The Coming Trade War and Global Depression

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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 GreatDepression. 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, recovere

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-Hawletariffs, 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, Hawaion 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 worlwhere 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 isbeing 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-liberaltrade, 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 theirefforts 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 ideologblocs 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 inthe Third World. The competition between the two superpowers was to give rather than to take from the

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-Co

War globalized neo-liberal trade dominated by one single superpower. The aim was not only to raiseincome and increase wealth, but also to close income and wealth disparity between and within economie

Today, income and wealth disparity is rationalized as a necessity for capital formation. The New York Timreports 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 o

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 risingeconomic 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 richeconomies, 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

Malik Rizwan Yasin CSS Notes 0300-9289949






not free. Whenever the US pronounces a nation to be not free, that nation will become less free as a resuof 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 freedomsinevitably 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 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 mountin

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 ofthe 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 associatedwith 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 toretaliate. The US could put tariffs on other European goods if the WTO rules against Airbus and vice vers

So if both governments are found in breach, both could retaliate, leading to a cycle of offensiveprotectionism. When the US was ruled to have unfairly supported its steel industry, tariffs were slapped b

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 economicinterests 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 andChina 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 economieAustralian 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 itsclose 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-airmissiles 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 incompetition with Russian-made Sukhoi Su-30s and Swedish JAS-39s. The open competition in arms expo

had been spelled out for the US Congress years earlier by Donald Hicks, a leading Pentagon technologist

the administration of president Ronald Reagan. "Globalization is not a policy option, but a fact to whichpolicymakers 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 USsoldiers 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 148member 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 welfar

of the people is viewed only as a collateral aim based on the doctrinal fantasy that "balanced" tradeinevitably 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 betweenations. Free trade has turned out not to be the win-win game promised by neo-liberals. It is very much

win-lose game, with heads, the rich economies win, and tails, the poor economies lose. Domesticdevelopment 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 domesticdevelopment. 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 tradeearnings 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 decimatedThird World agriculture. Failure to get the Doha Round back on track after the collapse of Cancun runs th

danger of a global resurgence of protectionism, with the US leading the way. Larry Elliott reported onOctober 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. Thereality 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 oback." 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 wagearbitrage. 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 gainerelatively little from increased manufactures trade, with most of the profit going to foreign capital. Marke

access for their most competitive manufactured export, such as textiles and apparel, remains highlyrestricted, and recent trade disputes threaten further restrictions. Still, the key cause of unemployment i

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 predominantlyagriculturally 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 understanbetter 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 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 througthe death of half of the poor by starvation, disease and local conflicts. The UN Development Programwarns 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 supposedlie 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-economicdevelopment 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 wiof 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 regimeoperating in a deregulated global foreign-exchange market, the exchanged value of a currency is regular

used to balance trade through government intervention in currency-market fluctuations against the worldmain 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. PPPcontrasts 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 thepurchasing 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 whe

there are no transportation costs and no differential taxes applied in the two markets. But the law of oneprice 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 highestprice 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 increasesits 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 Chineseeconomy 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 hegemonyon 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 deficithat 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 atthe 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 preventthem 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 wasconceived 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 ha

changed from a gold-backed currency to a global reserve monetary instrument that the US, and only theUS, 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 marketsmany 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 theffect 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 theworld 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 ontheir currencies in deregulated markets, the world's central banks must acquire and hold dollar reserves





corresponding amounts to market pressure on their currencies in circulation. The higher the marketpressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creat

a built-in support for a strong dollar that in turn forces all central banks to acquire and hold more dollarreserves, 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 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

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 USinflation low through low-cost imports and it makes US assets denominated in dollars expensive for foreig

investors. This arrangement, which Federal Reserve Board chairman Alan Greenspan proudly calls USfinancial hegemony in congressional testimony, has kept the US economy booming in the face of recurren

financial crises in the rest of the world. It has distorted globalization into a "race to the bottom" process oexploiting 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 goldsince 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 exportsand 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 actas 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 Uequity 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 Statesimpacts 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 unrecently 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 owncurrencies 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, ait 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 bee

pegged to the dollar for more than a decade. How can a nation manipulate the exchange value of itscurrency 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 January1, 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 recordshows 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 subordinatedcurrency 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 theUnited 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 thedollar 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 foradjustment 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 aChristian 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 derivedfrom, Jewish Talmudic law, particularly on the concept of equity - an eye for an eye. The Jews had devise

a legal system based on the dignity of the individual and equality before the law four centuries beforeChrist. There was no written Roman law until two centuries before Christ. The Roman law of obligatio wa

not conducive to finance as it held that all indebtedness was personal, without institutional status. Acreditor 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 hato 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 andmany cultures.

