THE INTEREST RATE CONUNDRUM, Part 1

Economics of denial

By Henry C K Liu



Suddenly this summer, all eyes are trained on rising interest rates around the
globe. The prospect of central banks tightening to ward off impending inflation
has abruptly interrupted the spectacular rise of all stock markets driven by
abnormally ample liquidity, but has yet to precipitate a market crash. Under
normal conditions, rising rates lower bond prices as well as equity prices. But
in the current liquidity boom that has produced a persistently inverted yield
curve, high short-term interest rates have crashed bonds but have left equity
prices higher than market fundamentals could justify.

Yet even as rising interest rates will eventually reduce liquidity to reverse
the rise of stock markets, it will not arrest the real decline of the US
dollar. The anomalous combination of rising interest rates and overpriced
stocks is explosive enough by itself; but adding to it the shocking impotence
of rising interest rates to arrest the declining value of the dollar, we have
an unstable mixture of deadly financial dynamite waiting to be detonated by
even seemingly unrelated minor events.

Normally, high interest rates should lift the exchange value of a currency to
reduce import prices to constrain inflation, which is one of the offsetting
benefits of a tight monetary policy that otherwise slows down the domestic
economy. Increased global capital inflow would also be attracted by high
interest rates.

But the US dollar is not a normal currency. It is a fiat currency that can be
produced at will by the United States, not backed by anything of intrinsic
value, yet assuming the role of a reserve currency for international trade and
finance. This unique characteristic is what lies behind dollar hegemony.

The US dollar is the head of the world's fiat-currencies snake. As the fiat
dollar declines in value over the long term, as expressed by its dwindling
purchasing power, all other fiat currencies decline with it because of dollar
hegemony within the current international finance architecture, even though
some currencies may decline faster temporarily because of varying local
conditions such as different interest rates and inflation rates. In that case,
the market registers the dollar as rising in exchange value against these
currencies, while in reality, all currencies are following the dollar in steady
net decline against real assets. Market cheerleaders then mislabel the
persistent rise in asset prices from the steady decline in currency value as
the sign of a healthy business boom in an allegedly dynamic global economy led
by the liquidity boom in the United States.

At the same time, some currencies may decline more slowly in purchasing power
than the dollar, causing the market to view these currencies as rising in
exchange value against the dollar while in reality they are also declining in
real value. The temporary divergence or convergence of exchange values between
and among currencies, caused sometimes by market inefficiency or at other times
by market overshoots, are what make currency arbitrage profitable, albeit with
corresponding risk of loss.

This global trend of declining currency value has been going on in the current
international finance architecture for several decades and has distorted the
historical and conventional relationship of interest rates to inflation and
economic growth. This distortion has sent central bankers looking desperately
for, if not new, at least newly rediscovered economic theories to construct
improved algorithms to guide their deliberations on monetary policy in the new
paradigm.

A new guru for the Fed

The Wall Street Journal (WSJ) on October 3, 2000, reported that the Federal
Reserve, the US central bank then under the chairmanship of Alan Greenspan, had
of late fallen under the influence of the views of Swedish economist Johan
Gustaf Knut Wicksell (1851-1926) on the relationship among interest rates,
inflation and economic growth. Wicksell argued that monetary policy works best
at containing inflation by pegging interest rates not to the level of money
supply as mandated by textbook neoclassical economics theory, but to the rate
of return on investment (ROI). Some critics described the Fed's new fad as
asking for advice from dead men who never had a chance to analyze present-day
data. Wicksell died three years before the 1929 stock-market crash.

Greenspan made his famous "irrational exuberance" speech at the
conservative American Enterprise Institute in Washington, DC, on December 5,
1996, when the Dow Jones Industrial Average (DJIA) was at 6,442, already more
than twice the pre-1987-crash high of 2,722. Less than a year earlier, on
January 31, 1996, the Fed had lowered Fed Funds Rate (FFR) target 25 basis
points from 5.5% to 5.25% to add liquidity to the very same irrational
exuberance Greenspan later warned against. The Fed did not raise the FFR target
again until four months after Greenspan's warning, and then only by 25 basis
points, back to 5.5%, on March 25, 1997.

Not surprisingly, the market kept rising despite the Greenspan warning and, on
January 14, 2000, with the FFR target still at 5.5%, the DJIA peaked at a
hyper-irrational level of 11,723, rising another 83% over Greenspan's warning
level. But the US gross domestic product (GDP) only rose from US$7.8 trillion
in 1996 to $9.8 trillion in 2000, or 25.6%. The DJIA climbed three times more
than the GDP in the four-year period after Greenspan's warning of
irrationality. One can only conclude that the US dollar had declined in value
by 57.4% in that time.

Two months later, after some secular bull-market corrections in which each down
closing was erased by subsequent gains, the DJIA scored on March 16, 2000, its
largest one-day point gain in history, 499.19 points, to close at 10,630.60. On
April 14, 2000, 22 trading days later, the DJIA plummeted 617.78 points,
closing at 10,305.77, its steepest point decline in a single day so far, but
the DJIA was still 50% higher than the 6,442 that prompted Greenspan's
irrational-exuberance warning more than four years earlier. This volatility
came purely from speculative forces operating in a liquidity bubble. The real
US economy did not change in 22 trading days.

