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The Foreign Capital Hoax
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 should enable the government to act as employer of last resort to maintain full employment 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 budget surplus is economically counterproductive and unsustainable because it drains credit from the economy. The colonial administration in British Africa learned that land taxes were instrumental in inducing the carefree natives into using its currency and engaging in financial productivity. Thus, according to Chartalist theory, an economy can finance 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 closed domestic monetary regimes. Countries participating in neo-liberal international âfree tradeâ 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 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 in dollar to meet domestic needs. But countries must accumulate dollars before they can attract foreign capital. Even then, with capital control, foreign capital will only invest in the export sector where dollar revenue can be earned. But the dollars that accumulate from trade surpluses can only be invested in dollar assets in the United States, depriving local economies of needed capital. The only protection from such attacks on domestic currency is to suspend full convertibility, which then will keep foreign investment away. Thus dollar hegemony starves the non-dollar economies of needed capital by depriving their governments of the power to issue sovereign credit domestically. Precisely to prevent such currency attacks, tight control on the international flow of capital was instituted by the Bretton Woods system of fixed exchange rates pegged to a gold-backed dollar at $35 per ounce after World War II. Drawing lessons from the prewar 1930s Depression, economics thinking prevalent immediately after WWII had deemed international capital flow undesirable and unnecessary. Trade, a relatively small aspect of most national economies, was to be mediated through fixed exchange rates pegged to a gold-backed dollar. The fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the participating economies. The impact of exchange rates were limited to the finance of international trade, and was not expect to dictate domestic monetary policy, which was crucial to domestic development and regarded as the province of national autonomy. Under principles of Chartalism, foreign capital serves no useful domestic purpose outside of an imperialistic agenda. Thus dollar hegemony essentially taxes away the ability of the trading partners of the United States 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. The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice between (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment/low interest rates, 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. Thus dollar hegemony makes possible US finance hegemony, which makes possible US exceptionism and unilateralism. The Foreign Exchange Carnage Finance capitalism has operated on fiat money issued by governments worldwide ever since Nixon abandoned in 1971 the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar. Beginning in the early 1960's, with the growth of Eurocurrency markets where banks in one European country could take deposits and make loans in currencies of other countries, the tight controls of international flow of capital set up by the Bretton Woods system of fixed exchange rates after World War II were effectively bypassed. When the fixed exchange rate system set by Bretton Woods finally broke down by 1973, with a gold-backed US dollar that became fatally wounded in 1971 by decades of US fiscal irresponsibility, the developed countries abandoned capital controls officially. In the late 80's, many developing countries followed suit. Growing from $190 billion at the beginning of the 1990s, daily turnover of foreign exchange grew almost one hundred fold to $1.5 trillion in unregulated foreign exchange markets. Only 5% of theses transaction is related to trade and others trade-associated transactions. The other 95% are financial transactions to facilitate international flow of funds, much of which involve speculative plays as traders bet on exchange rate fluctuations and interest rate differentials between currencies. This kind of financial speculation plays havoc with national budgets, macroeconomic planning and rational allocation of resources. Governments, businesses and individuals have become increasingly frustrated with the whimsical and often irrational activities in global financial markets that have such influence over national economies and are seeking some means to curb damaging and unproductive speculative activities. By 1996, some $350 billion of private capital flowed into emerging markets, a seven-fold increase in 6 years. The bulk of this inflow went through global commercial banks. After July 1997, the bulk of the outflow left in the form of sudden withdrawal also through commercial banks. For the two decades before the Asian Financial Crises that began in 1997, technical imbalances between interest rates set by different central banks for funds in different currencies distorted capital flow around the world from economic fundamentals. The resultant inflow of capital into Asia through inter-linked financial markets around the globe outstripped the region's viable absorption rate. Financial institutions took advantage of low cost funds denominated in currencies of select countries, namely Japan, Germany and the United States, to make loans at higher interest rates denominated in local Asian currencies. These institutions sought to strategically profit from recurring technical imbalances in global finance by assuming currency risks, rather than from traditional direct investment returns. Economists call this activity international arbitrage on the principle of open interest parity. In banking parlance, this type of activity is known as "carry trade". This abusive speculation was by no means limited to emerging economies. Corporation in developed economies routinely engaged in global financial and stock manipulative speculation at the expense of sound investment/production strategies. The public announcement of plans to open new factories in emerging markets in Asia and Latin America predictably lifted share value in home markets, regardless of such factories being risky loss-makers, for the loss would be more than offset by the increase market capitalization resulting from the publicity