The Romans were faced with a dilemma. Secular Jewish ideas and values were permeating Roman societ

but Judaism was an exclusive religion that the Romans were not permitted to join. The Romans could notassimilate the Jews as they did the Greeks. Early Christianity also kept its exclusionary trait until Paul, w

opened Christianity to all. Historian Edward Gibbon (1737-94) noted that Rome recognized the Jews as anation 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 dropout

refused responsibility in government and civic affairs and were conscientious objectors and pacifists in amilitant 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 againstpagans, 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 anbegan 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 theirown 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 he

by early Christianity for centralized government gave rise to monasticism and contributed to the fall of thRoman Empire.

By allowing a trade surplus denominated in dollars to be accumulated by non-dollar economies such as tyen, 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 securitytraditional 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 prinat 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 andwith immunity. The dollar is a fiat currency not backed by gold, not backed by US productivity, not backe

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 UStrade 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 usedagainst 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 thatone-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 forceprojection 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 ire-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 buyfoods 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-supportinginfrastructure 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 thathabitually lives beyond its means. If the trade deficit is paid with its currency, a downward pressure resu

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. Itallows 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-parexchange rate over a long period can run the risk of turning the temporary imbalance in productivity into

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, withglobalization of deregulated markets, the recurring US trade deficit is accompanied by an escalating loss 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 USand 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 throughregional 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 andoutput 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 becausethe jobs stayed within the nation. With globalization, it is another story. Jobs are leaving the United State

mercilessly. According to free-trade theory, the US trade deficit is supposed to cause the dollar to falltemporarily 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 suppose

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 ironicallymakes 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 ca

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 tim

the average annual GDP growth. The US enjoyed a booming economy when the dollar was gaining grounand 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 thanthreatened 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 consumersenriched 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 inflatioDollar 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 anunending stream of imports as the free tribute from conquered lands. This was what Greenspan meant b

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 beat 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 wit

fighting inflation. In a debt-driven economy, high interest rates are themselves inflationary. Raisinginterest 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-ratepolicy 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 betweeshort-term and long-term debts, a leading indication for inevitable recession down the road. The problemof 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 ointerest-insensitive investment draft could render monetary expansion ineffective in a recession. It is wha

is popularly called pushing on a credit string, where ample money cannot find creditworthy willingborrowers. 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, wouldnot 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. Thlate-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 periodcompared 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 2004through 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 betriggered 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. Givensuch 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 "NeEconomy" in the US in the past decade. The productivity increase not attributable to the importing of oth

nations' productivity is much less impressive. While published government figures of the productivity indeshow 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 realife 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 hasbecome 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 othese 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 i

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 risingand 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 inUS history could continue "indefinitely" as long as "we stick to sound policy", according to chairman Mart

Baily of the Council of Economic Advisers (CEA) as reported in the Wall Street Journal. A New York Timesreport 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 restof us mortals who are unfortunate enough to have to float in the daily turbulence of the market, can affoto 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 thetechnology and communication sectors, "long-term" evokes periods lasting less than five years. For hedg

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. Afor 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 USexports. 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 aut

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 in2000 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 by2005, that figure was expected to drop to 60% of the total. The fact of the matter is that Asia and Europ

are now faster growth markets for communication and technology.Reality proved disappointing. A 2004 UN Conference on Trade and Development (UNCTAD) report said th

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 grewat 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 asthat recorded in 2001. The annual rate of growth of retail e-commerce in the US in the year to the end o

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 numbersreleased 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 theCommerce 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 saleswere 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 outsourcedgoods, 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 framesactually 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 manufacturedid 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 integratedcircuit 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 toproducers 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 co

of semiconductor production continues to increase, manufacturers must sell larger and larger quantities ochips 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 2000economic 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 withtechnological 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 electroniccommunication 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 matchthem in virtual space. Today, ECNs handle roughly 25% of the volume in Nasdaq stocks. The NYSE and th