Interest rates and elections

The Fed in its board meeting on October 3, 2000, the same day of the WSJ report
on Wicksell, with the DJIA closing at 10,719.74, left the FFR target unchanged
at 6.5%, keeping inflation-adjusted the real short-term interest rate at a
historical high. This decision left the DJIA in the historical high range, but
left the Democratic Party with an anemic economy despite a fiscal surplus under
the administration of president Bill Clinton and robust corporate earnings in
the crucial months before the presidential election that November. Though a
rate reduction had been warranted by conventional wisdom over weak economic
data and ominous leading economic indicators, the DJIA stayed high because the
market believed the Fed would have to cut rates soon to prevent a sharp market
correction.

As it turned out, the Fed did not lower the FFR target until its January 3,
2001, board meeting, after the US Supreme Court snatched a near-victory from
the jaws of Democratic presidential candidate Al Gore and delivered a bitterly
contested White House to Republican George W Bush. The Fed then lowered the FFR
target by the larger-than-usual amount of 50 basis points to 6% to commence a
long downward rate cycle, with 13 more cuts in 30 months, to bottom at 1% on
June 25, 2003, pushing the short-term rate below neutral, meaning below the
inflation rate, feeding a multi-year credit bubble.

Only five days after the FFR hitting a historical low of 1%, the Fed, in a
belated epiphany on rediscovering inflation threats that had been glaringly
visible for some time, reversed course and raised the FFR target by 25 basis
points, followed by a "measured pace" of 18 more upward moves to
5.25% on June 29, 2006, and kept it there unchanged for over 11 months up to
now, with no signs of ending the cautious interest-rate "pause",
extending a liquidity boom that creates an interest-rate "conundrum".


'Conundrum' just another word for denial

Maestro Greenspan confessed publicly that with all his acknowledged wisdom, he
could not understand why long-term rates stayed low despite a high FFR while
the flat or inverted yield curve had been obviously caused by the Fed's own earlier
actions of releasing too much credit into the system. This easy credit fueled a
trade deficit that, because of dollar hegemony, was recycled as a
capital-account surplus in US Treasuries, pushing long-term rates down.

This trend is still going on and is exacerbated by endogenous liquidity
generated internally by debt securitization and hedging through derivatives.
What determines long-term interest rates is sustained monetary liquidity, or
excess money already in the system from previous short-term rates staying too
low and too long, as the Fed's subsequent gradualism in short-term rate hikes
was not able to stop the momentum effectively and quickly.

Timed for elections

On Tuesday, November 9, 2004, presidential-election day in the United States,
the FFR target was still at a below-neutral 1.75%, with the DJIA closing at a
bullish 10,386.37, giving incumbent George W Bush a temporary bull market, if
not quite a sustainable strong economy, to achieve an easy win over challenger
John Kerry, all the while with the Fed keeping a straight face about its being
an apolitical institution that operates on scientific monetary principles. The
Fed raised the FFR target to 2% in its meeting the day after the election when
it was politically safe to raise the rate, and kept it going upward to the current
5.25%.

The DJIA had closed at 10,719.74 on the same day of the WSJ-Wicksell report on
October 3, 2000, having broken the psychological 10,000 for the first time in
history on March 19, 1999. The DJIA had risen 50% from its previous low of
7,161.15 recorded on October 27, 1997, when it suffered a big one-day fall of
554.26 points, or 7.2%, from contagion from the Asian financial crisis.

On Monday, June 4, 2007, defying persistent news of a slowing economy, the key
index rose 91% higher than its 1997 low to close at an all-time high of 13,673.


Volcker's bloodletting experiment

Monetarists, who have dominated the Fed throughout most of its history,
subscribe to the theory that inflation can only be prevented either by high
interest rates to reduce growth by reducing the growth of money supply, or by
high unemployment to depress wages, which are two faces of the same coin.
Wicksell argued that monetary policy works best at containing inflation by
pegging interest rates to investment returns rather than money supply.

Wicksell's theory was given credence empirically in 1980 by then Fed chairman
Paul Volcker's brief experiment with targeting the monetary base with automatic
interest-rate adjustments by his "new operating procedure". The
disastrous and damaging result of violent fluctuation of the FFR forced the Fed
to drop Volcker's misguided approach after about six months.

The "new operating procedure" was adopted on October 6, 1979, by the
Fed as a therapeutic shock treatment for Wall Street, which had been
conditioned by former Fed chairman Arthur Burns' brazen political opportunism
during the Richard Nixon era in the 1970s to lose faith in the Fed's political
will to control inflation. The new operating procedure, by concentrating on
monetary aggregates, and letting it dictate FFR swings within a range from
13-19%, to be authorized by the Fed Open Market Committee (FOMC), was an
exercise in "creative uncertainty" to shock the financial market out
of its complacency about the Fed's traditional policy of interest-rate
stability and gradualism.