of a presence in an emerging market. Corporate borrowers in Asia, attracted by low rates in some foreign currency loans, have also assumed currency risks, at times even bypassing local banks to borrow directly overseas in global debt markets. Borrowers, anticipating asset inflation brought on by runaway growth, also succumbed to the irresistible temptation of borrowing short-term to finance long-term projects, thus adding to the risk they assumed. Simultaneously, many Asian banks have taken local currency deposits at low saving rates (in Hong Kong at times at negative interest rates - depositors pay the bank to keep their money in local currency) to invest overseas in risky foreign currency instruments yielding higher returns, engaging in carry trade. Local banks in turn replenished the depleted local capital pool with low-cost foreign currency loans from international banks, taking on both economic and currency risks. Borrowing low and lending high is the basic business of banks and there is nothing wrong with it if the activities occur within a well-regulated market in a bank's domicile community. With the advent of deregulated global banking, however, the unregulated internationalization of finance has created perilous systemic stress. Banks began to act as international loan brokers, profiting from interest rate spreads between local and foreign funds, often booking the risk premium added to overvalued currency interest rates as legitimate loan profits. These banks also began to maximizing their profits by maximizing loan volume, abrogating their traditional economic function as responsible financial pillars of local economies to ensure the productive allocation of capital. In time, local banks de-coupled their business self-interest from the economic impacts of their loans on the local economies, because they hedged the risk in such loans by passing it to overseas hedge funds which became the real loan originators to whom the banks themselves lend the funds. Western and Japanese international banks in turn provided funds to the local broker banks in Asia whose credit ratings were considered acceptable because the borrowers' exposures were hedged by instruments designed to transfer risk to other international institutions. In effect, the widespread transfer of business risks into currency risks forced the governments of the affected currencies to become lenders of last resort. This is the real economic effect of Hong Kong's, Argentina's and other currency peg regimes to the US dollar. To increase returns, banks also creatively skirt regulation through structured finance devices such as collateralized mortgage obligations (CMO) which releases pressure on capital requirements. CMOs are essentially new junior debts secured by old senior debts that takes advantage of the theory of large numbers and hierarchy of risk. Similarly, corporations issue convertible bonds that do not appear on the corporation's balance sheets, but expose the borrower to instant repayment requirements should its share value drop below the specified amount. So in an era of allegedly increased transparency, layers of opaqueness are introduced through structured finance. The unbundling of risk acts as a disguise of risk. Hedging does not eliminate risk, it merely passes risk along to other parties. In fact, complex hedging schemes, with the effect of reducing the risk exposure of individual lenders and inflating the credit worthiness of the hedged individual borrowers, when widely practiced, actually increase systemic risk exposure, initially of regional financial systems and ultimately of the global system. Yet the soundness of financial institutions continue to be assessed singularly without regard to counterparty credit worthiness and the breakdown of insularity within national borders, while financial markets have become intricately linked globally. A poor credit rating seldom means the denial of credit. It only means a higher interest rate which actually attracts more eager lenders who rationalize that the high risk has been compensated for by the increased lending rate. Junk bond rates are calculated from historical industrywide default frequencies. Through extensive hedging, private financial risks have been largely socialized globally, while profits from systemic efficiencies remain in private hands. The ingenious layering of protection against risk, while providing comfort to individual players, buys such comfort at the expense of the security of the total global system. At some point, the strained circular chain breaks at the weakest link and panic sets in. That break occurred in Thailand on July 2, 1997. When the Asian financial crises began in Thailand, it had not been triggered by hyperinflation or a sudden drop in corporate earnings. It was triggered by a collapse of an overvalued Thai currency pegged to the US dollar, the defense of which drained the Thai central bank of its foreign exchange reserves. In hindsight, it is indisputable that the conditions that led to the Asian financial crises were: unregulated global foreign exchange markets; the widespread international arbitrage on the principle of open interest parity (carry trade); short term debts to finance long-term projects; hard currency loans for project with only local currency revenue; overvalued currencies unable to adjust to changing market values because of fixed pegs and, above all, instant massive movement of funds that was susceptible to herd panic, known as contagion. Under these conditions, when a threat of currency devaluation caused by a dwindling of reserves appeared, the entire financial house of cards collapsed, causing havoc in connected economies in a chain reaction, called contagion. Collapse of one currency then quickly grew into regional economic crises within weeks, then turned global, eventually hitting Russia, Brazil, Argentina and Turkey. Because of this circular system of global hedging, the economic crises in Asia inevitably spread worldwide. The regional crises, each with unique local characteristics, are merely early symptoms of a ticking global time bomb constructed out of the complex calculus of inter-linked financial markets in which countless individual credit risks are legally masked as sound transactions through sophisticated hedging. Derivatives, financial instruments which derive their value from other underlying financial instruments or benchmarks such as stock indices or exchange rates, are the cards in the fragile house of cards built by a financial specialty known as "structured finance." |
