Liberating Sovereign Credit for Domestic Development

Part I: The Curse of Dollar Hegemony

By
Henry C.K. Liu

Ever since the end of the Cold War, which actually began winding down with President Nixon’s policy of Détente, trade has overwhelmed domestic development in the global economy, as superpower competition to win the hearts and minds of the world in the form of aid subsided. Persistent US fiscal deficits forced the abandonment in 1971 of the Bretton Woods regime of fixed exchange rates linked to a gold-back dollar. The flawed international finance architecture that resulted has since limited the global growth engine to operating with only the one cylinder of international trade, leaving all other cylinders of domestic development in a state of permanent stagnation.

Drawing lessons from the 1930s Great Depression, economics thinking prevalent immediately after WWII had deemed international capital flow undesirable and unnecessary for national development. Trade, a relatively small aspect of most national economies, was to be mediated through fixed exchange rates pegged to a gold-backed dollar. These fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the economies participating in international trade, which was expected to augment but not overwhelm the national economies. The impact of exchange rates was limited to the financing of international trade. Exchange rate considerations were not expected to dictate domestic monetary and fiscal policies, the chief function of which was to support domestic development and regarded as the inviolable province of national sovereignty.

The global economy is a comprehensive and complex system of which trade is only one sector. Yet economists and policy-makers promoting neoliberal globalization tend to view trade as the entire global economy itself, downplaying the importance of non-trade-related domestic development. Neoliberals promote market fundamentalism as the sole, indispensable path for national economic growth, despite ample evidence in the past two decades that trade globalization tends to distort balanced domestic development in ways that hurt not only the less developed, but also the developed economies. The distributional consequences of global trade liberalization frequently work against the poor, the unemployed and the financially weak in all economies. Reductions in tariffs reduce tax revenues for public spending that helps poor people and weaken needed protection for endangered domestic industries. While distributional consequences of trade liberalization are complex and country-specific, the general trend has been to exacerbate income disparity everywhere, which in turn leads to economic underperformance and political instability.

In the United States, the Mecca of free-market entrepreneurship, the statist sectors - public finance, defense, health care, social security and public education – have kept the economy afloat in recurring, protracted recessions, while entrepreneurial ventures such as corporate finance, insurance, high-tech manufacturing, airlines and communication languish in extended doldrums. Unregulated markets lead naturally to monopolistic centralization and abuses in corporate governance and finance. It is undeniable that "free" markets are inherently self-destructive of their own freedom. Free markets depend on enlightened statist regulations to remain free and to prevent them from turning into failed markets. Government, from monarchy to democracy, exists to protect the weak from the strong and to maintain socio-political stability with a just socio-economic order.

The current international finance architecture is based on the US dollar as the dominant reserve currency, which now accounts for 68 percent of global currency reserves, up from 51 percent a decade ago. Some 80 percent of all foreign exchange transactions involve dollars. In addition, all IMF loans are denominated in dollars, as are most foreign currency loans. Yet in 2003, the US share of global exports of goods and services was only 11% (US$1 trillion out of a world total of $9.1 trillion) and its share of global imports was 13.8% ($1.260 trillion). Commodity price and exchange rate changes led to a 10.5% rise in world merchandise trade value in 2003 above 2002. For the first time since 1995, dollar prices increased for both agricultural and manufactured products. World merchandise exports per capita will amount to $1,562 in 2004, or $4.30 per day, while 30 percent of the world's population of 6.4 billion lives on less than $1 a day, less than one-quarter of per capita export value.

Since the 1971 collapse of the Bretton Woods regime, the dollar has been a global monetary reserve instrument that the US, and only the US, can produce by fiat, not backed by gold. Despite recent corrections, the exchange value of the dollar is still at an 18-year trade-weighted high, notwithstanding record US current-account and fiscal deficits and the status of the US as the world’s leading debtor nation. The US national debt as of September 15, 2004 was $7.38 trillion, rising at the rate of $1.69 billion per day, against a gross domestic product (GDP) of $8.73 trillion for the same period.