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 firstime 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 thNYSE'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 polarizatioof 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 bpolicy. 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 earningor 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 byself-aggrandizing government policies. It merely got postponed for a more severe crash later. The idea o

ending the business cycle in a market economy was as much a fantasy as the assertion by the current vipresident, 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 Baghdadare 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% owned90% of all commercial wealth. And the top 10%, they said, owned 99%. It was a situation they pledged t

change if elected. But once in office, president Clinton and vice president Gore did nothing to redistributewealth 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 amongthe 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 econominationalism around the world against US-led neo-liberal globalization, while the North Atlantic TreatyOrganization (NATO) attack on Yugoslavia in 1999 revived militarism in the EU. Market fundamentalism a

espoused by the United States, far from being a valid science universally, was increasingly viewed by therest 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-imperialismare 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 FinancialMarkets" before the Joint Economic Committee said that "it is quite conceivable that a few years hence w

will look back at this episode [Asian financial crisis of 1997] ... as a salutary event in terms of itsimplications 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 theproblem 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 monetarytrade 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 forrevolutionary 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 monetaryvalue 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 hea higher return on his or her pension account. The capitalist in the individual is exploiting the worker in t

same individual. A conflict of interest arises between a worker's savings and his or her earnings. As Pogoused 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 lowwages 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 oher job to lower-wage earners overseas. The concept of the economic man who presumably always acts

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 useof 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 mandatesocial 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 hardchoice 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 socialismDollar hegemony against sovereign credit

Global trade has forced all countries to adopt a market economy. Yet the market is not the economy. It isonly one aspect of the economy.

A market economy can be viewed as an aberration of human civilization, as economist Karl Polanyi (18861964) pointed out. The principal theme of Polanyi's Origins of Our Time: The Great Transformation (1945

was that market economy was of very recent origin and had emerged fully formed only as recently as the19th century, in conjunction with capitalistic industrialization. The current globalization of markets that

followed the fall of the Soviet bloc is also of recent post-Cold War origin, in conjunction with the advent othe electronic information age and deregulated finance capitalism. A severe and prolonged depression





could trigger the end of the market economy, when intelligent human beings are finally faced with therealization that the business cycle inherent in the market economy cannot be regulated sufficiently to

prevent its innate destructiveness to human welfare and are forced to seek new economic arrangementsfor human development. The principle of diminishing returns will lead people to reject the market

economy, however sophisticatedly regulated.

Prior to the coming of capitalistic industrialization, the market played only a minor part in the economic li

of societies. Even where marketplaces could be seen to be operating, they were peripheral to the maineconomic organization and activities of society. In many pre-industrial economies, markets met only twic

a month. Polanyi argued that in modern market economies, the needs of the market determined social

behavior, whereas in pre-industrial and primitive economies the needs of society determined marketbehavior. Polanyi reintroduced to economics the concepts of reciprocity and redistribution in human

interaction, which were the original aims of trade.

Reciprocity implies that people produce the goods and services they are best at and enjoy producing themost, and share them with others with joy. This is reciprocated by others who are good at and enjoy

producing other goods and services. There is an unspoken agreement that all would produce that whichthey could do best and mutually share and share alike, not just sold to the highest bidder or, worse, to

produce what they despise to meet the demands of the market. The idea of sweatshops is totallyunnatural to human dignity and uneconomic to human welfare. With reciprocity, there is no need for laye

of management, because workers happily practice their livelihoods and need no coercive supervision.Labor is not forced and workers do not merely sell their time in jobs they hate, unrelated to their inner

callings. Prices are not fixed but vary according to what different buyers with different circumstances canafford or what the seller needs in return from different buyers. The law of one price is inhumane,

unnatural, inflexible and unfair. All workers find their separate personal fulfillment in different productivelivelihoods of their choosing, without distortion by the need for money. The motivation to produce and

share is not personal profit, but personal fulfillment, and avoidance of public contempt, communalostracism, and loss of social prestige and moral standing.

