Critique of Central Banking

Part III-d: The lessons of the US experience

By
Henry C K Liu

Part III-c: Still More on the US Experience


Hyper-inflation is destructive to the economy generally but it hurts wage earners more because of wage stickiness and inelasticity, causing wages to fall constantly behind the hyper-inflation rate. Hyper-inflation keeps prices rising so fast that it tends to reduce the volume of business transactions and to restrain economic activities. Hyper-inflation has brought down many government throughout history, and thus monetary-policy makers have developed a special sensitivity toward it. For private business, loss of sales under hyper-inflation can sometimes be temporarily compensated by inventory appreciation if the interest rate is below the inflation rate, but under such conditions credit to finance inventory would soon dry up.

Moderate inflation benefits both the rich and the poor, though not equally, because it not only keeps asset prices rising, of which the rich own more, it also equalizes wealth distribution, making the rich less privileged. Moderate inflation enables the middle class to raise its standard of living faster through borrowing that can be paid back with depreciated dollars, as most homeowners in the United States have done in recent decades. Lenders would continue to lend under moderate inflation even if real interest rates yield a narrower or even a slightly negative spread over the inflation rate, because idle money would suffer more loss under moderate inflation and because moderate inflation reduces the default rate, thus making even a narrow spread between interest rate and inflation rate profitable to lenders. Moderate inflation also stimulates growth, which means a larger economic pie for all even if the slice of the pie for lenders may be smaller. Moderate inflation negates the fatalistic American folklore that the rich get richer and the poor get poorer, and enables the American dream of social and economic mobility.

Deflation increases the purchasing power of money, but it puts upward pressure on unemployment and downward pressure on aggregate income. Thus, given a choice between deflation and hyper-inflation, owners of real assets tend to prefer hyper-inflation, under which wage earners are forced to into lower real wages after inflation. Policy makers always hope that hyper-inflation can be brought back under control within a short period of crisis management, before political damage sets in. Central banks in desperate times would look to hyper-inflation to "provide what essentially amounts to catastrophic financial insurance coverage," as US Federal Reserve Board chairman Alan Greenspan suggested in a November 19 address on International Financial Risk Management to the Council on Foreign Relations (CFR) in Washington.

Over the past two and a half years, since February 2000, the draining impact of a loss of US$8 trillion of stock-market wealth (80 percent of gross domestic product, or GDP), and of the financial losses associated with September 11, 2001, has had a highly destabilizing effect on the aggregate debt-equity ratio in the US financial system, and has pushed the ratio below levels conventionally required for sound finance. Total debt in the US economy now runs to $32 trillion, of which $22 trillion is private-sector debt. This private debt now is backed by $8 trillion less in equity, an amount in excess of one-third of the debt. Greenspan attributed the system's ability to sustain such a sudden rise of debt-to-equity ratio to debt securitization and the hedging effect of financial derivatives, which transfer risk throughout the entire system. "Obviously, this market is still too new to have been tested in a widespread down-cycle for credit," Greenspan allowed.

In recent years, the rapidly growing use of more complex and less transparent instruments such as credit-default swaps, collateralized debt obligations, and credit-linked notes has had a net effect of transferring individual risks to systemic risk. Greenspan acknowledged that derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles' heel. It appears that the benefit has been reaped in the past decade, leading to a wishful declaration of the end of the business cycle. Now we are faced with the Achilles' heel: "the possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort," explained Greenspan.

Greenspan asserted that such "catastrophic financial insurance coverage" should be reserved for only the rarest of occasions to avoid moral hazard. He observed correctly that in competitive financial markets, the greater the leverage, the higher must be the rate of return on the invested capital before adjustment for higher risk. Yet there is no evidence that higher risk in financial manipulation leads to higher return for investment in the real economy, as recent defaults by Enron, Global Crossing, WorldCom, Tyco, Conseco and sovereign Argentine credits have shown. Higher risks in finance engineering merely provided higher returns from speculation temporarily, until the day of reckoning, at which point the high returns can suddenly turn in equally high losses.