World trade is now a game in which the US produces fiat dollars and the rest of the world produces goods and services that fiat dollars can buy. The world's interlinked economies no longer trade to capture Ricardian comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to stabilize the value of their currencies in world currency markets. To prevent speculative and manipulative attacks on their currencies, central banks of all governments must acquire and hold dollar reserves in amounts that can withstand market pressure on their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. Only the Federal Reserve is exempt from this pressure, because the US Treasury can print dollars at will with relative immunity. This creates a built-in support for a strong dollar that in turn forces the world's central banks to acquire and hold more dollar reserves, making the dollar even stronger. This phenomenon is known as dollar hegemony, which is created by a geopolitically-constructed peculiarity through which critical commodities, among the most notable being oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance for the oil-exporting cartel since 1973. The trade value of a currency is no longer tied to the productivity of its issuing economy, but to the size of dollar reserves held by its central bank.

By definition, dollar reserves must be invested in dollar assets, creating an automatic capital-accounts surplus for the dollar economy. Even after a protracted period of sharp correction, US stock valuation is still at a 25-year high and trading at a 56% premium compared with emerging market averages. Between 1996 and 2003, the value of US equities rose around 80% compared with 60% for European and a decline of 30% for Japanese. The 1997 Asian financial crisis cut Asia equities values by more than half, some as much as 80% in dollar terms even after drastic devaluation of local currencies. Even though the US has been a net debtor since 1986, its net income on the international investment position has remained positive, as the rate of return on US investments abroad continues to exceed that on foreign investments in the US. This reflects the overall strength of the US economy, and that strength is derived from the US being the only nation that can enjoy the benefits of sovereign credit utilization while amassing external debt, largely due to dollar hegemony.

Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the distorted reflection in the mirror as a perfect representation.

In the language of economics, credit and debt are opposites but not identical. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern finance economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Debt turns corporate shares into Giffen goods, demand for which increases when their prices go up, and creates what Federal Reserve Board Chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.

Monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking. This view is valid only for specie money, which is a debt certificate that can claim on demand a prescribed amount of gold or other specie of value. But fiat money issued by a sovereign government is not a sovereign debt but a sovereign credit instrument. Sovereign government bonds are sovereign debt while local government bonds are agency debt but not sovereign debt, because local governments, while they possess limited power to tax, cannot print money, which is the exclusive authority of the Federal government or a central government. When money buys bonds, the transaction represents sovereign credit canceling public or corporate debt. This relationship is rather straightforward but is of fundamental importance.

Money issued by government fiat is now exclusive legal tender in all modern national economies. The State Theory of Money (Chartalism) holds that the general acceptance of government-issued fiat currency rests fundamentally on government's authority to tax. Government's willingness to accept the fiat currency it issues for payment of taxes gives such issuance currency within a national economy. That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government in the form of fiat money. When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment. A central banking regime operates on the notion of government-issued fiat money as sovereign credit. A central bank operates essentially as a lender of last resort to a nation’s banking system, drawing on sovereign credit.

Thomas Jefferson prophesied: "If the American people allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive people of all property until their children will wake up homeless on the continent their fathers occupied ... The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs."   This warning applies to other peoples in the world as well.

Government levies taxes not to finance its operations, but to give value to its fiat money as sovereign credit instruments. If it chooses to, government can finance its operation entirely through user fees, as some fiscal conservatives suggest. Government needs never be indebted to the public. It creates a government debt component to anchor the private debt market, not because it needs money. Technically, a sovereign government needs never borrow. It can issue tax credit in the form of fiat money to meet all its liabilities.   And only a sovereign government can issue fiat money as sovereign credit.

If fiat money is not sovereign debt, then the entire conceptual structure of finance capitalism is subject to reordering, just as physics was subject to reordering when man's worldview changed with the realization that the earth is not stationary nor is it the center of the universe. The need for capital formation to finance socially-useful development will be exposed as a cruel hoax, as sovereign credit can finance all socially-useful development without problem. Private savings are not necessary to finance public socio-economic development, since private savings are not required for the supply of sovereign credit. Thus the relationship between national private savings rate and public finance is at best indirect. Sovereign credit can finance an economy in which unemployment is unknown, with wages constantly rising to provide consumer buying power to prevent production overcapacity. A vibrant economy is one in which there is persistent labor shortages that push up wages to reduce overcapacity. Private savings are needed only for private investment that has no intrinsic social purpose or value. Savings without full employment are deflationary, as savings reduces current consumption to provide investment to increase future supply, which is not needed in an economy with overcapacity created by lack of demand, which in turn has been created by low wages and unemployment. Say's Law of supply creating its own demand is a very special situation that is operative only under full employment with high wages. Say's Law ignores a critical time lag between supply and demand that can be fatally problematic to the cash-flow needs in a fast-moving modern economy.   Savings require interest payments, the compounding of which will regressively make any financial scheme unsustainable. The religions forbade usury for very practical reasons.