There had been a traditional expectation in the market that even if the Fed
were to raise rates it would do so gradually so as not to permit the market to
be volatile. The banks could continue to lend as long as they could profitably
manage the gradual rise in rates.

Under the new operating procedure, the banks would be exposed to risks that
interest rates might suddenly and drastically go against even their short-term
credit positions. Also, banks had been seeking higher earnings by expanding new
loans beyond the growth of deposits, by borrowing shorter-term funds at lower
interest rates. This practice was given the benign name of "managed
liability" by regulators, allowing banks to profit from interest-rate
spreads over the yield curve, which had seldom if ever been allowed by the Fed
to stay inverted, that is, with short-term rates higher than longer-term rates,
at least for long.

This practice of interest-rate arbitrage later came to be known as "carry
trade" in bank parlance and, when internationalized, eventually led to the
Asian financial crisis of 1997 when interest-rate and exchange-rate volatility
became the new paradigm that could roil equity and currency markets.

The Fed's new operating procedure greatly increased the banks' risk exposure,
at least before the widespread practice of loan securitization shifting
individual bank risk to systemic risk for the entire financial market. On top
of it all, Volcker set an additional 8% reserve on bank-borrowed funds for
lending.

The new operating procedure violated the traditional mandate of the Fed, which,
as a central bank, was supposed to be responsible for maintaining orderly
markets, which meant smooth, gradual changes in interest rates that in turn
would keep money-supply fluctuation moderate and gradual so that prices would
not be detached excessively from market fundamentals. The new operating
procedure was a policy to induce the threat of severe short-term pain to
stabilize long-term inflation expectations.

Most economists agree that when money growth slows, market interest rates go
up. The trouble with the use of the FFR target to control money supply is that
it has to be set by fiat, which exposed the Fed to political pressure to keep a
liquidity boom going forever. A case can be made, and is frequently made, that
the Fed's FFR targets tend to be self-fulfilling prophecies rather than a
device to manage future trends. High FFR targets deflate while low targets
inflate, and there is little argument about that relationship, at least before
the age of structured finance when virtual money can be created within the
system circularly outside of the Fed's control. Under structured finance, high
FFR targets can actually inflate because they raise the cost of money needed
for protection through hedging and for profiteering through financial
arbitrage.

But there is plenty of argument about the Fed's projection ability on the
economy. History has shown that the Fed, more often than not, has made wrong
decisions based on faulty projection that at times borders on blind denial of clear
data. The new operating procedure let the monetary aggregates set the FFR
targets scientifically and provide political cover for the FOMC members if the
FFR target needed to go to double digits. This amounted to monetarism through
the back door, not by heroic intellectual confidence in scientific truth, but
by political cowardice.

The Federal Advisory Council (FAC) of the Federal Reserve Board is unique in
that it is a big-bank lobby composed of 12 representatives of the banking
industry that officially advises the Fed, itself a peculiar institution: an
all-powerful public institution mandated by law, but owned by private banks.
The FAC meets in secrecy four times a year with Fed officials to give the
banking industry an inside track on influencing Fed deliberation, if not
decisions.

The since-declassified minutes of the FAC show that four weeks before the
Volcker Fed announced its "new" operating procedure on October 6,
1979, the FAC had recommended a review of the Fed's "traditional"
operating procedure, before even the president of the United States, then Jimmy
Carter, was alerted of the Fed's deliberation and final decision to adopt a
"new" operating procedure. Initially, the FAC was concerned that
political pressure was likely to push the FFR down, not anticipating that money
supply would turn volatile to create extreme interest-rate volatility. Carter,
preoccupied with the Iran hostage crisis, was totally in the dark about the
impending volatile high-interest-rate policy with which the Fed under Volcker,
a Republican, was going to hit Carter's Democratic administration running for a
second term within a year.

To stabilize money supply, the Fed announced on March 14, 1980, a program of
Emergency Credit Controls. The program affected not only commercial banks, but
also money-market mutual funds and retail companies that issued credit cards.
Banks would be limited to 9% credit growth instead of the 17% they had seen in
February.

By April, the Fed was shocked by data showing money disappearing from the
financial system at an alarmingly rapid rate. The last two weeks in March saw
more than $17 billion vanish, representing an annualized shrinkage of 17%,
yielding a 34% change. Money was evaporating from the banking system as credit
dried up and borrowers paying off their debts in response to Carter's
moralistic jawboning to save the nation from hyperinflation through personal
restraint on consumption. Another cause was the shift from bank deposits to
three-month T-bills that were paying 15%, causing money to exit the market back
into the Fed's vault.

Volcker's new operating procedure adopted six months earlier now faced a
critical test. According to monetarist theory, the Fed needed to pump up new
bank reserves to stop the money-supply shrinkage. But in practice, Volcker and
the FOMC were applying monetarism, which by definition must be a long-term
proposition, to short-term turbulence, and in the process undermined their own earlier
efforts to fight hyperinflation and, worse, destabilized the economy
unnecessarily. When mortals play god, other mortals die unnecessarily.

