Critique of Central Banking By Henry C K Liu Part I:         Monetary theology Part II:       The European Experience Part III-a:   The US Experience Part III-b:   More on the US Experience Part III-c:   Still More on the US Experience Part III-d:   The Lesson of the US Experience Part 4a: The Asian experience This article appeared in AToL on June 18, 2003   Since the beginning of the new millennium, the world's three leading economies, the United States, the European Union and Japan, have experienced a rare synchronous slowdown while much of the developing world, including Asia, remained mired in economic and financial difficulties that started in Asia in 1997. This development has rendered inoperative the strategy of having the global economic engine stabilized by sequential boosts from the synchronized phasing of domestic business cycles in connected yet independent economies, like the well-timed sequential firing of a multi-cylinder internal combustion engine. The current global economic stagnation is not an accidental breakdown. It is the visible result of the coordinated operation of global central banking, burning out the economic spark plugs with super-rich gas in the form of universal and reflexive tight monetary measures, which have produced overlapping long-term imbalances in the global economy's major regional dynamos. The decade-long post-bubble deflation in Japan was linked to financial globalization that challenged the efficacy of the traditional Japanese financial system. The Tokyo Big Bang (financial deregulation) on April 1, 1998, crowned with a Central Bank Law on the same day, was designed to boost the value of the Japanese stock market, aiming to re-establish Tokyo's position as one of the top three global financial centers. Once the largest stock market in the world, Tokyo by 1998 had fallen steadily to less than half the size of New York in contrast with the latter's astronomical expansion. Although the Japanese had savings of about US$9 trillion in 1998, a third of the world total, most savings were held in low-interest bank and postal accounts on which the Japanese government traditionally relied for low-cost capital to fund its national economic plans. The population was aging rapidly and the government was worried there would not be enough money in the economy to support future pensioners because of the low return on savings. Neo-liberal market fundamentalists pushed through a series of radical reforms designed to change the way money traditionally flowed around the Japanese economy, recycling more savings into the stock market to boost yield. The government hoped to bring Tokyo back in line with the high trading levels of London and New York, pulling the value of the recycled savings up with it by increasing their rate of return. The reforms were called the Big Bang after a similar exercise in Britain 12 years earlier on October 27, 1986, which in turn was inspired by May Day in the US in 1975, which ended fixed minimum brokerage commissions that marked the beginning of diversification into electronic trading. Instead of bringing new prosperity and high returns to fund exploding pension obligations, the Tokyo Big Bang reduced Japanese banks, which earlier had been operating with spectacular success in a national banking regime in support of Japanese industrial policy, to near-terminal cases in a global central banking environment. Subsidized policy loans that had served postwar national purposes for half a century suddenly became non-performing loans (NPLs) as defined by new international standards set by the Bank of International Settlement (BIS), as corporate borrowers were forced by dollar hegemony to sacrifice profit margin to expand market share, while financial deregulation put downward pressure on the traditional norm of high price-earning ratios of Japanese equity. The banks' traditional holding of significant equity position in their corporate borrowers and the tradition of a controlled domestic market caused structural problems for the Japanese financial system in the new globalized competitive environment. The banks were squeezed by falling cash flow from loan service payments by their distressed debtors and by the falling market value of loan collateral and capital held in the shares of their borrowers. The Tokyo stock market's key Nikkei index tumbled from an all-time high of 21,552.81 recorded on June 13, 1994, to below the psychologically crucial 15,000 level in July 1995 when the yen's sharp appreciation hit manufacturers and exporters. The Nikkei is now around 8,500 and Japanese officials would kill to get it back to 15,000, but it seems to be an impossible dream because global central banking has forced deregulated markets to discount the market value of the Japanese system that had worked so miraculously for the previous half-century. The government tried to solve the problem with Keynesian deficit financing, only to be hit with international credit-rating downgrades on government bonds, despite the fact that Japan remains the world's biggest credit nation. Concurrently in Europe, persistently high levels of unemployment and anemic growth plagued the euro zone, whose European Central Bank (ECB) came into being on June 1, 1998, two months after Japan's. And in the United States, by the beginning of 2000, a steady collapse of the debt bubble began, generated by unsustainably high consumer, business and external debt levels that had been first engineered by the Federal Reserve (Fed) through regulatory indulgence and then later deflated through sharp rises in interest rates. Since then, the global economic engine has been stalled in all three cylinders by the efforts of the world's three dominant central banks to impose on the global economy destructively inoperative monetary policies. After allowing regulatory indulgence on the part of the US Security and Exchange Commission (SEC) to feed a historic bubble in US asset prices inflated by accounting fantasies, fraudulent analyses, and financial manipulation, the Fed, reversing its loose monetary policy since 1997, conducted a pre-election monetary tightening, repeatedly raising interest rates in quick succession during the second half of 1999 and the first half of 2000 to slow down the real economy. The Fed also spurred the ECB to follow suit, despite already slow growth and high unemployment in EU member economies. The Fed had discovered that for the United States, domestic consumer price stability in an expanding economy could be achieved through a strong-currency policy that would generate a capital account surplus to finance a current-account deficit that produced a low inflation reading through low-cost imports, as long as key commodities, such as oil, were denominated in US currency. For a whole decade, wealth has been created primarily through financial acrobatics, not real economic expansion either within the US or around the world. Conspicuous consumption along chic shopping boulevards, cruised by gas-guzzling sport-utility vehicles, to fill homes that rose in price by 60 percent annually, supported by the wealth effect of a stock-market bubble that made office clerical workers millionaires, buoyant by a trade regime that enabled a massive transfer of wealth from the poor to the super rich, is mistaken for economic growth. Fed chairman Alan Greenspan proudly called this US financial hegemony and told Congress that the financial crises that hit Asia in 1997 would have "salutary" effect on the US economy. During the past decade, central banks worldwide have achieved unprecedented heights of policy dominance through their function as chief guardians of strong national currencies in globalized, unregulated financial markets. Simultaneously, monetary authorities the world over have been promoting the doctrine of central-bank independence from duly constituted national governments and their national economic policies, as if populist government and people-oriented policies are financial evils that must be resisted. Poverty and unemployment are hailed as the foundation of sound money that should not be jeopardized by political pressure. This elitist doctrine is fundamentally incompatible with a political world order of independent nation states and the principle of consent of the governed. Any nation that forfeits its monetary prerogative also forfeits its political independence. The ECB's institutional structure represents the ultimate real-world application of this doctrine on a regional scale. In the name of central-bank autonomy, the Maastricht Treaty explicitly prohibits the ECB from seeking or taking instruction from constituent national governments, or European Community institutions such as the European Parliament, or "any other body", and bars constituent national governments from attempting to influence the decisions of the ECB. Critics have pointed out that those same rules place no reciprocal restrictions on the ECB's policy advocacy. ECB president Wim Duisenberg has unreservedly pushed euro zone economies to refashion their labor, product, services, capital and credit markets along neo-liberal market-fundamentalist lines, even in economies under social democratic governments. This has contributed to the EU's slow growth and high unemployment. Germany, the dominant economy in the EU, has persistently suffered high unemployment, which hit 9.7 percent in November, rising above the politically sensitive 4 million level; in eastern Germany, the unemployment rate was 17.6 percent. Article 105 of the Maastricht Treaty states clearly: "The primary objective of the European System of Central Banks shall be to maintain price stability." The wording of the Maastricht Treaty was not so much influenced by economic insights as it was written in a very specific political context: to persuade an inflation-averse Germany to exchange the deutschmark for the euro, by guaranteeing the stability of the new currency. This explains the focus on price stability and the fact that other objectives were mentioned separately and secondarily. The statutes of other central banks, such as the Fed, can be changed by action of a single legislature. The ECB would require all 15 member states and their parliaments to change the treaty that defines the structure and institutional mandate of the ECB. This makes the ECB one of the most independent central banks in