The relationship between assets and liabilities is expressed as credit and debt, with the designation determined by the flow of obligation. A flow from asset to liability is known as credit, the reverse is known as debt. A creditor is one who reduces his liability to increase his assets, which include the right of collection on the liabilities of his debtors. Sovereign debt is a pretend game to make private monetary debts denominated in fiat money tradable.

The sovereign state, representing the people, owns all assets of a nation not assigned to the private sector. This is true regardless whether the state operates on socialist or capitalist principles. Thus the state's assets is the national wealth less that portion of private sector wealth after tax liabilities, plus all other claims on the private sector by sovereign right. High wages are the key determinant of national wealth. Privatization generally reduces state assets while it may increase tax revenue. As long as a sovereign state exists, its credit is limited only by the national wealth. If sovereign credit is used to increase national wealth, then sovereign credit is limitless as long as the growth of national wealth keeps pace with the growth of sovereign credit.

When a sovereign state issues money as legal tender, it issues a monetary instrument backed by its sovereign rights, which includes taxation. A sovereign state never owes domestic debts except by design voluntarily. When a sovereign state borrows in order to avoid levying or raising taxes, it is a political expedience, not a financial necessity. When a sovereign state borrows, through the selling of sovereign bonds denominated in its own currency, it is withdrawing previously-issued sovereign credit from the financial system. When a sovereign state borrows foreign currency, it forfeits its sovereign credit privilege and reduces itself to an ordinary debtor because no sovereign state can issue foreign currency.

Government bonds act as absorbers of sovereign credit from the private sector. US Government bonds, through dollar hegemony, enjoy the highest credit rating, topping a credit risk pyramid in international sovereign and institutional debt markets. Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency in the international finance architecture. Architecture is an art the aesthetics of which is based on moral goodness, of which the current international finance architecture is visibly deficient. Thus dollar hegemony is objectionable not only because the dollar, as a fiat currency, usurps a role it does not deserve, but also because its effect on the world community is devoid of moral goodness, because it destroys the ability of sovereign governments beside the US to use sovereign credit to finance the development their domestic economies, and forces them to export to earn dollar reserves to maintain the exchange value of their own currencies.

Money issued by sovereign government fiat is a sovereign monopoly while debt is not. Anyone with acceptable credit rating can borrow or lend, but only sovereign government can issue fiat money as legal tender. When sovereign government issues fiat money, it issues certificates of its sovereign credit good for discharging tax liabilities imposed by sovereign government on its citizens. Privately-issued money can exist only with the grace and permission of the sovereign, and is different from sovereign government-issued money in that privately issued money is an IOU from the issuer, with the issuer owing the holder the content of the money's backing. But sovereign government-issued fiat money is not a debt from the government because the money is backed by a potential debt from the holder in the form of tax liabilities. Money issued by sovereign government by fiat as legal tender is good by law for settling all debts, private and public. Anyone refusing to accept dollars in the US for payment of debt is in violation of US law. Instruments used for settling debts are credit instruments.

Buying up sovereign bonds with government-issued fiat money is one of the ways government releases more sovereign credit into the economy. By logic, the money supply in an economy is not government debt because, if increasing the money supply means increasing the national debt, then monetary easing would contract credit from the economy. But empirical evidence suggests otherwise: monetary ease increases the supply of credit. Thus if fiat money creation by sovereign government increases credit, money issued by sovereign government fiat is a credit instrument.