The individual management of risk, however sophisticated, does not eliminate risk in the system. It merely passes on the risk to other parties for a fee. In any risk play, the winners must match the losers by definition. The fact that a systemic payment-default catastrophe has not yet surfaced only means that the probability of its occurrence will increase with every passing day. It is an iron law understood by every risk manager. By socializing their risks and privatizing their speculative profits, risk speculators hold hostage the general public, whose welfare the Fed now uses as a pretext to justify printing money to perpetuate these speculators' joyride. What kind of logic supports the Fed's acceptance of a natural rate of unemployment to combat inflation while it prints money without reserve to bail out private speculators to fight deflation created by a speculative crash?

It has been forgotten by many that before 1913, there was no central bank in the United States to bail out troubled commercial or investment banks or to keep inflation in check by trading employment for price stability. The House of Morgan then held the power of deciding which banks should survive and which ones should fail and, by extension, deciding which sector of the economy should prosper and which should shrink. At least the House of Morgan used private money for its predatory schemes of controlling the money supply for its own narrow benefit. The issue of centralized private banking was part of the Sectional Conflict of the 1800s between America's industrial North and the agricultural South that eventually led to the Civil War. The South opposed a centralized private banking system that would be controlled by Northeastern financial interests, protective tariffs to help struggling Northeast industries and federal aid to transportation development for opening up the Midwest and the West for investment intermediated through Northeastern money trusts.

Money, classical economics' view of it notwithstanding, is not neutral. Money is a political issue. It is a matter of deliberate choice made by the state. The supply of money and its cost, as well as the allocation of credit, have direct social implications. Policies on money reward or punish different segments of the population, stimulate or restrain different economic sectors and activities. They affect the distribution of political power. Democracy itself depends on a populist money policy.

The concept of a Federal Reserve System was first championed by Populists, who were ordinary citizens, rather than sophisticated economists or captured politicians or powerful bankers. In 1887, a group of desperate farmers in Lampasas county, Texas, formed the Knights of Reliance to resist impending ruin by "more speedily educating themselves" about the day when "all the balance of labor's products become concentrated into the hands of a few". It became the Farmers Alliance, which by 1890 had flowered into the Populist Movement. The Populist agenda was a major reform platform for more than five decades, giving the nation a progressive income tax, federal regulation of railroads, communications and other public utilities, anti-trust regimes, price stabilization and credit programs for farmers. Lyndon B Johnson was the last president with strong populist roots but tragically his populist domestic vision of the Great Society was torpedoed by the Vietnam quagmire.

The core issue behind the Populist Movement was money. Populists attacked the "money trusts", the gold standard, and the private centralized banking system. The spirit of this brief movement was captured by Lawrence Goodwyn in his book Democratic Promise: The Populist Movement in America. Falling prices of farm produce were the catalyst of protest. Falling prices were also inevitably accompanied by usurious interest rates. Both flowed from one condition: a scarcity of money. Most Americans today do not remember what historians call the Great Deflation that lasted three decades between 1866 and 1896. The Great Deflation worked in reverse of inflation. Inflation puts the rich at a disadvantage and spreads wealth more widely, allowing the middle class to grow and to enjoy higher standards of living. Deflation reconcentrates wealth and reduces the living standard of the middle and working classes. Borrowers face ballooning nominal debts from falling prices and wages.

Fernand Braudel (1902-1985) in his epic chronicle of the rise of capitalism showed that cycles of price inflation and deflation were recurring rhythms in the world's economies long before the founding of the United States. The very discovery of America was a great inflationary development by the increase of money supply in Europe through the plundering of Inca gold mines. Gold inflation lasted three centuries and was instrumental to the rise of Europe.

The US Federal Reserve System was founded in 1913 presumably to represent the financial interest of all Americans. In its obsessive phobia of inflation, the Fed has betrayed its original mandate. The chairman of the Fed in a true democracy should be a member of the common folks, supported by a technically competent but ideologically neutral staff, not a Wall Street economist who applauds "creative destruction" as a preferred path for growth. Greenspan himself allowed the view of an European leader in his November address: "What is the market? It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature."