the world. The treaty did not define "price stability", leaving a vacuum quickly filled by the new and independent ECB by defining price stability as "an inflation rate that does not exceed 2 percent over the medium term", a very tight definition by any standard. Interest-rate policy alone is an inadequate tool because a single instrument cannot hit multiple targets. Furthermore, using interest rates to control asset markets risks inflicting significant collateral damage on the rest of the economy, which was exactly what happened in the past few years. The BIS harbors latent ambitions to turn itself into a de facto World Central Bank (WCB) with the ECB as a model, while the argument for the need for a WCB is floated around in the upper reaches of internationalist monetary circles. Asia is home to 58 percent of the world's 6.25 billion people, with 43 percent of Asians living in East Asia and 37 percent in China alone. According to US Central Intelligence Agency (CIA) data, the US economy accounts for 21 percent of gross world product (GWP - $47 trillion in 2001), the EU accounts for 20 percent and Japan accounts for 7.3 percent. The three leading economies together account for $22 trillion - 47.3 percent of GWP. China, the second-largest economy in the world based on purchasing power parity (PPP; 12 percent of GWP), and seventh on a nominal basis ($1.3 trillion in 2001, 2.8 percent of GWP) is an exception to global trends of slow growth, continuing its rapid annual growth, officially announced as 7.3 percent in 2001 and 8 percent in 2002. Yet lest we should get carried away by statistics, the Chinese per capita gross domestic product (GDP) of about $900 in 2001 remains solidly in the less-developed-countries (LDC) category, way below Japan's $32,500. Of the 129 countries covered by the World Development Report, China ranked 76th in per capita GDP on a nominal basis and 68th on a PPP basis, a modest climb. China's economic strength rests purely on its size. China also adopted a Central Bank Law in 1995 and gave the People's Bank of China central-bank status, but the Chinese economy has remained a growth economy mostly because its currency is not freely convertible and its financial market is not open, and its central bank not fully independent. There is increasing evidence that the crisis in the Japanese banking system is not the cause but merely the symptom of that nation's economic malaise. This malaise can largely be traced to the Japanese economy's over-dependence on export for dollars, which in turn has resulted from the disadvantaged structural financial position Japan has allowed itself to fall into in the global financial system. BIS regulations, which force traditional Japanese national banking in support of a strong economy to shift toward central banking in support of a strong national currency, are a big part of that structural disadvantage. This is the reason Japan has been resistant to US demands for bank reform. The NPL problem in Japanese banks traces directly to BIS regulations. This is also true for all of Asia, particularly South Korea, and increasingly China. No doubt Japan needs to reform its banking system, but it is highly debatable that the reform needs to go along the line proposed by US neo-liberals, or that bank reform alone will lift the Japanese economy out of its decade-long doldrums (see The BIS vs national banks, May 14, 2002). All these problems contributed to and in turn were magnified by structural flaws and disorders in the international financial architecture and global trade, notably misaligned currency values and interest rate disparities. This has led to escalating mismatches between productive capacity and effective demand, which has been exacerbated by a "free trade" regime that has degenerated into a mad scramble for dollars that the United States can print at will. The whole world lives on an over-reliance on export to a US consumer market fueled by debt sustained by dollar hegemony. The ABC of the global economy is now expressed as America prints dollars to Buy the world's products on Credit provided by the world's producers. The US is exempt from a day of reckoning, since the US only has to print more dollars, as Fed Board member Ben Bernanke pronounced recently. Foreign creditors will only devalue their massive dollar holdings if they try to collect from the US economy. It is the ultimate demonstration of debtor power, with the debtor holding the power to print currency in which the debt is denominated. Asia, because of its largest population of low-wage workers, is holding the shortest end of the biggest global trade stick. The Asian financial crisis that began in 1997 had its genesis in Mexico, incubated by a decade of globalization of financial markets. The currency crisis that started in Mexico in 1982, in Britain in 1992, again in Mexico in 1994, in Asia in 1997, spreading to Russia and Latin America since and finally hitting both the EU and the US in 2000, and the deeper structural financial challenges facing the entire global economy, have been the inevitable result of the Fed, the ECB and the Bank of Japan applying their unified institutional mandates of domestic price stability through domestic interest-rate policies that have destabilized the post-Bretton Woods international finance architecture. The Mexican financial crisis of 1982 set the pattern for subsequent financial crises around the world. To recycle petrodollars beginning in 1973, US banks had sought out select LDCs, such as Brazil, Mexico, Argentina, South Korea, Taiwan, the Philippines, Indonesia, etc, for predatory lending. By 1980, LDCs had accumulated $400 billion in foreign debt, more than their combined GDP. In 1982, impacted by the Fed under Paul Volcker raising dollar interest rates sharply in 1979 to fight inflation in the United States, Mexico was put in a position of not being able to meet its obligations to service $80 billion in dollar-denominated short-term debt obligations to foreign, mostly US, banks out of a GDP of $106 billion. Debt service payments reached 62.8 percent of export value in 1979. Exports accounted for 12 percent of GDP while government expenditures accounted for 11 percent, which included public-education expenditure of 5.2 percent. Mexico was paying more in interest to foreign banks than it did to educate its young. Mexican foreign reserves had fallen to less than $200 million and capital was leaving the country at the rate of $100 million a day. Against this background, neo-liberal economists were claiming that poverty was being eradicated in Mexico by "free" trade, a claim they made the world over. A Mexican default would have threatened the survival of the largest commercial banks in the United States, namely Citibank, Chase, Chemical, Bank of America, Bankers Trust, Manufacturer Hanover, etc. To negotiate new loans for Mexico, all creditors would have to agree and participate, so that the new loans would not just go pay off some holdout creditors at the expense of the others. Many other creditor banks were smaller US regional banks that had only limited exposure to Mexico, and they did not want to "throw good money after bad" merely to bail out the major money center banks. The big banks had to lobby the Fed to step in as crisis manager to keep the smaller banks in line for the good of the system, notwithstanding that the crisis had been caused largely by the Fed's failure to impose prudent limits on the money center banks' frenzied lending to the Third World in the previous decade and Volcker's sudden high-interest-rate shock treatment in 1979, instead of traditional Fed gradualism that would have given the banks time to adjust their loan portfolios. Third World economies were falling likes flies from the weight of debts that suddenly became prohibitive to service, not much different from private businesses in the United States, except that countries could not go bankrupt to wipe out debt the way private business could in the US. Volcker's triumph over domestic inflation was bought with the destabilization of the international financial system, whose banks had acted like loan sharks in the Third World with Fed approval. The International Monetary Fund then came in to take over the impaired bank loans with austerity "conditionalities" forced on the debtor economies, while the foreign banks went home whole with the IMF new money. As a result, Third World economies, including those in Asia, fell into a debt spiral, having to borrow new money from the IMF to service the old debts, being forced by new loan "conditionalities" to forgo any hope of future prosperity. Living standards kept declining while foreign debts kept piling higher, leading to even higher unemployment and more bankruptcies. US banks, while continuing to advocate free markets and financial deregulation, were at the same time falling into total dependence on government bailouts, both domestically and internationally. US taxpayers were footing the bill the Fed incurred in bailing out its constituent banks, through higher government budget deficits, which contributed to higher inflation, which led to higher interest rates, which in turn intensified the Third World debt spiral, in one huge vicious circle. By the late 1980s, Mexico had temporarily resolved its debt crisis, though not its debt spiral, and was able to resume a Ponzi-scheme economic growth, relying to a great extent on rising foreign investment. To attract more foreign capital, the Mexican government, coached by neo-liberal market-fundamentalist economists, undertook major economic reforms in the early 1990s designed to make its economy more open to foreign investment, more "efficient", and more "competitive", neo-liberal code words for disguised neo-imperialism. These reforms included privatizing state-owned enterprises, removing trade barriers that protected domestic producers, eliminating restrictions on foreign investment, and reducing inflation by tolerating higher unemployment and pushing down already low wages and limiting government spending on social programs by marketizing them. Most important, it suspended exchange control within a fixed-foreign-exchange-rate regime. This was in essence a Washington Consensus solution and much copied all over Asia in the early 1990s. In effect, it was a suicidal policy masked by the giddy expansion typical of the