Economist Hyman Minsky rightly noted that whenever credit is issued, money is created. The issuing of credit creates debt on the part of the counterparty; but debt is not money, credit is. Debt is negative money, a form of financial antimatter. Physicists understand the relationship between matter and antimatter. Einstein theorized that matter results from concentration of energy and Paul Dirac conceptualized the by-product creation of antimatter through the creation of matter out of energy. The collision of matter and antimatter produces annihilation that returns matter and antimatter to pure energy. The same is true with credit and debt, which are related but opposite. They are created in separate forms out of financial energy to produce matter (credit) and antimatter (debt). The collision of credit and debt will produce annihilation and return the resultant union to pure financial energy un-harnessed for human benefit. The paying off of debt terminates financial interaction.

Monetary debt is repayable with money. Sovereign government does not become a debtor by issuing fiat money, which, in the US, takes the form of a Federal Reserve note, not an ordinary bank note. The word "bank" does not appear on US dollars. Zero maturity money (ZMM) in the dollar economy, which grew from $550 billion in 1971 when President Nixon took the dollar off a gold standard, to $6.6 trillion as of June 2004, is not a federal debt.   It amounts to about 65% of US GDP of $11.64 trillion, slightly below the national debt of $7.38 trillion at the same point in time. Sovereign credit is what gives the US economy its inherent strength.

A holder of fiat money is a holder of sovereign credit. The holder of fiat money is not a creditor to the state, as some monetary economists mistakenly claim. Fiat money only entitles its holder a replacement of the same money from government, nothing more. The dollar, being a Federal Reserve note, entitles the holder to exchange the note to another identical note at a Federal Reserve Bank, and nothing else. The holder of fiat money is acting as a state agent, with the full faith and credit of the state behind the instrument, which is good for paying taxes and is legal tender for all debt public and private. Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit. It is a certificate of state financial power inherent in sovereignty.

The Chartalist theory of money claims that government, by virtual of its power to levy taxes payable with government-designated legal tender, does not need external financing. Accordingly, sovereign credit enables the government to finance a full-employment economy even in a regulated market economy. The logic of Chartalism reasons that an excessively low tax rate will result in a low demand for currency and that a chronic government fiscal surplus is economically counterproductive and unsustainable because it drains credit from the economy continuously. The colonial administration in British Africa used land taxes to induce the carefree natives to use its currency and engage in financial productivity.

Thus, according to Chartalist theory, an economy can finance with sovereign credit its domestic developmental needs, to achieve full employment and maximize balanced growth with prosperity without any need for sovereign debt or foreign loans or investment, and without the penalty of hyperinflation. But Chartalist theory is operative only in predominantly closed domestic monetary regimes. Countries participating in neo-liberal international “free trade” under the aegis of unregulated global financial and currency markets cannot operate on Chartalist principles because of the foreign-exchange dilemma. Any government printing its own currency to finance legitimate domestic needs beyond the size of its foreign-exchange reserves will soon find its convertible currency under attack in the foreign-exchange markets, regardless of whether the currency is pegged at a fixed exchanged rate to another currency, or is free-floating. Thus all non-dollar economies are forced to attract foreign capital denominated in dollars even to meet domestic needs. But non-dollar economies must accumulate dollars reserves before they can attract foreign capital. Even with capital control, foreign capital will only invest in the export sector where dollar revenue can be earned. But the dollars that exporting economies accumulate from trade surpluses can only be invested in dollar assets, depriving the non-dollar economies of needed capital in domestic sectors. The only protection from such attacks on domestic currency is to suspend full convertibility, which then will keep foreign investment away.   Thus dollar hegemony, the subjugation of all other fiat currencies to the dollar as the key reserve currency, starves non-dollar economies of needed capital by depriving their governments of the power to issue sovereign credit for domestic development.

Under principles of Chartalism, foreign capital serves no useful domestic purpose outside of an imperialistic agenda. Dollar hegemony essentially taxes away the ability of the trading partners of the US to finance their own domestic development in their own currencies, and forces them to seek foreign loans and investment denominated in dollars, which the US, and only the US, can print at will with relative immunity.

The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice among (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment, interest rate policies, counter-cyclical fiscal spending, etc). With unregulated global financial markets, a government can have only two of the three options.

Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis. For more than a decade since the end of the Cold War, the US has kept the fiat dollar significantly above its real economic value, attracted capital account surpluses and exercised unilateral policy autonomy within a globalized financial system dictated by dollar hegemony. The reasons for this are complex but the single most important reason is that all major commodities, most notably oil, are denominated in dollars, mostly as an extension of superpower geopolitics. This fact is the anchor for dollar hegemony which makes possible US finance hegemony, which makes possible US exceptionism and unilateralism.

Foreign investors held $1.61 trillion, or 24.3 percent, of the $6.63 trillion of outstanding corporate bonds at the end of the first quarter of 2004, up from 22.1 percent in the first quarter of 2003, 13.5 percent on average throughout the 1990s and 11.9 percent in the 1980s. US life insurance companies held a slim lead as the largest owners of corporate debt, with $1.62 trillion, or 24.4 percent of the market, but that lead is expected to be overtaken soon by foreigners. The rising US trade deficits will continue to increase foreign ownership of all types of US securities. The dollar-denominated trade surplus for foreign economies is invested in US government and agency securities and corporate stocks and bonds. The jump in the US trade deficit to a record high of $55.8 billion for June 2004 has once again refocused the spotlight on the rising external indebtedness of the US economy. Despite the recent fall of some 20 percent in the exchange value of the dollar against other major currencies, the US trade gap increased to $55.8 billion in June 2004 from $42.7 billion in December 2003. The current account deficit trend, which measures the rate at which the US is going into external debt, continues to rise. The payments gap was $542 billion for 2003, easily eclipsing the previous high of $481 billion recorded in 2002. At current rate, the trade gap for 2004 will exceed $600 billion, an unsettling level of 5.2% of GDP.

The 9.7% annual decline in the real value of the U.S. dollar since the first quarter of 2002 has little effect in reducing the trade deficit. The dollar fell much more against the Euro (38% in nominal terms) than other currencies. The U.S. deficit with Western Europe rose 16.9% in the first half of 2004. Asian nations engaged in heavy intervention in foreign exchange markets in order to prevent the dollar from falling against their currencies. China and Hong Kong peg their currencies to the dollar at a fixed rate.

Federal Reserve Board chairman Alan Greenspan has expressed the view that the weaker dollar should eventually help narrow the trade deficit, with a warning that “creeping protectionism” could endanger the flexibility of the global financial system. Greenspan feels that global financial markets will be able to finance the US payments gap with a daily capital inflow of between $1.5 - 2 billion, provided trade and finance restrictions are not imposed by government measures. The national debt is rising at the rate of $1.69 billion per day. Net capital inflow requirement adds up to $730 billion annually. If and when this inflow of funds should reverse for any number of reasons, a major financial crisis could erupt. Flow of Funds data released by the Federal Reserve shows that US financial markets are becoming ever more dependent on inflows of foreign capital. This foreign capital has essentially been created by recycling US external debt, not savings. Foreign governments provided 86% of total capital inflows in the first quarter of 2004, 94% of which from Asia.

Greenspan has also denied the existence of a housing bubble, by noting that the US housing market is disaggregated. Yet the residential mortgage market is non-placed related. Fanny Mae, created by Congress during the New Deal decades ago to make home mortgages available to middle and low income buyers, and current under inquiry on violation of generally accepted accounting principles from supervisory authorities, markets its mortgage-backed securities worldwide and engages in large scale interest rate derivative trading. The stratospheric rise in home prices in recent years has been largely financed by low-cost, high debt-to-equity ratio mortgages sourced from foreign creditors.

During the fourth quarter of 2003, foreign creditors loaned US borrowers an unprecedented $848 billion annualized, an amount equal to one-third of all credit market lending. For 2003 as a whole, foreign investors accounted for 22.6 percent of net new lending in US markets and raised their share of outstanding credit market debt by a percentage point to 10.9 percent. Between 2000 and 2003, the volume of credit market instruments (US government securities, agency debt, corporate bonds and commercial papers) owned by foreign investors expanded by more than half. Mainly as a result of purchases of corporate and Treasury debt, foreign acquisitions of US credit market instruments soared to a record $611.2 billion in 2003, more than acquisitions in the previous two years combined. Between October and December of 2003, foreign investors bought 89 percent of net new securities issued by the US Treasury and 40 percent of bonds issued by US corporations. In a bid to stabilize their own currencies against a falling dollar, Asian central banks have been purchasing dollars to keep their currencies from rising, with which they then use to buy US sovereign and private debt. Largely as a result of this process, central banks and other foreign public agencies accounted for two thirds of the acquisitions of US Treasury securities during the fourth quarter of 2003. The trend is expected to increase for 2004.