The creation of the Federal Reserve System was the result of a confluence of political pressures. Fundamental among these pressure was the new awareness, as Braudel hinted, of a heretical proposition that capitalism cannot sustain price stability through market forces. That proposition may not be valid, but centuries of experimentation and innovation have yet to devise a monetary system that can provide permanent market price stability. It was increasingly recognized that the process of capital accumulation inherently produces periodic cycles of fluctuating money value: inflationary "easy money" stimulating economic growth, spreading wealth from the top down, followed by its depressant opposite "tight money" slowing down growth, reconcentrating wealth. Just as there is a business cycle in a market economy, there is a monetary cycle in a capitalistic system.

This peculiar nature of capitalism was allowed to work untamed until the arrival of political democracy. Any government adopting any money system that makes stable money a permanent feature would eventually confront political upheaval. There were no golden means of money value where all economic participants could be treated equally and justly. Technically, the rules of capitalism decree that money that is fixed in perpetual equilibrium is a formula for permanent stagnation.

The tight money in the United States at the beginning of the 20th century was caused by the restoration of the full gold standard (the Gold Standard Act of 1900) from the bimetallism that had been used in the US through much of the 19th century. Bimetallism had the fault of "bad money driving out good" as stated in Gresham's Law, named after Sir Thomas Gresham (1619-79), although it was controversial as to whether he in fact formulated the concept. The law states that the metal that is commercially valued at less than its face value tends to be used as money, and the metal that is commercially valued at more than its face value tends to be used as metal, and thus is withdrawn from circulation as money. It is an indirect confirmation of the validity of fiat money, as all commodities with intrinsic value would not be used as money given the option.

Permanent tight money means permanent high interest rates. And the money supply based on the gold standard after 1900 was inflexible for meeting the fluctuating demands of the economy. The resultant illiquidity rendered the financial system inoperative. The liquidity squeeze typically started in the South and the West when farmers brought their crops to market and traders and merchants needed short-term loans to finance a seasonal ballooning of trade. Rural banks were forced to turn to New York for additional funds. Country bankers and their farm clients learned from experience that life-or-death decisions over the economies of Kansas, Texas and Tennessee resided in the Wall Street offices of the likes of J P Morgan. Thus the term "money trusts" was no radical sloganeering or activist hysteria. It was a very mainstream term that everyone in the West and the South understood in the 1900s.

The Populists first proposed a solution to the money question in August 1886 at Cleburne, Texas, where the Farmers Alliance held a convention. The "Cleburne Demand" borrowed from the Greenback Party, which in the previous decade had fought against the gold standard and defended president Abraham Lincoln's fiat money, known as greenbacks, backed not by gold but by government credit, on which the North won the Civil War. Among the "radical" demands were federal regulation of the private banking system and a national fiat currency not retrained by gold.

The Populists distrusted both Wall Street and Washington and wanted an independent institution to carry out this task. They were openly inflationist, and advocated an expanding money supply to serve the growing economy and a federal issue to replace all private banknotes. Their slogan, "legal tender for all debts, public and private", appears today on Federal Reserve notes. Orthodox economists of the day scoffed at the proposals. A return to a populist monetary policy today would be a very constructive alternative to Greenspan's distortion of Schumpeterean creative destructionism.

The Fed has always considered it its sacred duty only to fight inflation. Still, there was a time it forced on the economy the pains of fighting inflation only after inflation had appeared, as then chairman Paul Volcker did in the early 1980s. But the Greenspan Fed in the late 1990s was shadow-boxing phantom inflation based on a theoretical anticipation of inflation from the wealth effect of an equity-market bubble that was at least producing a benefit of having unemployment trending below the so-called natural rate. The Greenspan bubble was actually accompanied by pockets of deflation, most visibly in the manufacturing and commodity sectors, mostly caused by excess investment that led to global overcapacity that fed low-priced imports to the US economy. Deflation has practically destroyed the farming and several other commodity and basic-material sectors in the past decade, including steel. It has eliminated much of US manufacturing. The deflation that faced selected sectors of the US economy in the past decade had not been market-induced as much as it was policy-determined. The Fed's fixation on driving inflation lower, regardless of economic consequences, has caused untold damage to the economy and forced its restructuring toward an unsustainable debt bubble.