On May 6, 1980, with the New York Fed's Open Market Desk furiously trying to
reverse a raging money-supply shrinkage, pumping in money to the system by
buying government securities and depositing the funds in banks to create new
additional "high power" money by increasing bank reserves for
lending, interest rates fell sharply and abruptly. The FFR dropped 500 basis
points in two weeks, from 18% to 13%, the bottom of the FOMC range in the new
operating procedure, and was actually trading below the low FOMC target range
at one point.

The Fed was in danger of losing control of its FFR target to the market and
jeopardizing it own credibility. The New York Fed notified the FOMC that it could
continue to follow the new operating procedure by injecting more bank reserves
to let the FFR fall below the low limit set by the FMOC or to tighten up the
supply of bank reserves to get the FFR back up to the 13% set by it. But it
could not do both, any more than a train could go in opposite directions
simultaneously.

Volcker opted for continuing the new operating procedure and staged an
emergency telephone conference of the FOMC to authorize a new low FFR target of
10.5%, down from 13%, way below the inflation rate of more than 12%.

Market conditions were such that interest falling below 10% would mean
below-neutral negative interest after inflation adjustment, which would start
another borrowing binge to exacerbate further inflation. The fundamental fault
of monetarism was being exposed by real life. The claim that stabilizing the
money supply would also stabilize interest rates was shown to be inoperative by
events. In reality, attempts to stabilize the money supply actually
destabilized interest rates and pushed them down in a fast-reacting dynamic
market in an environment of shrinking liquidity.

Desperate, the Fed under Volcker, with concurrence from an even more
panic-stricken Carter White House, started to dismantle Emergency Credit
Controls as fast as administratively feasible, so that demand for credit would
not be artificially shut down, in hope of making market interest rates rise
from more borrowing. Still, it took until July 1980 before the last of the
credit controls were lifted. Back in April, the New York Fed had injected
additional reserves into the banking system at an annualized rate of 14% and in
May at a 48% annualized rate in non-borrowed reserves, pushing interest rates
down and laying the ground for future inflation.

It was obvious that Volcker had panicked, spooked by the sudden economic
collapse set off by his own credit-control program to slow the rise in money
supply. By the last week of July, the FFR fell below the 13% discount rate and
hit 8.5%, down from 20% in late March. For one trading day, it dipped to 7.5%,
and for a time the Fed lost control. The short-term rate that monetary policy
regulates most directly was free-floating down on its own, unhinged from the
FFR target. With the FFR below the discount rate, the FFR could fall to zero by
banks responding to market forces. So the pressure to lower the discount rate
was overwhelming.

The financial markets had never seen anything like it. The money market became
a game in which the guards had thrown in the towel and the inmates were running
the asylum.

Correcting one overshoot with another

The FFR dropped from 20% in April 1980 to 8.5% in 10 weeks, in effect banishing
interest-rate gradualism out to the wilderness. In the autumn of 1979, the Fed
had seized the initiative to push the price of money up 100% to fight
inflation. Now, barely seven months later, the Fed allowed the price of money
to fall even more rapidly to reverse the money-supply shrinkage, with
"damn the inflation torpedo - full speed ahead in the sea of
liquidity" frenzy.

The recession was abruptly ended by the Fed's overreaction and Volcker, the
self-ordained slayer of the inflation dragon, became overnight a breeder of
baby dragons of even more aggressive inflationary DNA. The US economy now was facing
a worse, and more interest-rate-immune, inflation problem than when he had
become Fed chairman in July 1979 less than a year before.

Many businesses that had been profitable under a steady interest-rate regime
went bankrupt during this brief period of sudden Fed-manufactured volatility in
liquidity, but the banks were dancing in the street with windfall profits and
excess cash to lend. Volcker's "new operating procedure" experiment
put the Fed back on its traditional path: focusing on interest rates and not
money-supply numbers and vowing again to focus only on the long term. Yet for
the long term, money supply was the correct barometer, while for the short
term, interest rate was the appropriate tool. The Fed did not seem to have
learned anything, despite having made the United States - and the world - pay a
very costly tuition.

Volcker's high-interest-rate policy caused the dollar to rise in the
foreign-exchange market, making US exports less competitive, but US investment
overseas less expensive. The rise in import prices was moderated by lower
profit margins made affordable to foreign importers whose dollar earnings now
were worth more in local currencies.

Instead of restructuring the US economy and reforming the terms of globalized
trade to address a mounting structural US trade deficit, treasury secretary
James Baker under president Ronald Reagan took the easy way out and engineered
the Plaza Accord on September 22, 1985, to push the dollar down by coordinated
intervention by the central banks of the United States, Japan, West Germany,
France and the United Kingdom. Two weeks earlier, on September 6, the Fed had
raised the FFR target 25 basis points to 8% from 7.75% set mid-July, putting
upward pressure on the dollar as the Treasury was trying to push the dollar
down.