This motivation, albeit distorted today by the dominance of money, is still fundamental in societies

operating under finance capitalism. But in a money society, the emphasis is on accumulating the mostfinancial wealth, which is accorded the highest social prestige. The annual report on the world's richest

100 as celebrities by Forbes is clear evidence of this anomaly. The opinions of figures such as Bill Gates

and Warren Buffet are regularly sought by the media on matters beyond finance, as if the possession of money itself represents a diploma of wisdom. In the 1960s, wealth was an embarrassment among the

flower children in the US. It was only in the 1980s that the age of greed emerged to embracecommercialism.

In a speech on June 3 at the Take Back America conference in Washington, DC, Bill Moyers drew attentioto the conclusion by the editors of The Economist, all friends of business and advocates of capitalism and

free markets, that "the United States risks calcifying into a European-style class-based society". A front-page editorial in the May 13 Wall Street Journal concluded that "as the gap between rich and poor has

widened since 1970, the odds that a child born in poverty will climb to wealth - or that a rich child will fainto middle class - remain stuck ... Despite the widespread belief that the US remains a more mobile

society than Europe, economists and sociologists say that in recent decades the typical child starting out

poverty in continental Europe (or in Canada) has had a better chance at prosperity." The New York Timesran a 12-day series this month under the heading "Class Matters" that observed that class is closely tiedto money in the US and that "the movement of families up and down the economic ladder is the promise

that lies at the heart of the American dream. But it does not seem to be happening quite as often as itused to." The myth that free markets spread equality seems to be facing a challenge in the heart of

market fundamentalism.

People trade to compensate for deficiencies in their current state of development. Free trade is not alicense for exploitation. Exploitation is slavery, not trade. Imperialism is exploitation by systemic coercion





on an international level. Neo-imperialism after the end of the Cold War takes the form of neo-liberalglobalization of systemic coercion. Free trade is hampered by systemic coercion. Resistance to systemic

coercion is not to be confused with protectionism. To participate in free trade, a trader must havesomething with which to trade voluntarily in a market free of systemic coercion. All free trade participant

need to have basic pricing power that requires that no one else commands monopolistic pricing power.That tradable something comes from development, which is a process of self-betterment. Just as equality

before the law is a prerequisite for justice, equality in pricing power in the market is a prerequisite for fre

trade. Traders need basic pricing power for trade to be free. Workers need pricing power for the value of their labor to participate in free trade.

Yet trade in a market economy by definition is a game to acquire overwhelming pricing power over one'strading partners. Wal-Mart, for example, has enormous pricing power both as a bulk buyer and as a mass

retailer. But it uses its overwhelming pricing power not to pay the highest wages to workers in factoriesand in its stores, but to deliver the lowest price to its customers. The business model of Wal-Mart, whose

sales volume is greater than the gross domestic product (GDP) of many small countries, is anti-development. The trade-off between low income and low retail price follows a downward spiral. This

downward spiral has been the main defect of trade deregulation when low prices are achieved through thlowering of wages. The economic purpose of development is to raise income, not merely to lower wages

reduce expenses by lowering quality. International trade cannot be a substitute for domestic developmenor even international development, although it can contribute to both domestic and international

development if it is conducted on an equal basis for the mutual benefit of both trading partners. And thechief benefit is higher income.

The terms of international trade need to take into consideration local conditions, not as a reluctant

tolerance but with respect for diversity. The former Japanese vice finance minister for international affairsEisuke Sakakibara, in a speech titled "The End of Market Fundamentalism" before the Foreign

Correspondent's Club in Tokyo on January 22, 1999, presented a coherent and wide-ranging critique of global macro-orthodoxy. His view, that each national economic system must conform to agreed

international trade rules and regulations but need not assimilate the domestic rules and regulations of another country, is heresy to US-led, one-size-fits-all globalization. In a computerized world where outpu

standardization has become unnecessary, where the mass production of customized one-of-a-kindproducts is routine, one-size-fits-all hegemony is nothing more than cultural imperialism. In a world of

sovereign states, domestic development must take precedence over international trade, which is a system

of external transactions made supposedly to augment domestic development. And domestic developmenmeans every nation is free to choose its own development path most appropriate to its historical

conditions and is not required to adopt the US development model. But neo-liberal international tradesince the end of the Cold War has increasingly preempted domestic development in both the center and

the periphery of the world system. Quality of life is regularly compromised in the name of efficiency.