It is an economic truism that low inflation for a large, complex economy can only be achieved by driving certain sectors into deflationary levels. Businesses in these unfortunate sectors are held in a state of protracted if not perpetual loss to face bankruptcy and liquidation. This detachment of profit from real production and the dubious linkage of profit to financial speculation and manipulation Greenspan accepts happily as Schumpeterean "creative destruction" (from economist Joseph A Schumpeter, 1883-1950). Pockets of deflation and bankruptcy are integral parts of systemwide disinflation that inevitably produces losers who allegedly made wrong business bets. It turned out that these wrong bets were not against market forces as much as they were against Fed policy bias. The stable value of money is to be maintained at all cost, except for speculative growth, which is translated to mean ever-rising share prices. Rising share prices, unlike rising wages, are not viewed by the Fed as inflation, a rationale hard to understand.

But the negatives of selective deflation are considered by the Fed as secondary and acceptable systemwide. These losses at various deflationary phases have included the farmer belt, the oil patch, the timber industry, the mining sector, steel, the manufacturing sector, transportation, communication, high technology and even defense. In 1984-85, deflation had became a fundamental disorder in the economy. Income loss and shrinking collateral squeezed debtors in deflationary sectors facing fixed nominal levels of debt that required appreciated dollars to repay. Raw-material prices fell by 40 percent from their peaks in 1980. It was a repeat of the 1920s' selective economic damage. Overall prices throughout the 1980s as reflected by the Consumer Price Index (CPI) remained around 3 percent and the economy expanded moderately and continuously. What actually happened was a structural shift of wealth distribution toward polarization of rich and poor. A split-level economy was instituted by government policy, between the favored and the dispensable. In the 1880s and again the 1890s, similar developments produced political agrarian revolts that historians call American Populism.

In 1830, there were only 32 miles (51 kilometers) of railroads in the United States. By 1860, at the start of the Civil War, there were more than 30,000 miles. The three decades after the Civil War was called the Railroad Age by historians, a period that saw a fivefold increase in rail mileage. The rail sector dominated the investment market and was the chief source of new wealth and baronial fortunes. The Age of Robber Barons, represented by the likes of Cornelius Vanderbilt (railroads), Andrew Carnegie (steel), John D Rockefeller (oil) and Morgan (finance), with the birth of big monopolistic corporations and interlocking holding companies, was inseparable from railroad expansion.

The private railroads received free public land in amounts larger than the size of Texas. The scandalous Credit Mobilier, which built the Union Pacific, paid a dividend of 348 percent in one year to watered-down shares given to corrupt members of Congress and state officials, a hundred times that of convention, even after having billed the company double for runaway construction cost. The price-fixing and selective price-gouging, government corruption, stock and business fraud, cost-padding, stock-watering and manipulation such as insider trading and sweetheart loans of the Railroad Age made the so-called crony capitalism of which the United States now accuses a developing Asia looks like child's play.

Notwithstanding the disingenuous neo-liberal claim that the Asian financial crises of 1997 that devastated the economies in the region were the inevitable result of Asian crony capitalism, and not of unregulated market fundamentalism, the scandalous railroad boom of the 1860s in the United States did not hurt the US economy. Far from it, it heralded in the age of finance capitalism. The difference was that in the 1860s, the US opposed free trade and adopted high protective tariffs, government support of industrial policy and infrastructure development and national banking. But most important of all, the US of the 1860s was not victimized by the tyranny of a foreign-currency hegemony, as Asia is today by dollar hegemony. Just as pimples are the symptoms of hormone imbalance and not the cause, corruption is often the symptom of fast growth.