The Plaza Accord when finally put in place pushed the Japanese yen down by more
than 50% against the US dollar with central-bank intervention. But it had
little discernable effect on the US trade deficit. It did allow the United
States to export deflation to Japan to use the dollar's low exchange rate to
boost US asset value nominally. The Plaza Accord decoupled dollar interest
rates from the exchange value of the dollar and also decoupled the traditional
link between rising interest rates and falling equity prices.

Time magazine reported on January 26, 1987, that John Makin, director of
fiscal-policy studies at Washington's American Enterprise Institute, argued
that the value of the US dollar was "totally irrelevant. If the budget
deficit isn't going to improve very much, the trade deficit isn't either."


Sidney Jones, an economist at the Brookings Institution, also warned of a
danger if the dollar's exchange rate continued to serve as the main instrument
for altering the trade balance: the risk that the US inflation rate, about 2%
in 1986, would flare up. "Once those import prices do go up, then you can
get away with increasing domestic prices. That's probably a greater inflation
risk than simply the increase in the price of imported goods," Jones was
quoted as saying.

Yet the US House of Representatives passed a highly restrictive omnibus trade
bill, though it stalled in the pro-trade Republican-controlled Senate.

China enters the trade picture

Predictably, the same Passion play over trade with Japan seen two decades ago
is now being re-enacted with China. And if China yields to US pressure as Japan
did to revalue its currency upward against the dollar, China will face decades
of deflation as Japan did.

China launched its economic reform and "open to the outside" policy
in 1978, and a good part of the excess global liquidity resulting from the
recycling of oil revenue after the 1973 oil crisis went into China after 1978,
and to other economies in Asia, to fund the newly industrialized countries,
known as Asian Tigers, eager to trade with and invest in China. For almost
three decades, China has been riding on a liquidity boom created by the US
Federal Reserve's stealthy devaluation of the purchasing power of the dollar.

Ironically, pundits of all colors have since applauded China for its
"wisdom" in adopting market capitalism as a path out of poverty,
while the whole world has become addicted to easy money denominated in dollars
of falling value that actually makes everyone poorer in real terms, only that
some become poorer, and more quickly, by comparison. Pathetically, neo-liberal
economists have fallen over one another hailing the poverty-eradication powers
of market fundamentalism.

The income equality hoax

J Bradford DeLong, an economics professor at the University of California at
Berkeley and former Treasury official in the Clinton White House, attracted
mainstream attention by claiming in a February 2001 paper ("The world's
income distribution: Turning the corner?") that global income distribution
had been trending toward equality through globalization. Such claims not only
fly in the face of World Bank data on the Gini coefficient, which measures
income equality in economies, they ignore the fact that all wages have been
falling in purchasing power globally even if rising nominally, improving
statistical equality as nominal wages in poor economies rise at the faster rate
because they started from a lower base both nominally and in real terms.

Neo-liberal ideology asserts that inequality is the result of poverty and that
as poverty is relieved, inequality recedes. This assertion neglects the
possibility that inequality itself causes poverty, not as calculations in a
zero-sum game, but as a damper on consumer demand in a global economy plagued
by overcapacity. Globalized trade, rather than domestic development, has been
hailed by neo-liberal economists as the solution to both inequality and
poverty. Opposition to globalization by the world's poor has been labeled misguided
by the neo-liberal mainstream that holds monopolistic sway in the media in
defiance of glaring conditions of poverty on the ground.

The Harrod-Domar model of development

Neo-liberal economists point to the Harrod-Domar model of economic growth to argue
that unequal distribution of income promotes faster economic growth and greater
employment because the rich save more than the poor, so that a greater volume
of domestic savings will increase the supply of capital available for
investment; and the accelerated capital formation will raise gross domestic
product and resulting incomes, a virtuous cycle feeding back into greater
savings. Thus income inequality, even with widespread poverty, is regarded as
good for development, not merely as a transitional compromise but as a
permanent structural necessity. This is in essence the International Monetary
Fund/World Trade Organization model of market fundamentalism since discredited
by factual data.

Even the late Deng Xiaoping, paramount leader of China's economic reform, fell
for this fallacy and accepted the need to "let some people get rich
first". Predictably, the word "first" soon disappeared in
Chinese economic policy deliberations until it was too late. Finally, the new
leadership in China under President Hu Jintao and Premier Wen Jiabao is at long
last addressing the problem of income disparity both between people and between
regions, but the task is made more Herculean by the two-decade-long
solidification of a political and bureaucratic superstructure embedded with
powerful resistance of special interests of those who got rich first and want
to stay more rich permanently.

Notwithstanding that the Harrod-Domar model may not be operative in a world
plagued by overcapacity from overinvestment and insufficient demand as a result
of income inequality, the model neglects the fact that under globalized finance
capitalism, even the savings of the rich in the poor economies are siphoned off
to US capital markets, draining the local economy of desperately needed
capital. The global dollar glut in the context of dollar hegemony that current
Fed chairman Ben Bernanke mistook for a global savings glut is the living
evidence against the validity of the Harrod-Domar model of economic growth.
Income inequality in the economies that export to the United States provides
capital formation only to the US by financing a US capital-account surplus with
the current-account surpluses these economies earn from trade.