The rising US external debt, fuelled by a $600 billion trade deficit coupled with record federal budget deficit of more than $500 billion, has prompted concerns that, at some point, foreign investors are going to lose confidence and begin withdrawing funds or at least slowing the inflow. There is also the nagging risk that ever-growing current account deficits would lead to US protectionist measures and an overdue questioning of the role of the dollar as a primary reserve currency. World economic growth as a whole continues to depend critically on expansion of the US economy, but this expansion is dependent on and continues to generate ever-increasing levels of domestic and external debt. The US economy is vacuuming up the world's surplus capital to finance its rising debt, depraving other economies of needed capital for domestic development, while dollar hegemony prevent non-dollar economies from utilizing sovereign credit. China's strong manufacturing sector attracted foreign direct investment (FDI) worth $53.5 billion in 2003, compared with US$52.7 billion in 2002. The US, traditionally the largest recipient of FDI, saw such investment plunge by 53% in 2003 to reach $30 billion - the lowest in 12 years. But while FDI in the US supports the dollar economy, almost all of China’s fast rising FDI is concentrated in the export sector, which operates to support the dollar economy, not China’s domestic development or the yuan economy.

Interest rates, at least short term rate controlled by the Fed Funds rate (FFR) target, are not predictable by merely observing market trends since the FFR is determined not by market fundamentals but by Federal Reserve ideology of sound money as dictated by the Fed’s institutional role of fighting inflation, modified by its judgment on the need for counter-cyclical monetary stimulation. The only way to predict FFR level is to get into the mind of Greenspan, or whoever happens to be Chairman of the Fed.

But low interest rates does not stop foreigners from investing in the US, it only pushes foreigners from low-yield US Treasuries into higher-yield corporate bond markets. If foreigners should stop funding US debts, the Fed can make up the slack by printing more dollars, as Fed Vice Chairman Ben S. Bernanke has publicly suggested, killing the two birds of high oil price and massive debts with one inflationary stone. But the dollars that foreigners have accumulated from trade surpluses from the US cannot be converted back into their own currencies without causing their own currencies to appreciate against the dollar, thus reducing foreign exporters’ trade surplus in dollars. This is part of the circular trap of dollar hegemony. Also, foreign exporters selling the dollars they have accumulated from trade will only cause the dollar to fall further, causing these foreigners to lose more than they gain as their remaining dollar holdings will lose foreign exchange value against their own currencies.

Thus if China which as of September 2004 holds over $485 billion in foreign reserves sells $10 billion for yuan, or euro, or yen to try prevent loss from a falling dollar, the remaining $475 billion will be worth less than the gain (or stop-loss) from the $10 billion sale, which adds downward pressure on the dollar. Thus foreign-owned dollars are trapped with nowhere to go except to stay in the dollar economy. It does not mean however, that these dollars will all return to the US geographically; some will remain as euro-dollars (which has nothing to do with euros, but is a term meaning offshore dollars).   The expansion of euro-dollars, mostly in Asia, will mean that the dollar economy is swallowing up Asia, turning it into a financial colony of the dollar which the US can print at will with relative immunity.

Dollar hegemony may be good for the dollar economy, but it is not necessarily good even for the US economy. Those who still have jobs or income in the US that earn more than their counterparts outside of the US will fall victim to outsourcing brought about by corporate arbitrage on cross-border wage disparity. Worker pension funds, in search of highest return on investment from transnational corporations that maximize their profit from cross-border wage arbitrage, are unwittingly depriving the future pensioners of their high-wage jobs, pushing them into early involuntary retirement with reduced annuity. Unemployment in the US will continue to rise to support transnational corporate profit maximization from outsourcing.   First textile, than manufacturing, then high-tech and next will be financial services, beyond back office outsourcing, but hungry 25-year-old investment bankers and traders overseas who will settle happily for $1 million a year instead of the $3 million demanded by bankers and traders in New York. Cross-border wage disparity will not moderate until cross-border purchasing power parity (PPP) gap moderates, and PPP gap is mostly a dysfunctionality of the exchange rate regime under dollar hegemony.