early phase of a Ponzi scheme. The new foreign investment was used to provide spectacular returns on earlier foreign investment with the help of central-bank support of overvalued fixed exchange rates, while neo-liberal economists were falling over one another congratulating themselves on their brilliant theoretical insight and giving one another awards at insider dinners, while collecting fat consultant fees from banks and governments. Star academics at Harvard, Massachusetts Institute of Technology (MIT), Chicago and Stanford, multiple snake heads of the academic Medusa, as well as those in prestigious policy-analysis institutions with unabashed ideological preferences that served as waiting lounges for policy specialists of the loyal opposition, busily turned out star disciples from the Third World elite who, armed with awe-inspiring foreign certificates and diplomas, would return to their home countries to form influential policy-making establishments, particularly in central banks, to promote this scandalous game of snake-oil economics. Every year, sponsored by the IMF and the World Bank, central bankers gathered in Washington, housed in luxurious hotel suites served by fleets of limousines to reassure one another of their monetary magic, communicating through opaque press releases couched in cryptic jargon. Mexico's devaluation of the peso in December 1994 precipitated another crisis in the country's financial institutions and markets that caused an abrupt collapse of a "booming" economy that had not benefited Mexico as much as foreign capital. Within Mexico, most of the benefit went to the elite comprador class at the expense of the general population, particularly the poor but even the middle class. International and domestic investors, reacting to falling confidence in the peso, sold Mexican equity and debt securities. Foreign-currency reserves at the Bank of Mexico, the nation's central bank, were insufficient to meet the massive demand of disillusioned investors seeking to convert pesos to dollars. In response to the crisis, the United States organized a financial rescue package of up to $50 billion in funds from the US, Canada, the IMF and the BIS. The multilateral rescue package was intended to enable Mexico to avoid defaulting on its debt obligations, and thereby overcome its short-term liquidity crisis, and to prevent the crisis from spreading to other emerging markets through contagion. It was not to help a Mexican economy hemorrhaging from a bankrupt monetary policy, one that allowed international investors to collect their phantom Ponzi peso profits in real dollars. The Mexican rescue package in 1995 created moral hazard on a global scale. In the weekend before Mexico's pending default, the US government took the lead in developing a rescue package. The package put together by the Fed under Alan Greenspan and the Treasury under Robert Rubin, a former co-chairman of Goldman Sachs and a consummate bond trader, included short-term currency swaps from the Fed and the Exchange Stabilization Fund (ESF), a commitment from Mexico to an IMF-imposed economic austerity program for $4 billion in IMF loans, and a moratorium on Mexico's principal payments to foreign commercial banks, mostly US, with Fed regulatory forbearance on bank capital adjustments that affected bank profits. It also included $5 billion in additional commercial bank loans, additional liquidity support from central banks in Europe and Japan, and prepayment by the US to Mexico for $1 billion in oil, and a $1 billion line of credit from the US Department of Agriculture. The ESF was established by Section 20 of the Gold Reserve Act of January 1934, with a $2-billion initial appropriation. Its resources has been subsequently augmented by special drawing rights (SDR) allocations by the IMF and through its income over the years from interest on short-term investments and loans, and net gains on foreign currencies. The ESF engages in monetary transactions in which one asset is exchanged for another, such as foreign currencies for dollars, and can also be used to provide direct loans and guarantees to other countries. ESF operations are under the control of the Secretary of the Treasury, subject to the approval of the president. ESF operations include providing resources for exchange-market intervention. The ESF has also been used to provide short-term swaps and guarantees to foreign countries needing financial assistance for short-term currency stabilization. The short-term nature of these transactions has been emphasized by amendments to the ESF statute requiring the president to notify Congress if a loan or credit guarantee is made to a country for more than six months in any 12-month period. It was Bear Stearns chief economist Wayne Angell, a former Fed governor and advisor to then Senate majority leader Bob Dole, who first came up with the idea of using the ESF to prop up the collapsing Mexican peso. Bear Stearns had significant exposure to peso debts. Senator Robert Bennett, a freshman Republican from Utah, took Angell's proposal to Greenspan and Rubin, who both rejected the idea at first, shocked at the blatant circumvention of constitutional procedures that this strategy represented, which would invite certain reprisal from Congress. Congress had implicitly rejected a rescue package that January when the initial proposal of extending Mexico $40 billion in loan guarantees could not get enough favorable votes. The chairman of the Fed advised Bennett that the idea would only work if Congress's silence could be guaranteed. Bennett went to Dole and convinced him that the whole scam would work if the majority leader would simply block all efforts to bring this use of taxpayers' money to a vote. It would all happen by executive fiat. The next step was to persuade Dole and his counterpart in the House, Speaker Newt Gingrich. They consulted several state governors, notably then Texas governor George W Bush, who enthusiastically endorsed the idea of a bailout to subsidize the border region in his state. Greenspan, who historically opposed bailouts of the private sector for fear of incurring moral hazard, was clearly in a position to stop this one. Instead, he used his considerable power and influence to help the process along when key players balked. The peso bailout would lead to a series of similar situations in which private investors got themselves into trouble, vindicating the moral-hazard principle that predicts such people will take undue risks in the presence of bailout guarantees. As Thailand, Indonesia, Malaysia, South Korea, and Russia stumbled into crisis, culminating in the collapse of hedge-fund giant Long-Term Capital Management (LTCM), which played key roles in precipitating the crisis to begin with, Greenspan moved to increase liquidity to support the distressed bond markets. At the helm of LTCM was yet another former member of the Fed board, ex-vice chairman David Mullins. Mullins was there to plead for help from his former colleagues. When New York Fed president William McDonough helped coordinate a bailout of LTCM at his offices, Greenspan defended McDonough before a congressional oversight committee. Reflecting on all the corporate welfare being doled out to prop up bad private-sector investments worldwide, Bill Clinton appointee Alice Rivlin, the able former congressional budget director, observed that "the Fed was in a sense acting as the central banker of the world". During Clinton's first term, Greenspan had handed the president a "pro-incumbent-type economy" and was rewarded with a seat next to the First Lady in Clinton's televised State of the Union address and a third-term appointment as Fed chairman. Crony capitalism was in full swing. Short-term currency swaps are repurchase-type agreements through which currencies are exchanged. Mexico purchased dollars in exchange for pesos and simultaneously agreed to sell dollars against pesos three months hence. The US earned interest on its Mexican pesos at a specified rate. Historically, the US and Mexican economies have always been closely integrated in a semi-colonial relationship. In 1994, the United States supplied 69 percent of Mexico's high-value-added imports and absorbed about 85 percent of its low-cost labor-intensive exports. US investors have provided a substantial share of foreign investment in Mexico and have established numerous manufacturing facilities there to take advantage of low wages and unregulated labor and environmental regimes. Also, the US has served as a large market for illegal Mexican immigrant labor in its underground economy and farm sector, which has grown to be a sizable foreign-currency earner for Mexico. Mexico has long been the third-largest trading partner of the United States, accounting for 10 percent of US exports and about 8 percent of US imports in 1994. The maquiladora assembly industry concentrated on the Mexican side of the US-Mexico border was hailed by neo-liberals as a model of successful free trade, instead of the sweatshop zone it actually was. In 1994, under newly installed president Ernesto Zedillo, a Yale-educated economist, Mexico entered the North American Free Trade Agreement with the United States and Canada. NAFTA, conceived as a regional economic counterweight to the EU, further opened Mexico to foreign investment and bolstered investor interest on the hope that with NAFTA, Mexico's long-term prospects for stable economic development were likely to improve, at least for the benefit of foreign investors. NAFTA, as negotiated and signed in December 1992 by the administrations of Mexican president Carlos Salinas de Gortari and US president George Bush Sr, and as amended and implemented by the Salinas and Clinton administrations in 1993, did not offer Mexico any significant increase in access to the US market. Rather, Mexico was blackmailed into signing NAFTA to prevent Mexican businesses from being bankrupted wholesale by sudden waves of pending US protectionism. Mexico was also advised by neo-liberals to adopt an exchange-rate system intended to protect foreign investors who could exchange their peso earnings for dollars at the Mexican central bank at an overvalued rate. In 1988, the nominal exchange rate of the peso had been fixed temporarily in relation to the US dollar. However, because the inflation rate in Mexico was greater than that in