The point here is not to apologize for corruption but to point out that corruption is part and partial of finance capitalism, as the savings and loan (S&L) crisis, the Milken junk-bond scandal and Enrontitis of recent times continue to show clearly. The real culprit was not corruption but deregulation. The Telecommunications Act of 1996, for example, which aimed to create competitive markets for voice, data and broadband services, unleashed a flood of investment in wireless licenses, fiber-optic cable networks, satellites, computer switches and Internet sites, and accounted for much of the new capital that poured into the economy through Wall Street's equity and credit markets. The same was true in the energy sector. But the biggest culprit was financial deregulation.

The deregulation program under the administration of president Ronald Reagan phased out federal requirements that set maximum interest rates on savings accounts. This eliminated the advantage previously held by savings banks in financing home ownership. Checking accounts that paid interest could now be offered by savings banks. All depository institutions could now borrow from the Fed in time of need, a privilege that had been reserved for commercial banks. In return, all banks had to place a certain percentage of their deposits at the Fed. This gave the Fed more control over state chartered banks, but diluted the Fed's control of the credit market. The Garn-St Germain Act of 1982 allowed savings banks to issue credit cards, make non-residential real-estate loans and commercial loans - actions previously only allowed to commercial banks.

Deregulation practically eliminated the distinction between commercial and savings banks. It caused a rapid growth of savings banks and S&Ls that now made all types of non-homeowner-related loans. S&Ls could then tap into the huge profit centers of commercial-real-estate investments and credit-card issuing and unsavory entrepreneurs looked to the loosely regulated S&Ls as a no-holds-barred profit center.

As the 1980s wore on, the US economy appeared to grow. Interest rates continued to go up as well as real-estate speculation. The real-estate market was in a bubble boom. Many S&Ls took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases lending more money then the value of the projects, in anticipation of still-rising prices. When the real-estate market crashed dramatically, the S&Ls were crushed. They now owned properties that they had paid enormous amounts of money for but weren't worth a fraction of what they paid. Many went bankrupt, losing their depositors' money. In 1980, the US had 4,600 thrifts; by 1988, mergers and bankruptcies left 3,000. By the mid-1990s, fewer than 2,000 survived. The S&L crisis cost US taxpayers $600 billion in "bailouts". The indirect cost was estimated to be $1.4 trillion.

Money supply is a complex issue and at this moment in history it is a term of considerable chaotic meaning. The official definition by the Federal Reserve of M1, 2 and 3 is clear (see note 1), but its usefulness even to the Fed is as limited as it is clear. Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University on September 5, 1997, with Milton Friedman in the audience, in defense of the accusation that Fed policy failed to anticipate the emerging inflation of the 1970s and, by fostering excessive monetary creation, contributed to the inflationary upsurge, and the claim that some monetary-policy rules, such as the Taylor rule, however imperfect, would have delivered far superior performance, admitted that the Fed's (indeed economics') knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. Greenspan observed that the monetary policy of the Fed has involved varying degrees of rule-based and discretionary-based modes of operation over time. Very often historical regularities have been disrupted by unanticipated change, especially in technologies, both hard and soft. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy, Greenspan asserted. It was an apology for muddling through.

Greenspan admitted that in the late 1970s, the Fed's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Fed, in response to such evaluations, acted aggressively under the then newly installed chairman Paul Volcker. A considerable tightening of the average stance of policy, based on intermediate M1 targets tied to reserve operating objectives, eventually reversed the surge in inflation. Greenspan was careful not to draw attention to the high cost of the reversal.

The 15 years before the Asian financial crises that began in 1997 had been a period of consolidating the gains of the early 1980s and extending them to their logical end, ie, the achievement of price stability. Although the ultimate goals of monetary policy have remained the same over the past 15 years, the techniques used by the Fed in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. The early Volcker years focused on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest-rate movements, resulting in wide interest-rate volatility.