US interest rates will stay below market for the foreseeable future, until dollar hegemony ends. Whether dollar hegemony ends depends on whether China has enough foresight to kick start a new international finance architecture. So far, there is no sign that China has the wits to do much, except complacently counting the dollars China accumulates while not realizing the more dollars China holds, the more the Chinese economy loses by exporting real wealth from the yuan economy to the dollar economy, as Japan has done since the end of the Cold War. Hopefully the new generation of Chinese leaders will be better advised about the curse of dollar hegemony. On the other side, the US is getting to be like Saudi Arabia, which has been ruined by its oil riches denominated in dollars, saddling the country with a whole generation of citizens with no marketable skills at competitive wages. The only difference is that while Saudi Arabia pumps oil, the US prints dollars.

Dollar hegemony is reducing the US to a country whose workers are overpaid across the board by international standards. While Greenspan justifies US high wages by citing continuous rise in productivity, such rise is achieved essentially by foreign workers doing most of the producing. Ultimately, productivity cannot be increased by not working. The only jobs that will not be outsourced will be those that are location-tied, such as cooking and serving meals, caring for the sick, the young and the aged, vacuuming carpets, cleaning toilets and picking fruits. Such jobs do not pay a living wage in the US turbo economy, and to fill them the US imports illegal immigrants. Greenspan’s warning about creeping US trade protectionism amounts to a trade-off between losing high-pay jobs and defaulting on low-interest foreign debts.

Foreigners are buying US corporate debt, not equities. To fund its twin deficits, the US economy continues to rely on sustained foreign funding. Foreigners purchased net public debt of $61.33 billion and $21.3 billion of corporate bonds in February 2004, but practically no equities, only $100 million. Even then, private investor purchases of public debt fell by half to $10 billion, the rest bought by foreign central banks which are constrained by policy on high-risk investment. The lack of interest in equity suggests that foreigners have little faith in the continuing growth of the US economy and are aware that the US bankruptcy regime grants preference to debt before equity.

Net portfolio inflows into the US of $83.4 billion in February 2004, although slightly lower than $92.3 billion in January, were almost double the $45 billion a month required to fund the US current account deficit. This validates Greenspan’s assertion that the US has no trouble funding its external deficit. US workers, however, will have trouble holding on to their high-paying jobs.

Liberating Sovereign Credit for Domestic Development

Part II: China and a New International Finance Architecture

By
Henry C.K. Liu

Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency in the international finance architecture. While frequently rationalized as necessary for facilitating world trade, dollar hegemony is not benign. It inevitably contributes to increasing trade friction in the global trading system, by pushing exchange rates manipulation as the main tool of competition in export trade.

China’s trading relationship with the US impacts the entire global economy materially. Much has been made about China’s pegging its currency to the dollar even though the yuan is not freely convertible. Calls for upward revaluation of the Chinese yuan are heard frequently. There may be a case for arguing for higher prices for Chinese exports, if the increase is passed directly onto wages to increase domestic demand. But the logic of revaluing the yuan, or any currency, as a means of balancing trade is flawed. Exchange rate moves affect the price of both import and export, but their impact on trade balance may only result in changes in the volume of trade rather the monetary value of trade. With a stronger yuan, less Chinese goods and services may be exported to the US, but at a higher price; and more US goods and services may be exported to China at a lower price, but the trade imbalance in monetary value may remain the same after initial adjustments. Historical data suggest that US firm will take advantage of the exchange rate move to raise prices of US exports. The result may merely be higher inflation rate for the US and eventually for the global economy.