the United States, a peso nominal depreciation against the dollar was needed to keep the real exchange rate of the peso from increasing. With the nominal exchange rate of the peso fixed, the real exchange rate of the peso appreciated during this period. In 1989, this fixed-exchange-rate system was replaced by a "crawling peg" system, under which the peso-dollar exchange rate was adjusted daily to allow a slow rate of nominal depreciation of the peso to occur over time. In 1991, the crawling peg was replaced with a band within which the peso was allowed to fluctuate. The ceiling of the band was adjusted daily to permit some appreciation of the dollar (depreciation of the peso) to occur. The Mexican government used the exchange-rate system as an anchor for an unsustainable economic policy, ie, as a way to reduce inflation through shrinking the economy, to force a politically destabilizing fiscal policy, and thus to provide a comfortable climate for foreign investors, who managed to carry home the same dollars they brought in via a short circuit, while leaving only their peso holdings behind that the Mexican central banks had promised to guarantee as fully convertible at an over-valued fixed exchange rate despite predictable unsustainability. Before 1994, Mexico's strategy of adopting sound monetary and austere fiscal policies appeared to be having its intended effects of making foreign capital feel secure while the Mexican economy was steadily being hollowed out. Inflation had been steadily reduced by the inflated peso, government social spending was down to reduce the budget deficit, and foreign capital investment was increasing. Moreover, unlike in the years before 1982, most foreign capital was flowing to Mexico's private sector that yielded higher returns rather than as low-interest loans to the Mexican government to finance budget deficits. Although Mexico was experiencing a very large current-account deficit, both in absolute terms and in relation to the size of its economy, neo-liberal policy makers did not consider it an immediate problem. They pointed to Mexico's large foreign-currency reserves, its rising exports, and its seemingly endless ability to attract and retain foreign investment. This attitude ignored the fact that true wealth was leaving Mexico through the turning of peso assets into dollar assets, masked by a Mexican stock-market bubble fueled by an over-valued peso. Reality finally unmasked the faulty neo-liberal theory by late 1994. Mexico's financial crisis was the inevitable outcome of the growing inconsistency between its monetary and fiscal policies, its over-dependence on export for growth, and its exchange-rate system pegged to the dollar. Partly because of an upcoming presidential election, Mexican authorities were reluctant to take actions in the spring and summer of 1994, such as raising interest rates or devaluing the peso, that could have reduced this inconsistency. This structural policy inconsistency was exacerbated by the government's response to several economic and political events that created investor concerns about the likelihood of a currency devaluation. In response to investor concerns, the government issued large amounts of short-term, dollar-indexed notes called tesobonos. By the beginning of December 1994, Mexico had become particularly vulnerable to a financial crisis because its foreign-exchange reserves had fallen to $12.5 billion while it had tesobono obligations of $30 billion maturing in 1995. A country can respond to a current-account deficit in four ways: 1. Attract more foreign capital denominated in dollars. The US does not need to do this because of dollar hegemony, but Mexico, which could not print dollars, thus was forced to attract more foreign capital denominated in dollars with a Ponzi scheme of paying old capital with new capital. 2. Use foreign-exchange reserves to cover the deficit. The US can do this by printing dollars, the reserve currency of choice, but Mexico could not print dollars, only pesos, which put more pressure on the peso-dollar exchange rate. 3. Allow its currency to depreciate, thus making imports more expensive and exports cheaper. But for deeply indebted Mexico, a depreciated peso would make servicing existing foreign loans more expensive in peso terms. 4. Tighten monetary and/or fiscal policy to reduce the demand for all goods, including imports, shrinking the economy. A country such as Mexico can only use (3) and (4), as most Asian countries also found out in 1997. It was obvious that Mexico was experiencing a large current-account deficit financed mostly by short-term portfolio capital that was vulnerable to a sudden reversal of investor confidence. Nevertheless, neo liberal policy makers in both Mexico and Washington, while acknowledging that the peso was overvalued and the existing exchange rate was unsustainable, were undecided about the extent to which the peso was overvalued and if and when financial markets might force Mexico to take action. Estimates of the overvaluation ranged between 5 and 20 percent. Moreover, Fed and Treasury officials under Alan Greenspan and Robert Rubin respectively did not foresee the magnitude of the crisis that eventually unfolded. The IMF was oblivious to the seriousness of the situation that was developing in Mexico and, for most of 1994, did not see a compelling case for a change in Mexico's exchange-rate policy. In the period prior to July 1997, when the Asian financial crises broke out first in Thailand, the IMF was praising South Korea and most other Asian economies for its continuing growth and sound exchange-rate policies. Even after financial contagion was in full force, the IMF kept releasing complacent prognoses of the temporary nature of the crisis as a passing liquidity crunch, while denying its structural causes. The objectives of the US and IMF rescue packages for Mexico, after the December 1994 devaluation and the subsequent loss of market confidence in the peso, were (1) to help Mexico overcome its allegedly short-term liquidity crisis and (2) to limit the adverse effects of Mexico's crisis spreading to the economies of other emerging market nations and beyond. No effort was directed at restructuring fundamental neo-liberal policy faults, nor to admit that localized isolation is empty hope in a globalized system. Many observers opposed any US financial rescue to Mexico. They argued that tesobono investors should not be shielded from financial losses on moral-hazard grounds, and that neither the danger posed by the spread of Mexico's crisis to other nations nor the risk to US trade, employment, and immigration was sufficient to justify such bailout. The Bank of Mexico, the central bank, increased the interest rate from 9 percent to 18 percent on short-term, peso-denominated Mexican government notes, called cetes, in an attempt to stem the outflow of capital. However, despite higher interest rates, investor demand for cetes continued to lag. Investors were demanding even higher interest rates on newly issued cetes because of their perception that the peso would be subject to progressively larger devaluation by rising interest rates. It was a classic vicious circle. Options available to the Mexican government at this time included (1) offering even higher interest rates on cetes; (2) reducing government expenditures to reduce domestic demand, decrease imports, and relieve pressure on the peso; or (3) devaluing the peso. All three options would lead to increased downward pressure on the peso and the economy. The only workable option, exchange control in the form of restrictive capital flow, was not considered by the Harvard-Yale-trained Mexican central bankers, nor encouraged by US advisors. It was not until 1998, when Malaysia successfully adopted exchange control, that some born-again market-failure fundamentalists, led by MIT economist Paul Krugman, grudging acknowledged it as a legitimate option. From the perspective of the Mexican authorities, the first two choices were unattractive in a presidential-election year because they could have led to a significant downturn in economic activity and could have further weakened Mexico's banking system. The third choice, devaluation, was also unattractive, since Mexico's success in attracting substantial new foreign investment to feed its Ponzi scheme depended on its commitment to maintain a stable exchange rate. In addition, a stable exchange rate had been an essential ingredient of long-standing policy agreements among government, labor, and business, and these agreements were perceived as ensuring economic and social stability. Also, the stable exchange rate was considered a key to continued reductions in the inflation rate by orthodox neo-classical economics. Ironically, typical of all Ponzi schemes, success was fatal because it accelerated unsustainability. Rather than adopting any of these options, the government chose, in the spring of 1994, to increase its issuance of tesobonos. Because tesobonos were dollar-indexed, holders could avoid losses that would otherwise result if Mexico subsequently chose to devalue its currency. The government promised to repay investors an amount, in pesos, sufficient to protect the dollar value of their investment. Tesobono financing in effect dollarized Mexican sovereign debt and transferred foreign-exchange risk from investors to the Mexican central bank and government and to provide a short-term liquidity solution that would exacerbate long-term structural problems. Tesobonos proved attractive to domestic and foreign investors. However, as sales of tesobonos rose, Mexico became vulnerable to a financial market crisis because many tesobono purchasers were portfolio investors who were very sensitive to changes in interest rates and related risks. Furthermore, tesobonos had short maturities, which meant that their holders might not roll them over if investors perceived (1) an increased risk of a government default or (2) higher returns elsewhere. Market discipline operated like a pool of circling hungry sharks. Nevertheless, Mexican authorities viewed tesobono financing as the best way to stabilize foreign-exchange reserves over the short term and to avoid the immediate costs implicit in the other alternatives. In fact, Mexico's foreign-exchange reserves did stabilize at a level of about $17 billion from the end of April