This is the reason the French and the Dutch voted against the European Union constitution, as a resistan

to the US model of globalization. Britain has suspended its own vote on the constitution to avoid a likelyvoter rejection. In Italy, cabinet ministers suggested abandoning the euro to return to an independent

currency in order to regain monetary sovereignty. Bitter battles have erupted among member nations inthe EU over national government budgets and subsidies. In that sense, neo-liberal trade is being

increasingly identified as an obstacle, even a threat, to diversified domestic development and national

culture.

Global trade has become a vehicle for exploitation of the weak to strengthen the strong both domestically

and internationally. Culturally, US-style globalization is turning the world into a dull market for unhealthyMcDonald's fast food, dreary Wal-Mart stores, and automated Coca-Cola and bank machines. Every airpo

around the world is a replica of a giant US department store with familiar brand names, making it hard toknow which city one is in. Aside from being unjust and culturally destructive, neo-liberal global trade as i

currently exists is unsustainable, because the perpetual transfer of wealth from the poor to the rich is nomore sustainable than drawing from a dry well is sustainable in a drought, nor can stagnant consumer







The Phillips curve, formulated in 1958, describes the systemic relationship between unemployment and

wage-pushed inflation in the business cycle. It represented a milestone in the development of macroeconomics. British economist A W H Phillips observed that there was a consistent inverse

relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from1861 to 1957. Whenever unemployment was low, inflation tended to be high. Whenever unemployment

was high, inflation tended to be low. What Phillips did was to accept a defective labor market in a typical

business cycle as natural law and to use the tautological data of the flawed regime to prove its validity,and made unemployment respectable in macroeconomic policymaking, in order to obscure the irrationali

of the business cycle. That is like observing that the sick are found in hospitals and concluding that

hospitals cause sickness and that a reduction in the number of hospitals will reduce the number of thesick. This theory will be validated by data if only hospital patients are counted as being sick and the sick

outside of hospitals are viewed as "externalities" to the system. This is precisely what has happened in thUnited States, where an oversupply of hospital beds has resulted from changes in the economics of

medical insurance, rather than a reduction of people needing hospital care. Part of the economic argumeagainst illegal immigration is based on the overload of non-paying patients in a health-care system

plagued with overcapacity.

Nevertheless, Nobel laureates Paul Samuelson and Robert Solow led an army of government economists the 1960s in using the Phillips curve as a guide for macro-policy trade-offs between inflation and

unemployment in market economies. Later, Edmund Phelps and Milton Friedman independently challengethe theoretical underpinnings by pointing out separate effects between the "short-run" and "long-run"

Phillips curves, arguing that the inflation-adjusted purchasing power of money wages, or real wages,would adjust to make the supply of labor equal to the demand for labor, and the unemployment rate

would rest at the real wage level to moderate the business cycle. This level of unemployment they calledthe "natural rate" of unemployment. The definitions of the natural rate of unemployment and its

associated rate of inflation are circularly self-validating. The natural rate of unemployment is that at whicinflation is equal to its associated inflation. The associated rate of inflation is that which prevails when

unemployment is equal to its natural rate.

A monetary purist, Friedman correctly concluded that money is all-important, but as a social conservativhe left the path to truth half-traveled by not having much to say about the importance of the fair

distribution of money in the market economy, the flow of which is largely determined by the terms of

trade. Contrary to the theoretical relationship described by the Phillips curve, higher inflation wasassociated with higher, not lower, unemployment in the US in the 1970s and, contrary to Friedman's claim

deflation was associated also with high unemployment in Japan in the 1990s. The fact that both inflationand deflation accompanied high unemployment ought to discredit the Phillips curve and Friedman's notio

of a natural unemployment rate. Yet most mainstream economists continue to accept a central tenet of

the Friedman-Phelps analysis that there is some rate of unemployment that, if maintained, would becompatible with a constant rate of inflation. This they call the "non-accelerating inflation rate of

unemployment" (NAIRU), which over the years has crept up from 4% to 6%.