This increases the cost of capital for the exporting economies, which have to
offer returns drastically higher than the return they get from US sovereign
debt merely to induce their own capital to come back home. And even then,
capital flows only to the export sector, to earn even more dollars to pay
foreign capital denominated in dollars, putting these economies in a perpetual
competitive disadvantage for global capital.

China is a perfect example of a booming economy caught in this trap. To look
for better returns than its dollar reserves get from US Treasuries, China is
beginning to pursue so-called "alternative investment" in higher-risk
private-equity firms while it continues to face a capital shortage in its rural
regions and most non-export sectors.

The GDP-growth mirage

By the mid-1960s, the theory equating domestic development with growth in gross
domestic product was already not empirically supported by evidence. GDP
attributes profits to the country where factories or mines or financial
institutions are located, regardless of ownership nationality, even though
profit and investment may not stay there permanently.

The accounting shift from GNP (gross national product), which measures total
value added from both domestic and foreign sources claimed by residents of a
country, to GDP has turned many struggling, exploited economies into
statistical boomtowns, while seducing local leaders to embrace a global economy
while their countries slide into further poverty.

But such micro-evidence has been systemically dismissed by mainstream economics
because it goes against the prevalent macro-paradigm of trade globalization,
which is deemed intellectually uncontestable and ideologically correct.
Moreover, the evidence goes against powerful economic interests of the rich
economies and is dismissed as the result of a democracy deficit. By making the
rules of development treat capital as more scarce compared with labor and thus
the more valuable factor of production, owners of capital are logically
justified in receiving a larger share of the benefits from development.

Lawrence Summers as chief economist of the World Bank (1991-93) used a similar
economic argument for dumping pollution from advanced economies on to
developing economies to achieve an overall lower cost globally. The only
problem with this perverted cost-benefit approach to welfare economics is that
it is not true. Optimum development requires capital and labor to be assigned
fair and equitable value so that supply and demand can be balanced and for all
human lives to be treated with equality, because as many around the world have
since recognized, global warming recognizes no economic or national borders.

Captive buyers of US sovereign debt

In 1995, after the US Federal Reserve had started to hike the FFR target the
previous year and sharply curtailed its own purchase of Treasury bills,
triggering the Mexican peso crisis and a subsequent US slowdown, the Bank of
Japan initiated a program to use its foreign reserves 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 to 1997,
the entire increase in foreign-held US dollar reserves.

In 1995, East Asia claimed 47% of capital flows to all low-and-middle-income
countries. In 1996 alone, about $100 billion flowed into East Asia, which Asian
central banks had to buy up with local currencies and invest the dollars in US
Treasuries.

But in 1997, $150 billion flowed out in the three months after July,
exacerbating the Asian financial crisis by draining foreign reserves held by
Asian central banks. These recycled dollars pushed up stock prices in the US
both before and after the crisis.

Interest-rate gradualism rendered inoperative

Volcker's new operating procedure was instituted in 1980, some 27 years ago.
Nowadays, with structured finance, which can add endogenous liquidity created
internally by risk-management schemes to protect against a liquidity crunch, a
new dimension has been added.

That new dimension is that in stabilizing the money supply, instead of sending
interest rates down, it will send interest rate skyward because of fierce
competition for money by market participants addicted to an endless supply of
cheap money, turning the liquidity boom into a liquidity bust. When the market anticipates
money getting tight, everyone wants to borrow before money dries up. Money
becomes easy only if there are fewer borrowers than money available for
lending. When everybody wants more easy money, including lenders who must
borrow money in order to lend, money becomes hard to get very fast.

It is now generally recognized that the most effective way for the Fed to
stabilize the monetary system is through a consistent, gradual "steady as
she goes" interest-rate policy without surprises or sudden reversals. The
credit market has grown accustomed to gradualist interest-rate policies. That
is the rationale for a soft landing to cushion the adverse effects of the previous
bubble.

The problem with gradualism is that it is increasingly out of step with a
fast-paced financial world driven by structured finance with all manners of
financial derivatives that tend to create sudden systemic super-volatility even
though the financial instruments employed have been designed to ensure
stability for individual market participants. High volatility has become a
profit opportunity for hedge funds, banks and traders.

Ironically, China's gradualism in financial reform and exchange-rate adjustment
has been vehemently attacked by impatient US officials and politicians,
notwithstanding the Fed's own traditional preference for monetary gradualism.
Ironically, gradualism works in a controlled capital market, which China still
has, but not in the de-controlled global capital market led by the US.

Scientific cover for Greenspan

Wicksell's theory of linking interest rates to the rate of return on investment
(ROI) provided a timely scientific cover for Greenspan's high-interest-rate
policy in the face of an economic slowdown as the 2000 US presidential election
approached. Interest rates could stay high with theoretical justification
because US investment offshore was getting good returns even though the
domestic economy was showing clear signs of stagnation.