through August 1994, when the presidential elections came to a conclusion. Mexican authorities expected that investor confidence would be restored after the August presidential election and that investment flows would return in sufficient amounts to preclude any need for continued, large-scale tesobono financing. After the election, however, foreign-investment flows did not recover to the extent expected by Mexican authorities, in part because peso interest rates were allowed to decline in August and were maintained at that level until December. During the autumn of 1994, it became increasingly clear that Mexico's mix of monetary, fiscal, and exchange-rate policies needed to be adjusted. The current-account deficit had worsened during the year, partly as a result of the strengthening of the economy related to a moderate pre-election loosening of fiscal policy, including a step up in development lending, which was considered by market fundamentalists as a big no-no. Imports had also surged as the peso became further overvalued. Mexico had become heavily exposed to a run on its foreign-exchange reserves as a result of substantial tesobono financing. Outstanding tesobono obligations increased from $3.1 billion at the end of March to $29.2 billion in December. Also, between January and November 1994, US three-month Treasury bill yields had risen from 3.04 percent to 5.45 percent, substantially increasing the attractiveness of US government securities. In the middle of November 1994, Mexican authorities had to draw down foreign-currency reserves to meet the demand for dollars. On November 15, 1994, in response to US domestic economic conditions, the Fed raised the federal funds rate by three-quarters of a percentage point to 5.5 percent, raising the general level of dollar interest rates and further increasing the attractiveness of US bonds to investors. By late November and early December, poor economic performance spilled over to political incidents that caused apprehension among investors regarding Mexico's political stability. These concerns were compounded on December 9, when the new Mexican administration revealed that it expected an even higher current-account deficit in 1995 but planned no change in its exchange-rate policy. This decision led to a further loss in confidence by investors, increased redemptions of Mexican securities, and a significant drop in foreign-exchange reserves to $10 billion. Meanwhile, Mexico's outstanding tesobono obligations reached $30 billion, all coming due in 1995. However, Mexican government officials continued to assure investors that the peso would not be devalued. On December 20, Mexican authorities sought to relieve pressure on the exchange rate by announcing a widening of the peso-dollar exchange-rate band. The widening of the band in effect devalued the peso by about 15 percent. However, the government did not announce any new fiscal or monetary measures to accompany the devaluation - such as raising interest rates. This inaction was accompanied by more than $4 billion in losses in foreign reserves on December 21 and, on December 22, Mexico was forced to float its currency freely. The discrepancy between the stated exchange-rate policy of the Mexican government throughout most of 1994 and its devaluation of the peso on December 20, along with a failure to announce appropriate accompanying economic-policy measures, contributed to a significant loss of investor confidence in the newly elected government and growing fear that default was imminent. Consequently, downward pressure on the peso continued. By early January 1995, investors realized that tesobono redemptions could soon exhaust Mexico's reserves and, in the absence of external assistance, that Mexico might default on its dollar-indexed and dollar-denominated debt. As 1994 began, signs were visible that Mexico was vulnerable to speculative attacks on the peso and that its large and growing current-account deficit and its exchange-rate policy might not be sustainable. However, neo-liberal economists generally thought that Mexico's economy was characterized by "sound economic fundamentals" and that, with the major economic reforms of the past decade along Washington Consensus lines, Mexico had laid an adequate foundation for economic growth in the long term. In reality, Mexico was exporting real wealth and importing hot money with the help of a flawed central-bank policy that was attracting large capital inflows and held substantial foreign-exchange reserves derived from foreign debt. Concerns about the viability of Mexico's exchange-rate system increased after the assassination of presidential candidate Luis Donaldo Colosio in the latter part of March and the subsequent drawdown of about $10 billion in foreign-exchange reserves by the end of April. Just after the assassination, US Treasury and Fed officials temporarily enlarged long-standing currency-swap facilities with Mexico from $1 billion to $6 billion. These enlarged facilities were made permanent with the establishment of the North American Financial Group in April. The initiative to enlarge the swap facilities permanently preceded the Colosio assassination. Mexican foreign-exchange reserves stabilized at about $17 billion by the end of April 1994. At the end of June 1994, a new run on the peso was under way. Between June 21 and July 22, foreign-exchange reserves were drawn down by nearly $3 billion, to about $14 billion. In early July, Mexico asked the Fed and Treasury to explore with the central banks of certain European countries the establishment of a contingency, short-term swap facility. That facility could be used in conjunction with the US-Mexican swap facility to help Mexico cope with possible exchange-rate volatility in the period leading up to the August election. By July, staff in the Fed had concluded that Mexico's exchange rate probably was overvalued and that some sort of adjustment eventually would be needed. However, US officials thought that Mexican officials might be correct in hoping that foreign capital inflows could resume after the August elections. In August, the US and the BIS established the requested swap facility, but not until US officials had secured an oral understanding with Mexico that it would adjust its exchange-rate system if pressure on the peso continued after the election. The temporary facility incorporated the US-Mexican $6 billion swap arrangement established in April. At the end of July, pressure on the peso abated, and Mexican foreign-exchange reserves increased to more than $16 billion. Significant new pressure on the peso did not develop immediately after the August election, but at the same time, capital inflows did not return to their former levels. The Fed and Treasury did not foresee the serious consequences that an abrupt devaluation would have on investor confidence in Mexico. These included a possible wholesale flight of capital that could bring Mexico to the point of default and, in the judgment of US and IMF officials, require a major financial assistance package. IMF officials thought that Mexico's sizable exports meant there was not a need to adjust the foreign-exchange policy. They did not foresee the exchange-rate crisis and, for most of 1994, did not see a compelling case for a change in Mexico's exchange-rate policy. The IMF completed an annual review of Mexico's foreign-exchange and economic policies in February 1994. The review did not identify problems with Mexico's exchange-rate policy. This pattern of IMF complacency was repeated in Asia and Latin America throughout the rest of the decade. Whereas the 1982 rescue package would turn out to be just the beginning of a protracted process of managing Mexico's excessive indebtedness, including several concerted debt-rescheduling exercises, a debt buy-back, and the 1990 debt-reduction agreement negotiated under the terms of the Brady Plan, the 1995 rescue package worked better. After the 1982 rescue package, Mexico received support from the Fed and the Treasury on three other occasions, but always in the form of interim financing while other workouts were concluded. The difference between the 1982 and 1995 packages is that while the former was followed by a decade of living in "exile" from the international capital markets, the latter was successful in quickly restoring market access. The difference in outcomes must be related to the size of the financial package and its medium-term quality. In 1995 the financial rescue package was designed to be large enough plausibly to solve Mexico's liquidity crisis; in 1982, the package was large enough to avoid a Mexican default but for the next six years the country had to go from one rescheduling exercise to another, with the uncertainty of whether the country would be able to meet its obligations always lurking on the horizon. Success in the 1995 package was not applicable to correcting Mexico's fundamental debt problem. In 1995, after the Federal Reserve started to hike interest rates in 1994 and sharply curtailed its own purchase of Treasury bills, triggering the Mexico peso crisis and a subsequent US slowdown, the Bank of Japan initiated a program to buy $100 billion of US treasuries. China bought $80 billion. Hong Kong and Singapore bought $22 billion each. South Korea, Malaysia, Thailand, Indonesia and the Philippines bought $30 billion. The Asian purchase totaled $260 billion from 1994-97, the entire increase in foreign-held US dollar reserves. These recycled dollars pushed up stock prices in the United States. Like the rest of the world, Asia is heavily dependent on export to the United States. Japan, by far the largest Asian economy, is paralyzed by an export addiction for dollars that are useless in Japan. This paralysis is made worse by an institutionally based policy dispute between the Ministry of Finance and the Bank of Japan, its newly installed central bank, in dealing with its economic woes. The dispute centers on the nature of the Japanese banking system and its traditional national banking role in supporting the export-based national economic policy. Central banking, as espoused by BIS regulations, challenges the very root of Japanese political-economy culture, which has never viewed reform as a license to weaken Japanese nationalism that saved Japan from Western imperialism in the 19th century. The Japanese