But after nationwide NOW (negotiable order of withdrawal) interest-bearing checking accounts were introduced, the demand for M1, in the judgment of the Federal Open Markets Committee (FOMC), became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth, in the FOMC's judgment, no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending.

As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting the Fed policy stance.

By the early 1990s, the usefulness of M2 was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Fed was forced to begin disregarding the signals M2 was sending.

Greenspan recognized that, in fixing on the short-term rate, the Fed lost much of the information on the balance of money supply and demand that changing market rates afforded, but for the moment the Fed saw no alternative. In the current state of knowledge, money demand has become too difficult to predict. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices have been an integral part of the development of monetary policy.

In recent years, for example, the Fed expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as the Fed attempted to assess the implications for financial and economic stability of the extraordinary rise in equity prices, a rise based apparently on continuing upward revisions in estimates of US corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services could not both be an objective of a particular monetary policy, which, after all, has one effective instrument: the short-term interest rate. The Fed chose product prices as its primary focus on the grounds that stability in the average level of these prices was likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Greenspan discovered that he had been very wrong about the "robust" long-term earning prospects of US corporations by 2000.

Greenspan also admitted that over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. In the years 1997 through 2000, M3 increased by about 460, 600, 500 and 600 billions per year, respectively. In 2001 M3 expanded much more rapidly - by about $1.1 trillion - to a total of about $8 trillion. The surge in the money supply since the attacks on September 11, 2001, was equal to about $300 billion, which significantly represents about 3.0 percent of GDP, this after the Fed injected $1 trillion into the banking system in the days following the terrorist attacks in New York and on the Pentagon. Since the beginning of 2000, $8 trillion of stock market wealth has vanished, that is 80 percent of annual GDP, or the entire M3 in 2001. Another way to look at these figures is that the entire face value of the US money supply has vanished through market correction.

Market participants look at money supply differently. To M1, 2 and 3, they add L, which is M3 plus all other liquid assets, such as Treasury bills, saving bonds, commercial paper, bankers' acceptances, non-bank eurodollar holdings of non-US residents and, since the 1990s, derivatives and swaps, generally coming under the heading of structured finance instruments. The term MZM (money with zero maturity) came into general use. The Fed has poor, if any, information on L and it does not seem to want to know as it persistently declines to support its regulation or reporting on it. Over-the-counter (OTC) derivatives now are estimated to involve notional values of more than $150 trillion. No one knows the precise amount.

The Office of Controller of Currency (OCC) quarterly report on bank derivatives activities and trading revenues is based on call-report information provided by US commercial banks. The notional amount of derivatives in insured commercial bank portfolios increased by $3.1 trillion in the third quarter of 2002, to $53.2 trillion. Generally, changes in notional volumes are reasonable reflections of business activity but do not provide useful measures of risk. During the third quarter, the notional amount of interest-rate contracts increased by $3 trillion, to $45.7 trillion. Foreign-exchange contracts increased by $27 billion to $5.8 trillion. The number of commercial banks holding derivatives increased by 17, to 408. Eighty-six percent of the notional amount of derivative positions was composed of interest-rate contracts, with foreign exchange accounting for an additional 11 percent. Equity, commodity and credit derivatives accounted for only 3 percent of the total notional amount.

Holdings of derivatives continue to be concentrated in the largest banks. Seven commercial banks account for almost 96 percent of the total notional amount of derivatives in the commercial banking system, with more than 99 percent held by the top 25 banks. OTC and exchange-traded contracts comprised 87.9 percent and 12.1 percent, respectively, of the notional holdings as of the third quarter of 2002.

The notional amount is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. The risk in a derivative contract is a function of a number of variables, such as whether counterparties exchange notional principal, the volatility of the currencies or interest rates used as the basis for determining contract payments, the maturity and liquidity of contracts, and the creditworthiness of the counterparties in the transaction. Further, the degree of increase or decrease in risk-taking must be considered in the context of a bank's aggregate trading positions as well as its asset and liability structure. Data describing fair values and credit risk exposures are more useful for analyzing point-in-time risk exposure, while data on trading revenues and contractual maturities provide more meaningful information on trends in risk exposure.