Global money supply continued to expand through the effect of Fed policy under
dollar hegemony, which permitted the US trade deficit to finance the
capital-account surplus, keeping dollar long-term rates low even as the Fed
kept the FFR high. The flat yield curve, at times inverted, meaning long-term
rates falling below short-term rates, no longer automatically brings on
recessions because liquidity is kept high by the circular flow from the trade
deficit back into the capital-account surplus, with inflation kept low by
outsourced low wages and asset prices kept high by excess money that steadily
loses purchasing power.

This was the point when US economic policy began to make the macro-tradeoff in
seeking benefits from globalization at the expense of the domestic economy.
This tradeoff became possible because of dollar hegemony, in which global trade
and finance are denominated in fiat dollars that the US, and only the US, can
print at will with little short-term penalty.

Capital is permitted to milk labor in all economies, including the United
States, so that global ROI can stay high. The tradition of lowering short-term
interest rates in response to a slowing US economy has been preempted by the
need to keep short-term interest rates high to attract capital inflow and to
compensate for the continuing devaluation of the dollar independent of
short-term exchange-rate fluctuations. High dollar interest rates are needed to
sustain the US capital-account surplus. With the help of the Fed, the US Treasury
has become a major player in the "carry trade" business, paying a low
interest rate on Treasury bonds to lend the proceeds to US banks at a higher
rate, which they in turn lend to corporate and private borrowers at even higher
rates.

While this tradeoff had been fully understood by the Clinton economic team led
by Robert Rubin, a bond trader par excellence from Goldman Sachs prior to
joining the White House, the US public, particular laborers, had been
completely oblivious until too late to an impending fate that would cause them
to lose off their backs the shirts made by Ladies Garment Workers Union members
to be replaced by cheaper ones made in low-wage Asia, particularly China.

Bond market crash

Pimco's Total Return Bond Fund manager William H Gross, a highly respected
veteran bond-fund manager with an impressive record for profitably managing
more than $100 billion of bond funds, the world's largest, admitted publicly
recently that he made "a big mistake" betting on the Fed lowering the
interest rate to offset a slowing US economy due to the collapse of the housing
sector because of a subprime mortgage meltdown. As a bond investor, Gross
understandably sets his sight single-dimensionally on interest-rate movements,
since the price of bonds moves in the opposite direction of interest rates.

While Gross accurately predicted a slowing economy, he failed to realize that
the Fed was pegging the interest rate to high nominal corporate global earnings
boosted by a regime of universal currency devaluation, but with the US dollar
devaluing at a faster rate than many other currencies, thus increasing overseas
earnings in dollar terms. Pimco's bond portfolios lost on two levels from its
bad interest-rate call: from a collapse in nominal bond prices as rates stayed
high and from a net long-term decline in the real purchasing power of the
dollars its bonds held after persistent devaluation against real assets.

Strong dollar in the US national interest

Of course, the US Treasury, which by law requires the Fed to support its
exchange-rate policy as a matter of national security, has repeatedly declared
that a strong dollar is in the US national interest. And a strong dollar in the
existing international finance architecture requires high dollar interest rates.
Now, in addition to national security and national interest justifications, a
respectable scientific theory has been resurrected to support Greenspan's
high-interest-rate policy required by his liquidity bubble.

With globalization of trade and finance, field data have demolished the
conventional wisdom that unemployment below a structural level of 6% causes
inflation, because US consumer prices are held down by import costs kept low by
global wage arbitrage and by low-wage illegal immigrant workers, despite a
global decline in the purchasing power of all currencies led by dollar
hegemony. Greenspan called his high rates "equilibrium interest
rates". But the dollar is strong only in relation to other key currencies,
while all currencies continue to devalue against real assets in a global weak
currency trend led by the dollar. Despite rhetoric, the US has not had a real
strong-dollar policy for decades.

The politics of economics

The Fed, notwithstanding its intellectual pretense and self-proclaimed political
independence, has always been a political institution. The politics of monetary
economics repeatedly resurrects from the intellectual wasteland, the
theoretical Siberia as it were, new gurus to support its latest ideological
interpretation of an ever-changing economy. Nobel laureates are proponents of
theories that explain "scientifically" the latest wave of political
expediency.

The list includes the most politically contested joint award to Gunnar Myrdal
and Friedrich August von Hayek (1974, Myrdal for interdependence of economic,
social and institutional phenomena, in contrast to Hayek for theory of money,
economic fluctuations and market fundamentalism) that led Myrdal to call for
the abolition of the prize on moral grounds.

Others on the list were Milton Friedman (1976, monetary history and monetarism
theory and stabilization policy), Theodore W Schultz and Arthur Lewis (1979,
economic development of developing countries), James Tobin (1981, financial
markets and expenditure decisions, employment, production and prices), George J
Stigler (1982, industrial structures, functioning of markets and causes and
effects of public regulation), Franco Modigliani (1985, saving and of financial
markets), Robert M Solow (1987, economic growth), Robert Lucas (1995, rational
expectation), Amartya Sen (1998, welfare economics), Robert C Merton and Myron
S Scholes (1997, precise valuation of options/derivatives), Robert A Mundell
(1999, exchange-rate regimes), and George A Ackerlof, A Michael Spence and
Joseph E Stiglitz (2001, markets with asymmetric information), etc, etc.