model, until it became captured by Japanese militarism, provided inspiration for nationalist movements all over Asia against Western imperialism. After 1979, central banking has been viewed increasingly as the monetary institution of financial neo-liberalism, which has become synonymous with economic neo-imperialism. In the US and EU, fiscal policy was significantly diminished as a macroeconomic policy tool in the 1990s, releasing the Fed and the ECB to assume the role of meta-political economic manager for their societies. Money, instead of an engine of commerce for the benefit of people, has become an economic icon whose sanctity must be defended with human casualties for the good of the increasingly internationalized financial system. Unregulated global financial markets operating within the context of international monetary anarchy allows these two key central banks to impact economic growth adversely, first in the rest of the world, now even in their home countries. When the Fed moved to tighten monetary policy in 1999-2000, after a panic ease in 1997-99, it in effect suppressed global economic growth by forcing the ECB and other central banks into a series of parallel rate hikes designed to support the value of their currencies against the dominant dollar. With joblessness rising and growth restrained around the world, pressure mounted on the United States to expand its already unsustainable current-account deficit, to the inevitable detriment of many US households and businesses, particular in the manufacturing sector but increasingly in the information and data-processing sectors as well. The so-called New Economy died. The Fed, the ECB and most other central banks have remained uniquely opaque entities. In fact, the Fed takes pride in playing cat-and-mouse games with the market over the prospect of its interest-rate policy and allows the financial market to operate like a lottery, with the winner being the lucky one who correctly guessed its interest-rate decisions. Most Asian central banks follow reactively Fed policy and action. Bill Gross, manager director of Pimco, the largest bond-investment fund in the United States, may not have a monopoly on truth, but he controls vast investment power over the credit market and makes decisions based on his views. He wrote recently that 13 percent of the US stock market, 35 percent of the US Treasury market, 23 percent of the US corporate bond market, and 14 percent direct ownership in US companies are now in the hands of non-US investors. And with the trade deficit at 6 percent of GDP and the US need to attract nearly 80 percent of all the world's ongoing savings just to keep the dollar at current levels, "an end to the party is clearly in sight". Gross said that former Treasury secretary Robert Rubin's policy of a strong dollar succeeded so famously that US bonds and stocks now have lower yields and much higher price-to-earnings ratios (P/Es) than most alternative markets. This strong-dollar policy, implemented through the Fed under Alan Greenspan, has painted the US into a corner from which either a falling dollar, depreciating financial markets, or both are "nearly inevitable". The net foreign debt in the US economy is now 22 percent of GDP. Assuming an economic recovery, the US economy is on a trajectory toward a debt burden of 40 percent of GDP within five years, roughly the debt-to-GDP ratio of Argentina in 2000. What keeps the US afloat is dollar hegemony. The US cannot forever borrow in order to buy more from the rest of the world than it sells. The interest burden will eventually be so heavy that foreign investors will be unwilling or unable to keep financing this rising debt. When that happens, the dollar will drop and dollar interest rates will spike upward. The United States will then be forced to run a trade surplus with a drastic devaluation of the dollar and/or a draconian deflation in real incomes in order to reduce demand for imports and make US goods cheap enough to run a surplus in world markets. Yet this will directly shrink world trade, making it difficult for the US to reduce its cumulated debt. The costs of balancing trade through deflation would be near fatal. According to one calculation (Godley 1995), bringing a current-account deficit of 2 percent GDP into balance would require a 10 percent drop in GDP and a jump of 5 percent in the unemployment rate. With today's trade deficit of 4 percent and rising, the required contraction in GDP would be 20 percent or greater and an unemployment rate of an additional 10 percent to the current 7 percent. Attempting to regain balance through currency devaluation could be catastrophic. Goldman-Sachs recently estimated that it would take a more than 40 percent drop in the dollar just to halve the US current-account deficit. Getting to a trade balance will be even more difficult because US manufacturing capacity may well have shrunk below the level needed to eliminate the trade deficit through expanding exports. Given relentless import competition, investors are reluctant to make long-term capital available to small and medium manufacturing firms, and some large ones as well. The grim outlook for manufacturing also reduces the incentive for young people to invest in becoming skilled manufacturing workers. The low savings rate in the United States also contributes to the current-account problem but it is now a function of a deficiency in private rather than public savings. This is a much harder problem to solve. In fact, the US does not seem to know how to raise its private savings rate without putting a damper on its relentless push on expanding consumer finance. Under current conditions, increasing the savings rate would reduce consumer demand, upon which the US economy and the world depend. Japan's economic problem is rooted in the geopolitical shift resulting from the end of the Cold War. The Japanese economy has outgrown its postwar role as an export engine. With the end of the Cold War, Japan no longer enjoys geopolitically induced special trade concessions from the United States. The continuing trade surplus with the US is now contingent on its being recycled into dollar assets. Not only will the continued expansion of export to the US not be sustainable at a rate that will help the doomed Japanese domestic economy, but even effective stimulation of domestic consumption cannot solve the Japanese dilemma because the domestic economy is too small to sustain the enormous and growing overcapacity of its export engine. The Japanese economy cannot be revived by domestic restructuring unless it is prepared to shrink drastically to the size of the United Kingdom. No monetary or fiscal measures can overcome this structural problem, which is the legacy of policies of General Douglas MacArthur's occupation after World War II. The Japanese problem is not a purely economic problem. It is a political-economy problem. What Japan needs is to restructure its international economic relationships away from its unnatural partner, the United States, toward its natural partner, China, and to shift from an export economy to a regional-developmental economy. The anchor of US policy in Asia is the United States' "special relationship" to Japan. The intensity and bitterness of the historical conflict between Japan and the US for their separate interests in Asia have not been eliminated by the post-World War II facade of "special relationship" or by the Mutual Defense Treaty. Before World War II, Japan, not China, was seen by most US leaders as America's chief rival in Asia. They squeezed Japan's access to vital raw materials, particularly oil, and so obstructed Japan's plan of becoming a great regional power through its conquest of a fragmented China weakened by a century of Western imperialism. While the targets of Japanese expansion in World War II were primarily the colonies of the British and French empires, the sole exception being the Philippines, the objective made it necessary for Japan to disable the US Pacific Fleet. The Pacific theater against Japan in World War II was won mainly by US efforts, unlike the European theater, where Britain and the Soviet Union also played major roles. It was the Japanese attack on Pearl Harbor that forced Adolf Hitler to declare war on a formally neutral United States, thus saving Britain from imminent defeat. It was one of the two strategic errors Germany made, the other being the invasion of the Soviet Union. Without a two-front war that eventually destroyed the German 6th Army on Russian soil in February 1943 and the relentless Soviet counteroffensive afterward that tied up half of German military assets, it would be doubtful whether the US landing in Normandy in 1944 would have been as successful as it was. Britain, in winning a Pyrrhic victory against Germany with US and Soviet help, lost both empire and greatness. Together with Britain, supposedly the winner, Japan and Germany, the vanquished, were thrown by World War II into the arms of the United States as suppliants, in a subordination masked by the euphemism of "special relationships". Postwar Germany, divided into socialist East and capitalist West, benefited economically from the Cold War by the need of the US to subsidize West Germany to keep it safely in the Western camp. Outside of imposed anti-Sovietism and anti-communism, West Germany enjoyed enviable autonomy from US policy domination. Japan enjoyed much less autonomy than West Germany, a fact many Japanese resented as US racism. Further, Germany had a real historical phobia against a powerful Russia pushing westward, while Japan had less real reason to fear China, or an Soviet Union that was fundamentally Europe-oriented. Japan had already defeated Russia once. After the Japanese surrender, MacArthur at first aimed at restructuring Japanese politics and economics to prevent a return to militarism. For that purpose, MacArthur's occupation regime purged from Japanese politics all wartime leaders, instituted land reform, and began breaking down large corporate conglomerates (zaibatsu or keiretsu), in favor of populist if not socialist forces. This strategy would begin to change in the early months of 1948 with what would be labeled in diplomatic history as "The Reverse Course". As fears of Soviet expansion grew in Washington, concerns also grew that MacArthur's reform program was making