Monetary economists have no idea if notional values are part of the money supply and with what discount ratio. As we now know, creative accounting has legally transformed debt proceeds as revenue. With the telecoms, the Indefeasible Right of Use (IRU) contracts, or capacity swaps, were perfectly legal means to inflate revenue. The now disgraced and defunct Andersen White Paper in 2000, well known in telecom financial circles, defined IRU swaps between telecom carriers by accounting each sale as revenue and each purchase of a capital expense which is exempted from operating results emphasized by Wall Street analysts and investors. While common sense would see this as inflation of revenue by hiding underlying true cost, Andersen argued that these capacity exchanges are not barter agreements, but are sales of operating leases and purchases of capital leases. Thus by creative accounting logic, swaps are not acquisition of "equivalent interests" because risks and rewards of buying a capital lease are greater than those of an operating lease. Since operating leases are not similar assets as capital leases, there is logic in booking revenues over the life of a contract when they are fully paid at closing. It can also be argued that such accounting logic on the operating leases misleadingly strengthens the value of the capital assets. Which was exactly what happened.

GE Capital on March 13, 2002, launched a multi-tranche dollar bond deal that was almost doubled in size from $6 billion to $11 billion, making it the largest-ever dollar-denominated corporate bond issue. Officially the bond sale was explained as following the current trend of companies with large borrowing needs, such as GE Capital, locking in favorable funding costs while interest rates are low. On March 18, Bloomberg reported that GE Capital was bowing to demands from Moody's Investors Service that the biggest seller of commercial paper should reduce its reliance on short-term debt securities. The financing arm of General Electric, then the world's largest company, sought bigger lending commitments from banks and replacing some of its $100 billion in debt that would mature in less than nine months with bonds. GE Capital asked its banks to raise its borrowing capacity to $50 billion from $33 billion.

Moody's, one of two credit-rating companies that have assigned GE Capital the highest "AAA" grade, has been increasing pressure on even top-rated firms to reduce short-term liabilities since Enron filed the biggest US bankruptcy to that date in December. Moody's released reports analyzing the ability of 300 companies to raise money should they be shut out of the commercial paper market. GE Capital and H J Heinz Co said they responded to inquiries by Moody's by reducing their short-term debt, unsecured obligations used for day-to-day financing. Concerns about the availability of such funds have grown this year after Qwest Communications International Inc, Sprint Corp and Tyco International Ltd were suddenly unable to sell commercial paper.

Moody's lowered a record 93 commercial paper ratings last year as the economy slowed, causing corporate defaults to increase to their highest in a decade. One area of concern for the analysts is the amount of bank credit available to repay commercial paper. While many companies have credit lines equivalent to the amount of commercial paper they sell, some of the biggest issuers do not. GE Capital, for example, has loan commitments backing 33 percent of its short-term debt. American Express has commitments that cover 56 percent of its commercial paper. Coca-Cola supports about 85 percent of its debt with bank agreements, according to Standard & Poor's, the largest credit-rating company, which said it is also focusing more attention on risks posed by short-term liabilities, though it hasn't yet decided whether to issue separate reports.

Companies have sold $107 billion of investment-grade bonds in the first half of this year, up from $88 billion during the same period in 2001. The amount of unsecured commercial paper outstanding has fallen by a third to $672 billion during the past 12 months. GE Capital, which has reduced its commercial paper outstanding from $117 billion at the beginning of the year, plans to continue to reduce short-term debt. It took one step in that direction last week when it sold $11 billion of long-term bonds, some of which will be used to reduce its outstanding commercial paper. As part of the sale, GE Capital sold 30-year bonds with a coupon of 6.75 percent. The company usually swaps some or all of those fixed-rate payments for floating-rate obligations. Last year, GE Capital paid on average 3.23 percent for its floating-rate, long-term debt, 70 basis points more than on its commercial paper, according to a company filing.