NAIRU means that the price of sound money for the US is 6% unemployment. The US Labor Departmentreported the "good news" that in May 7.6 million persons, or 5.1% of the workforce, were unemployed in

the United States, well within NAIRU range. Since low-income people tend to have more children than th

national norm, that translates to households with more than 20 million children with unemployed parentsOn the shoulders of these unfortunate, innocent souls rests the systemic cost of sound money, defined ashaving a non-accelerating inflation rate, paying for highly irresponsible government fiscal policies of

deficits and a flawed monetary policy that leads to skyrocketing trade deficits and debts. That is equivaleto saying that if 6% of the world population dies from starvation, the price of food can be stabilized. And

unfortunately, such are the terms of global agricultural trade. No government economist has bothered tofind out what would be the natural inflation rate for real full employment.

It is hard to see how sound money can ever lead to full employment when unemployment is necessary to





keep money sound. Within limits and within reason, unemployment hurts people and inflation hurtsmoney. And if money exists to serve people, then the choice between inflation and unemployment

becomes obvious. The theory of comparative advantage in world trade is merely Say's Lawinternationalized. It requires full employment to be operative.

Wages and profits

And neo-classical economics does not allow the prospect of employers having an objective of raising

wages, as Henry Ford did, instead of minimizing wages as current corporate management, such as theFord 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 overcapacityeconomy.

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 chasinafter 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 aimat 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 wagearbitrage. This will enable the low-wage economies to begin to be able to afford the products they produc

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 aswage 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 moderncurse 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 goodmanagement; it is legalized theft. Executives should only receive bonuses if both profit and wages in the

companies rise as a result of their management strategies.

Sovereign credit and dollar hegemony

In an economy that can operate on sovereign credit, free from dollar hegemony, private savings are

needed only for private investment that has no clear socially redeeming purpose or value.

Savings are deflationary without full employment, as savings reduce current consumption to provideinvestment 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. Privatesavings 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 fullemployment, 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 regressivelymake 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 mea

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 fthe 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 outstandingvalue 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. Chartalisholds 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 taxliabilities, 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 accepits 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 asovereign-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 worldchanged. 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/FourthWorld 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 a500-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 formof 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 doe

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 bythe 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

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 mostlydenominated 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 toUS markets for dollars with which to provide the return on dollar-denominated FDI. US economic policy ishifting from trade promotion to FDI promotion. The US trade deficit is financed by the US capital accoun

surplus which in turn provides the dollars for FDI in the exporting economies. A trade spat with the EUover 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 USaffiliates 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 therationale 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 Asianequities 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 theinternational 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 aboth 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 aroundthe 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 thatstarted 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 25members 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 longlocked 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 liquidEuropean 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 onbanks 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 ofUS 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 Frenchretirement accounts investing in non-French assets is both distasteful and irrational for the average Frenc

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 $80

billion in dollar reserves. The Bank of Japan (BOJ), the central bank, has bought more than 300 billiondollars with yen from currency markets in the past two years in an effort to stabilize the exchange value

the yen, which continued to appreciate against the dollar. Now, the BOJ is faced with a dilemma: continu

buying dollars in a futile effort to keep the yen from rising, or sell dollars to try to recoup yen losses on itdollar 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 ofits dollar reserves. After the initial two days of sale, the remaining unsold $792 billion reserves would hav

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 yenwill leave the yen money supply to return to the BOJ if it sells dollars for yen, or the equivalent in euros iit 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 yenmoney 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 willrise, 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 thedollar 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 bankhave 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-helgold is $29,835 per ounce. At that price, an ounce of gold would buy a car. Meanwhile, the market price o

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 goldtrading 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 thtrading 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 Africangovernments spend three times as much on debt service as they do on health care. Britain has proposed

half-measure that would have the International Monetary Fund (IMF) sell about $12 billion worth of itsgold 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 theprice 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 andBarrick 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'scommodity 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, includingoil. The Bush administration, at first apparently unwilling to take on a congressional fight, began in April t

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 cancellationfor some poor nations to the World Bank and African Development Fund as a sign of progress in the Grou

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 th

Internet on June 15, on the headline of Pat Buchanan's syndicated column of the same date, "Reviving thforeign-aid racket", wrote:

This not a bailout of Africa's poor or Latin American peasants. This is a bailout of the IMF, the World Bankand 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 "infrastructureprojects", 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 fothe second leg of this scheme. He wants $25 billion a year for the indefinite future, as I recall, and he hathe 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 MikhaiGorbachev to engage in "shock therapy" to convert from communism to capitalism. It produced the wors

inflation in the history of Russia, caused the collapse of the Soviet federation, and sank the Russian peopinto 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 timewithout causing a major global financial crisis. Yet, against the US equity markets, the dollar appreciated







position of being a new creditor for receiving the money in exchange for his cow. The buyer exchanges hcreditor 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 redeemablefor the substance of value behind it based on the strong credit of the issuer. The issuer of private money

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 orcreate 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 moneyBut 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 sovereigncreditor. 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 thestate 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 fromothers 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 theeconomy. For things that are not for sale, such as political office, money is useless, at least in theory. Th

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 (debtor 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 redeemssovereign 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 dollarswithin US jurisdiction is in violation of US law. One is free to set market prices that determine the value,

purchasing power, of the dollar, but it is illegal on US soil to refuse to accept dollars for the settlement ofdebts. 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 isovereign 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 governmentallows a fiscal surplus by spending less than its tax revenue, the money supply shrinks and the economyslows. 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 fixatedon 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 thwould 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 dollaand 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 thonly 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 MarketCommittee (FOMC) controls the money supply, by buying or selling government securities with fiat dollar

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 theworld 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 th

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 theeconomy. That is why monetary easing is not deficit financing.

Money and inflation

It is sometimes said that war's legitimate child is revolution and war's bastard child is inflation. World Wa

I was no exception. The US national debt multiplied 27 times to finance the nation's participation in thatwar, 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 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 discounrate 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 loansthey 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. Businessactivity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, addin

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

sound footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, th

central bankers explained.

At this point, a technical process inadvertently gave the New York Federal Reserve Bank, which was closeallied 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 operatioof 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 goldand the amount of gold held by the government was relatively fixed. Money in the banking system wascreated entirely through the discount window at the regional Federal Reserve banks. Instead of buying o

selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off wouldextinguish money in the banking system, making the money supply self-regulating in accordance with th

"real bills" doctrine to maintain the gold standard. The regional Feds bought government securities not toadjust 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 boughtgovernment 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 inmultiple 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 fallaccordingly in financial markets. And when the regional Feds did not act in unison, the credit market cou

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 NewYork 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 fullunderstanding 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 fataflaw 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 theRoaring 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 bydepressed 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 membershipbecause of high unemployment in boom times. The prosperity was entirely fueled by the wealth effect of

speculative boom in the stock market that by the end of the decade would face the 1929 crash and landthe 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 economin 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 isan 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 premature

with preventive measures of tight money. It is a strategy that requires letting a bubble pop only inside abigger 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 capitalizationof 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. The2,750 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 a6,381. From its August 12, 1982, low of 777, the DJIA began its most spectacular bull market in history. 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 at386. 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 July1932, 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 stockprices were overvalued by 30% in 1929. But when the crash came, the overshoot dropped the index by

89% in less than three years.

Money and gold

When money is not backed by gold, its exchange value must be managed by government, morespecifically by the monetary policies of the central bank. No responsible government will voluntarily let th

market set the exchange value of its currency, market fundamentalism notwithstanding. Yet centralbankers 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 bankershave 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 exchangrate 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 thedynamic 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 theeconomy 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 economicreconstruction. 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. PresidentStrong 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 countriesMontagu 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 goldstandard 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 mean

that, to accomplish postwar economic reconstruction that would preserve prewar British interests, Europewould "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 torival 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 bankin New York to play an increasingly central role in international finance in competition with the Londonmarket.

Herbert Hoover, after losing his second-term US presidential election to Franklin D Roosevelt as a result o

the 1929 crash, criticized Strong as "a mental annex to Europe", and blamed Strong's internationalistcommitment to facilitating Europe's postwar economic recovery for the US stock-market crash of 1929 an

the subsequent Great Depression that robbed Hoover of a second term. Europe's return to the goldstandard, 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 tomanipulate the Fed's open market operations to keep US interest rate low to ease market pressures on t

overvalued pound sterling. Hoover, with justification, ascribed Strong's internationalist policies to what heviewed 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 UnitStates 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 substantia

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 directorAdolph 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 prioritbetween 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 bythe 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 itoday'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 system.

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The Coming Trade War and Global Depression

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