It is not difficult to see that many economic concepts honored by the Nobel
Committee, while usually for work done decades earlier, were concepts much in
vogue at the time the prizes were awarded, soon to be followed by real-life
disasters caused by the unquestioning, widespread applications of these very
same admired concepts. The latest example is Stiglitz, who, very much part of
the economics establishment that promoted market fundamentalism, summarized by
the Washington Consensus, despite his early work on asymmetrical market
information, only belatedly raised questions about the claim of market
fundamentalism as the god-sent solution for the post-Cold War economic order.
Like the Nobel Peace Price, the Prize for Economics is highly politicized.

Wicksell provided an intellectually respectable cover for Greenspan to abdicate
his responsibility as chairman of the most powerful central bank in the world,
by pretending to follow the flow of the market, to treat interest as the price
of money set by market forces, and not as a monetary authority with a mandate
to promote full employment and balanced growth for the world's interconnected
economies. The embarrassing question is never asked: Why is a central bank even
needed if financial markets are on self-adjusting autopilot?

The fact is that monetarists at the Fed are fervently and ceaselessly
intervening in the financial and currency markets, and the only difference
between them and Keynesians is that they intervene to favor capital as
expressed by the nominal value of money, while Keynesians intervene to protect
labor from structural unemployment and below-inflation wages deemed necessary
by monetarists for fighting inflation.

As post-Keynesian economist Paul Davidson insightfully said, everyone has an
income policy; they just don't like the other fellow's income policy but claim
their own is "free" market determined. Extending their distaste for
inept bureaucracy, neo-conservative monetarists reject the policy imperative of
government, while neo-liberal monetarists reject government responsibility for
the welfare of all citizens by supporting an income policy favoring the rich.

The installation of a new guru at the Fed always stimulates rethinks on Wall
Street. Traders and investors have to reverse their traditional knee-jerk
reaction to sell when the Fed raised short-term interest rates. Even as real
corporate earnings fall amid rising rates, such falls are disguised nominally
as rising profit by across-the-board currency devaluation.

A word about Wicksell

Knut Wicksell, born in Stockholm, published his book Value, Capital and Rent
(1893) in Swedish, and it was not translated into English until 1954. His
two-volume Lectures on Political Economy (1901-06) and Selected
Papers on Economic Theory (1958) were read only by professionals. Wicksell
did rigorous work on marginal theory of price and distribution and on monetary
theory. Lectures on Political Economy has been aptly called a
"textbook for professors". In an unusually volatile career, including
brief imprisonment for exercising free-speech rights, he wrote and lectured
tirelessly on radical issues, which did not figure among the attitudes admired
by Greenspan, a disciple of Ayn Rand's cultish objectivism of extreme
individualism.

Wicksell was an advocate of social and economic reforms of all sorts, most
notably neo-Malthusian population controls. He extended David Ricardo's concept
of uneven income distribution based on the iron law of wages, asserting that a
totally free economy does not naturally equalize wealth distribution, as wealth
created by growth would be distributed in greater share to those who already
had wealth. Wicksell defended government intervention to improve national and
public welfare through equitable distribution of the benefits of growth.

Wicksell's theory of interest, published in his 1898 book Interest and
Prices, distinguishes the natural rate of interest from the money rate of
interest. The money rate of interest, or nominal rate, is merely the interest
rate in the capital markets, while the natural rate of interest is the interest
rate that is neutral to prices in the real market, or rather, the interest rate
at which supply and demand in the real market are at equilibrium. Economic
growth takes place when the natural rate of interest is higher than the market
rate - a view shared by the Austrian School, despite the difference Austrian
individualism has with the institutionalism of Wicksell.

In his later years, Wicksell was admired by a new generation of economists who
became known as the Stockholm School, whose members included Nobel laureates
Gunnar Myrdal and Bertil Ohlin (1977 - trade theory). They developed Wicksell's
ideas on the cumulative process into a dynamic theory of monetary
macroeconomics simultaneously with but independently of the Keynesian
revolution.

Greenspan's selective use of other people's ideas is notorious. His fondness of
Schumpetrean "creative destruction", which he cites in practically
every speech, always leaves out the second half of Joseph Schumpeter's world
view: that "creative destruction" leads to monopolies (a la Microsoft)
and accelerates the coming of socialism, the worst possible nightmare for
Greenspan and his fellow central bankers.

Joseph A Schumpeter (1883-1950) wrote in chapter 3 of his Capitalism,
Socialism and Democracy (1942): "Economic progress in capitalist
society means turmoil." And in chapter 13, section 2, he wrote:
"Capitalism inevitably and by virtue of the very logic of its civilization
creates, educates and subsidizes a vested interest in social unrest."

Keynesianism
aims to save capitalism by taming its internal contradiction with a moderate
dose of socialist prescription.


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