The bottom line of all this is that the funding cost of GE Capital will go up, which will hit GE Capital profit, which constitutes 60 percent of its parent's profit. This in turn will hit GE share prices, which in turn will force rating agencies to pressure GE further to shift from low-cost commercial papers to bonds or bank loans, which will further reduce profit, which will further increase rating pressure, and so on. PIMCO (Pacific Investment Management Co), the world's largest bond fund, having dumped $1 billion in GE commercial paper from its holdings, publicly criticized GE for carrying too much debt and not dealing honestly with investors. GE announced it might sell as much as $50 billion in bonds only days after investors bought $11 billion of new bonds in the biggest US sale in history. PIMCO director Bill Gross disputed GE's contention that the new bond sales were designed not to capture low rates, but because of troubles in its commercial paper market. If the GE short-term rate rises because of a poor credit rating, the engine that drives GE earnings will stall. Gross dismissed GE earning growth as not being from brilliant management, former GE chairman Jack Welch's self-aggrandizing books not withstanding, but from financial manipulation, selling debt at cheap rates and using inflated GE stocks for acquisition. GE had $127 billion in commercial paper as of March 11, 2002, according to Moody's. This amounts to 49 percent of its total debt. Banks' credit line only covers one-third of the short-term exposure.

The erosion of market capitalization value does impact money supply. Asset valuation is the collateral for debt. As asset value falls, credit ratings fall, which affect interest costs, which affect profits, which affect asset value. Moreover, a major counterparty default in structured finance will render the Fed helpless in keeping the money supply from sudden contraction, unless the Fed is prepared to depart from its traditional practice of relying solely on interest-rate policy to effectuate monetary ease, a move Greenspan apparently has served notice he is prepared to make.

The logic of fighting inflation by raising interest rates is mere conventional wisdom. Furthermore, interest-rate policy is merely a single instrument that cannot possibly be relied upon to play the complexity of a symphony like the economy. The debate on whether a high interest rate is inflationary or deflationary seems to be a puzzling controversy in economics. Within the current international financial architecture, interest rates cannot be fully understood without taking into account their impact on exchange rates and credit markets. Nor can inflation be understood in isolation.

In a globalized financial market, if the exchange rate is artificially sustained by high interest rates, there is little doubt that the impact would be deflationary on the local economy. This logic is also supported by empirical data in recent years. Yet many astute economists insist that a high interest rate causes inflation, at least in the long run. Perhaps this can be true in closed economies, but it is no longer necessarily true in open economies in a globalized financial market.

Interest rates are the prices for the use of money over time. These prices do not always track the purchasing power of money, which is the monetized expression of the market value of commodities (the transaction price) at a specific time. The purchasing power of money fluctuates over time, expressed by the prices of futures and options, which are functions of the uncertain elasticity between interest rates and inflation rates.

As the price for the use of money over time rises, the general effect will be deflationary if money is viewed as a constant store of value. Otherwise, money will forfeit its function as a constant store of value. On the other hand, if money is viewed as a medium of exchange, the ultimate liquidity agent, then rising price for its use over time is inflationary as a cost.

Now, in any economy, money tends to play both roles, though not equally and not consistently over time. For market participants, depending on their positions (borrower or lender) at specific points of the economic cycle (expanding or contracting liquidity), they will find different views of money (exchange medium or value storer) to be to their financial advantage. Thus borrowers generally consider a high interest rate as leading to cost inflation (bad), and lenders consider a high interest rate as leading to asset deflation (good up to a point). Asset deflation offers good buying opportunities for those who have money or have access to credit, but bad for those who hold assets but need money, and the pain is proportional to asset illiquidity. Since most holders of ready cash also hold assets, deflation has only a limited and short-term advantage for them. For inflation to be advantageous, continued expansion of credit is required to keep asset appreciation ahead of cost inflation.