Japan geopolitically unreliable, ideologically unstable, economically weak, and geopolitically vulnerable to subversive infiltration or, in the longer run, perhaps even military invasion with Fifth Column help. As China liberated itself by establishing a socialist state in 1949, MacArthur was ordered to turn US occupation policy abruptly into a strategy of keeping Japan from turning toward socialist paths. Since Japan was viewed as a "strong point" by key US grand strategists George Kennan, George Marshall, and Dean Acheson, a more politically regressive and economically conservative program was put into place. It was a program designed to stabilize the Japanese political economy and to set the stage for revived limited Japanese military strength in the future that would assist US efforts in countering international communism in Japan and the rest of East Asia. To support this controlled military power, a US trade subsidy/preference regime for Japan was instituted. MacArthur, who had all but set himself up as the new emperor of Japan and who had built a postwar popularity within US domestic politics, criticizing the State Department for shortcomings ranging from Eurocentrism to excessive meddling in the Pacific to lack of political will to use nuclear weapons on China, would argue not only against reversing the anti-zaibatsu program, but also against strengthening the Japanese military from whom he had suffered well-publicized defeat with deep personal embarrassment. Ironically, it was left to the Supreme Military Commander/Occupier to argue that economic growth and a stable political order were the most important weapons in the struggle for containment of the communist threat for Japan, not the creation of military might. Nobody doubted the general's argument about the importance of economic strength and political stability, but many at the US Defense Department and some even at the State Department subsequently insisted that they wanted a major portion of the fruits of US supplied economic revival to be channeled into Japanese military strengthening. In their minds, Japan should accept a significant share of the burden of defending itself and containing communism in the region. This position would win the debate in Washington and would be presented to Japanese authorities in 1950-51 by president Harry Truman's special envoy, John Foster Dulles. In the 1950s, the administrations of Truman and Dwight D Eisenhower both believed that open tolerance of Japanese resistance to US imports, systematic undervaluation of the yen, and total reliance on US military protection were necessary to strengthen Japan domestically and legitimize it internationally as a solid anti-communist ally. After persistent persuasion by premier Yoshida Shigeru, US leaders also decided that pushing the Japanese government too soon and too hard to build up its military significantly merely to reduce the US defense burden could lead to a popular backlash in Japan that might threaten the budding alliance and, by association, the maintenance of US military bases in Japan. Japan, a recent and very bitter enemy, was clearly not sharing much of the cost burden of the anti-communist alliance early in the Cold War. In fact, it worked to benefit economically from it. The kernel of this dilemma is still alive in the developing relationship of new US-Japan relationship under the current administration of President George W Bush. While the Bush Team claims a continuation of the strong-dollar policy, there is much open talk of coordinated government intervention against a yen devaluation beyond 120 to the dollar. Concerned about the acceptance of the US-Japan alliance in domestic US politics, US leaders decided they must maintain US dominance of the political alliance in exchange for generous US aid, trade, and military protection policies Washington had already granted to Tokyo. As the sole economic power that had directly profited from World War II, the United States had the resources and the confidence to buy Japanese support with economic carrots. In particular, Yoshida would be pushed to accept Washington's pro-Kuomintang (KMT, or Nationalist) and tough anti-communist China policies. US elites worried that if Yoshida diverged too strongly from the anti-communist strategies being advocated by the United States, Congress and the public would demand a fundamental reconsideration of the already controversial one-way economic relationship. The same argument was presented to other national leaders around the world as a reason for them to shun independent national-policy lines toward the communist world. The geopolitical foundation of the Marshall Plan was obvious, but the US domestic-politics argument was the classic mantra. Yet the cost for Japan of compliance with US geopolitical leadership demands was very high because the United States had adopted such a tough policy toward China, with which Japan would have preferred to have closer economic and diplomatic ties than intransigent US policy would allow. This problem exists even today, albeit under different geopolitical conditions. The Truman administration's need to guarantee domestic consensus for its domestically controversial early-Cold War grand strategy often compelled it to abandon its privately preferred economic and diplomatic strategies toward China. In 1949-50, the US refused to abandon KMT leader Chiang Kai-shek and recognize the new People's Republic of China (PRC), despite Truman's personal disdain for Chiang and KMT corruption and Madam Chiang's deft manipulation of the Republican right wing and the anti-communist Christian fundamentalists in US domestic politics. At the outbreak of the Korean War, the Truman administration reversed earlier statements of neutrality regarding the Chinese Civil War and sent the 7th Fleet to protect KMT-controlled Taiwan from potential forceful unification with the communist mainland. This locked the United States into an exclusive diplomatic relationship with Chiang's regime until 1973, and the 7th Fleet continues to be active in the Taiwan Strait today. The Taiwan issue remains the main obstacle to normal US-China relations. After the late-1950 escalation of the Korean War, a desperate Truman administration applied a total embargo on China, and policies more hostile than those applied to the Soviet Union (this imbalance in the Coordinating Committee for Multilateral Export Controls - CoCom - regime would come to be known as the "China Differential"). Many of the US diplomatic and trade policies around the world, particularly in Asia, were often viewed by top presidential advisors as ineffective or even counterproductive on geopolitical grounds, but politically unavoidable on domestic grounds, particularly after the outbreak and escalation of the Korean War from June-November 1950. To understand the sacrifice Tokyo had to make in order to grant the United States a firm leadership role on the budding US-Japan alliance's China policy, it is critical to note just how important the Chinese economy had been to Japan in modern history. It was the search for a preferred integrated economic relationship with China that fueled Japanese aggression on the mainland in the 1930s. Japanese leadership was actually obsessed first and foremost with the threat from the Soviet Union and the lessons of World War I about the need for an autarkic economy to provide staying power in war. The quest for Japanese autarky on the Asian mainland helped drive Japan deeper and deeper into a quagmire in China and, eventually, into war with the United States over oil supply. In the 1920s and for most of the 1930s, China (including Manchuria) was by far Japan's biggest export market and import provider in the region. Japanese exploitation of Chinese resources financed the Japanese military machine for World War II. In 1949, Yoshida and other members of the Japanese elite saw real economic and political benefits in establishing relations with the new communist regime in Beijing. Postwar Japan wanted to appear sympathetic to the new Asian post-colonial nationalist movements, a theme of the wartime Co-prosperity Ring. The problem was not that PRC-Japan trade was viewed as against US or Japanese national interests, but that it was unacceptable to US domestic politics. In February and March 1949, six months before the founding of the People's Republic, the US National Security Council produced NSC 41, a report on China trade policy. The document reflected a cautious faith in the possibility of Chinese Titoism and the usefulness of US trade with areas held by the Chinese Communist Party as a way to reduce the CCP's dependence on Moscow. The sections on Sino-Japan trade were, in a sense, more practical, emphasizing the goal of reducing the US burden of rebuilding Japan as well as gaining some degree of political leverage over China through trade dependence with Japan. The State Department was hardly indifferent to the concerns raised by opponents to Sino-Japanese trade, so NSC 41 and other directives advised MacArthur to encourage trade on a quid pro quo basis and to try to find alternative markets and raw-material sources elsewhere in Asia to reduce Japanese dependence on China for critical materials. The need for such alternative markets for Japan was one of the arguments Washington used on Japan to secure its support for keeping Southeast Asia out of communist hands early in the Cold War. This constituted another "Reverse Course", in which the United States went from a critic to a supporter of European imperialism in British Malaya and Indochina. Despite US restrictions, Japanese trade with mainland China grew tenfold from 1947-50. The Korean War and the US-led embargoes against China halted this trend. Another problem facing the United States in its calculation about US-China and US-Japan trade was that, for economic and political reasons, Britain was unwilling to apply the strict export-control measures toward China that Washington demanded, fearing the damage such measures would do to British Hong Kong. In November 1949, top US officials recognized that if Western Europe traded relatively normally with China while the United States and Japan embargoed it, this would only serve to increase the expense of the US relationship with Japan without any real costs being raised to the Chinese economy. Although the Truman