for International Cooperation

(Please see September 2004 series: Liberating Sovereign Credit for Domestic Development - written three years before the global market meltdown in July 2007)

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