China's excessive dependence on foreign trade has significantly distorted its economic growth, as indicated by the high percentage of foreign trade to its gross domestic product (GDP), estimated to reach near 90% in 2004. China’s high-growth coastal east and south depend heavily on foreign trade. The average rate of foreign trade dependence of the 12 provinces and municipalities in coastal east and south China was 74.5% in 2000 while the rate in the 19 provinces and autonomous regions in the interior central and western regions was only 10%. In 2003, Shenzhen and Shanghai scored 356.3% and 148.7% respectively. Much of this trade takes the form of low-wage assembly for re-export, and although the trend is changing toward vertically integrated manufacturing, the re-export aspect remains dominant. Some 54% of China’s total exports were being traded by foreign investors.

China does not have a diversified trade market. Trade between China and its three biggest trade partners - the US, Japan and the European Union - accounts for about one half of its total. The economic performances of these major trade partners not only critically affect their trade with China, but also affect Chinese trade with the rest of the world in which China incurs a persistent, small but rising deficit. Trade between China and the US constituted 5.4% of China's GDP in 1997. The ratio climbed to 13% of the $1.4 trillion GDP in 2003 when trade volume was $181 billion with a US deficit of $124 billion. Since China incurred an overall trade deficit of $500 million in 2003, the entire US trade deficit with China was transferred to other economies outside China, mostly in developing economies. Yet the abnormally high reliance on trade with the US, with an ever-widening trade gap, is a structural cause for rising Sino-US trade conflicts. The US trade deficit with China is now the largest in the world. China alone was responsible for 53% of the increase in US non-oil trade deficit through June 2004. US imports from China are now five times the value of US exports to China, making this the most imbalanced trading relationship for the US, albeit US trade policy limiting “dual use” technology export to China also contributed to this imbalance. The relatively low growth rate of the matured economies, such as the US, EU and Japan, cannot sustain the high growth rate of Chinese export trade. Also, all three of these countries are actively engaged in using low-wage manufacturing in China for world-wide re-export, distorting Chinese export data.

Trade reliance ratio is determined by many factors, including GDP calculation, exchange rate distortions, methods of trade and trade competence of a nation. Nevertheless, one fact stands out: China’s dollar-denominated trade surplus benefits the dollars economy and not the yuan economy. It contributes significantly to China’s capital shortage for domestic development, siphoning needed capital to its foreign reserves.

China’s import for 2004 is expected to exceed $500 billion and total trade could exceed $1 trillion, with total sales of consumer goods and capital goods reaching $1.83 trillion, which appears impressive until when it translates to only $1,306 per person. Because of high trade reliance ratio, some $330 billion of goods will fail to show up in 2004 Chinese GDP, which is expected to rise around 8% from 2003 to $1.5 trillion. The economy grew 9.6% in second quarter, slowing from 9.8% in the first quarter after the government imposed lending curbs to cool an overinvestment boom that caused power shortages, infrastructure bottlenecks and escalating inflation. The government targeted growth at 7% earlier for 2004. China will continue to import advanced technology equipment, high-tech products, basic raw materials and consumer goods, but it has a long way to go before reaching the full potential of a developed Chinese domestic market.

Chinese trade reached a record high of $851 billion in 2003 with a GDP of $1.4 billion; exports rose 34.6% to $438 billion against a rise in imports of 39.9% to $413 billion. In the first eight months of 2004, China recorded a trade deficit of $950 million; exports rose 35.8% to $361 billion while imports increased 40.8% to $362 billion. The continuing increase in China’s foreign exchange reserves in the face of a trade deficit means that China’s domestic sector is subsidizing its export sector to the tune of its trade deficit plus its foreign exchange reserves growth. Wealth has left the yuan economy into the dollar economy.

The distributional consequences of trade on energy consumption are significant. For the US, energy consumption per dollar of GDP dropped from 17,440 Btu in 1973, year of the OPEC oil embargo, to 9,460 Btu in 2003. The drop was achieved partly by importing energy-intensive products. Unlike other developing countries such as India, South Korea and Brazil, the amount of energy consumed per dollar of GDP has decreased dramatically in China over the past two decades. Still, China consumed 35,000 Btu per dollar of GDP in 1999. With average annual GDP growth rates around 7-8% over the last decade and energy consumption growth rates somewhat lower, China has been reducing its energy intensity. This is in large part a result of government efforts to conserve energy, and the updating of industrial plant equipment. China's Energy Conservation Law entered into force on January 1, 1998. The government h