administration would continue to try to prevent China from getting strategically important materials (1A and 1B items on the CoCom list), it seemed resigned to allow PRC trade with the US and Japan on a "cash basis". The logical standard was that the same criteria should be applied to China that were being applied to the Soviet Union and Eastern Europe. In the first half of 1950, the picture became more mixed as relations with Beijing worsened after the January seizure of US consular property and the February signing of the Sino-Soviet defense treaty. The United States wanted to find a balance between, on the one hand, reducing the burden on the Japanese economy (and, indirectly, on the United States) by allowing trade between Japan and the PRC, and, on the other, reducing Japanese dependence on China, which could provide China with political leverage over Tokyo and threaten US dominance. The Truman administration pushed this argument particularly hard on other non-communist partners in East Asia, which had been reluctant to open up their economies to their former Japanese occupiers. The administration argued that increasing their trade with Japan was a necessary role for these allies since Japan's natural market in China had fallen to the communists. The Korean War would radically alter this picture, with the US leveling the "China Differential" in CoCom. It was clear that domestic politics, rather than the "high politics" of strategy, was driving US trade policy toward China, as was true with the US attitude toward Chinese accession to the World Trade Organization five decades later. This all but destroyed Sino-Japanese trade, as some 400 items were put on the list of prohibited products. Over the next several years, important elites, including president Eisenhower himself, recognized the illogic of the China Differential and a strict Japanese embargo on China. But significant relaxation of China-Japan trade restrictions would remain in place until well after the end of the Korean War. Throughout 1951, John Foster Dulles, Truman's envoy to Japan for negotiations on the Japanese Peace Treaty, would apply the same logic with Yoshida Shigeru. Dulles made various arguments why Japan should reject Beijing as a diplomatic partner, continue recognizing Chiang Kai-shek's regime on Taiwan as the sole legitimate government of all of China, and sign a peace treaty with Chiang's Republic of China rather than the PRC. Dulles also sought Yoshida's general compliance with US limits on trade contacts with the PRC. Like most Japanese elites since MacArthur, Yoshida was anti-communist. But as a practical matter, Japan wanted diplomatic ties with Beijing and much more extensive trade relations than Dulles's preferred scenario would allow. Yoshida bluntly put it: "I don't care whether China is red or green. China is a natural market, and it has become necessary for Japan to think about markets." In his effort to persuade Japanese leaders, Dulles' trump card was not a geostrategic argument but a domestic political one. He emphasized that if Japan did not comply with US general Cold War strategy, the military protection of Japan by US forces would become more controversial domestically, as would economic aid and Japan's preferential trade and financial arrangements. It was this domestic political argument, above all others, that convinced the reluctant Japanese that questioning the US leadership role in the Cold War in Asia could carry devastating results for the maverick nation's security and economic interests. Dulles would return to this tried-and-true bargaining tactic again as president Eisenhower's Secretary of State in order to prevent Japan from establishing politically significant trade offices in China. The result of Japan's acquiescence to US demands, the December 1951 Yoshida Letter and subsequent bilateral Peace Treaty negotiations with Taipei in 1952, locked Japan into a pro-Taiwan, anti-Beijing diplomatic posture for the next 21 years. With Japanese acquiescence to America's harsh economic sanctions regime against China, the small-scale but promising trade between Japan and the PRC allowed by the US in 1949-50 practically disappeared. Politicians are probably held in as low esteem in Japan today as in the United States. For an Asian culture, that is a serious development. Unfortunately, the bureaucracy, which basically sets policy for Japan, is also not trusted because of the present anemic state of the economy and US media scapegoating. After a whole decade of slow growth, the streets of Tokyo still do not look like those of a poor economy, because the Japanese government has been effectively insulating the Japanese public from the real pain. The US had a cozy relationship with the Liberal Democratic Party but had a contentious relationship over trade. Today, young people in Japan are more openly nationalistic than the subdued older generation. It will be increasingly more difficult for the United States to work with Japan as time passes. For many years, Japan has counted on its economic strength to provide its regional and global influence. There was one magic moment when the yen was 79 to a US dollar and the Japanese economy on a currency basis was larger than the US economy and Herman Khan was predicting the Japanese Century. The psychological shock in shifting from a position of a rising economic powerhouse to a situation where the world is criticizing Japan's economy has sapped Japan's self-confidence. Market capitalization of Japanese equity fell from 50 percent of global value to just 10 percent, even as the US lost 60 percent of its peak market capitalization. The economic difficulties Japan is experiencing are not a banking problem, as US neo-liberal economists keep saying. The central bank, though newly created, has become part of the problem. But the central problem involves a much broader system of a dual economy of successful transnational companies built on subsidiaries and networks of other small companies that are operating along unique Japanese relationships. The Finance Ministry, trying to help consumers by dropping the discount rate to 0 percent, failed to help consumers but decimated the insurance industry because it offered a guaranteed rate of return on its pension plans that are now much higher than current returns on investment. The industry could not find any place to put the money to provide the return it had guaranteed. Large insurance companies went broke and the people counting on them for their pensions no longer had pensions. As a result, people started not renewing their policies. Japan is becoming an older society faster than any society in the world. But it has a large savings base, about $10 trillion, which amounts to about a per capita amount of $80,000, enough to cover per capita debt in the United States at its height. But 60 percent of that money is held by people over 65 who are not robust consumers. How does one motivate such an economy? The world has never seen a country with a population this old. The world consensus is pushing Japan into a quick solution so as to avoid an even more traumatic Asian financial crisis. The concern in Tokyo is that, if Japan did "fix" the economy in a hurry, it might cause more trouble than would a gradual approach. The US has told Japan to lead. The first solution Japan came up with when the Asian economy started to collapse was a $100 billion security fund to help Asian economies, which the US rejected. Economic growth has been flat since the real-estate and stock bubble burst in 1990, except for 1996, when real GDP growth was 3.6 percent due to a large fiscal stimulus and low interest rates. Japan remains a massive net exporter of goods to the rest of the world as its economy sinks. It has emerged as a model for other Asian economies to avoid, rather than copy. Japan, as an Asian culture, places importance on the national economy and operates as if individuals and companies can only prosper if the national economy prospers. The US economy operates as a "natural" calculus of individual survival. To Americans and American corporations, a national economic boom has no meaning unless the individual unit first benefits. As markets globalize, this creates problems for management in both cultural regimes. For Japan, bailouts are normal, while in the US bailouts, though they occur, are exercised with apologies. When in trouble, the US economy historically sacrifices quickly the weak and the small, while the Japanese economy punishes the strong and big gradually. When the long-overdue US recession hits, Americans will see their faith in market free enterprise shaken as the Japanese have been losing their faith in their command economy, despite the fact that the government has been reasonably effective in insulating the Japanese public from economic pain. The Campaign 2000 rhetoric in the United States was already slightly populist and the recession has yet to begin. The recent Bush tax plan was couched in heavy populist rhetoric. The problem is that around the world there are visible signs of exhaustion. Asia and Latin America are completely worn out after six years of tumult. The US boom was fed mostly by global deflation, and there have not been free lunches even in the US. Even those who are still doing well have to work 14-hour days and most families need to be two-income households to make do. The press has stop running stories about people with $60,000 annual incomes living in their cars in Silicon Valley because it is no longer news. At this rate, unemployment may even come as a relief and a guiltless way to get off the treadmill. There was a moment in the late 1960s, before the Vietnam War blew away all of America's surpluses, that people with good incomes were beginning to take three-day weekends on a regular year-around basis and eight-week vacations. From Los Angeles to Dallas to Scarsdale, fathers were home by 5:30pm barbecuing for the whole family and mothers had time for their children, and the GDP was a mere $200 billion. Economists thought then that if the GDP reached $1 trillion, all economic problems would be solved. Instead, the GDP is now more than $10 trillion, and there is financial crisis everywhere - from health care to social security to education, even defense. There appears to be a problem with what growth really is. Next: The Japanese Experience