Issues in Marxian Theory of Money and Credit

Henry C.K. Liu hliu at
Mon Mar 8 16:07:59 PST 1999

Your academic debate on Marxist theory of money and credit has little to do with the situation behind the Asian financial crises. The collapse in Asian is the result of an abrupt rupture in the unregulated global system of financial markets. Beginning in the early 1960's, with the growth of Euromarkets 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. Drawing lessons from the 1930 depression, economic thinking prevailing immediately after the War had deemed international capital flow undesirable or unnecessary. When the fixed exchange rate system finally broke down in the early 1970's, the developed countries abandoned capital controls officially. In the late 80's, many developing countries followed suit. In the last decade, daily turnover of foreign exchange grew over one hundred fold to over US$1.5 trillion from US$190 billion. By 1996, some US$350 billion of private capital flowed into emerging markets, a seven fold increase in 6 years. For the past two decades, technical imbalances between interest rates set by different central banks for funds in different currencies distorted capital flow around the world. 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. Economist name this development as 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 market speculation at the expense of sound production strategies. The public announcement of plans to open new factories in Asia predictably lifted share value in home markets, regardless such factories risked being loss-makers, for the loss would be more than covered by the increase market capitalization. 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. Borrowers, anticipating asset inflation brought by run away 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) to invest overseas in risky foreign currency instruments yielding higher returns, engaging in carry trade. Local banks in turn have 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 of a bank's domicile community. With the advent of 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 weak 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. 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 effect of Hong Kong's and other Asian currency peg to the US dollar. 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 and 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 rate. Through extensive hedging, private financial risks have been largely socialized globally. 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 1, 1997. Because of this circular system of global hedging, the current economic crises in Asia

inevitably will 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 indexes or exchange rates, are the cards in the fragile house of cards built by a financial specialty known as structured finance. International finance in recent years has been saturated with disastrous and scandalous abuses that clearly and repeatedly epitomize the deficiencies of the unregulated global inter-linking of financial markets. Speculators have been blamed for precipitating the run on Asian currencies that started the financial crises. Yet speculation and risk management are two sides of the same coin. At the opposite end of a prudent hedge, a speculator is required. In a structurally flawed system, perfectly honorable businessmen or institutions individually true to high ethical and financial standards, can unwittingly participate in systemic games of dubious value. Data on the now 20-months-old Asian financial crises show that currency hedging individually by sophisticated businesses and alert government bodies, domestic and foreign, as protective measures against foreign exchange exposures in both debts and revenues, have been mostly responsible for the sudden currency turmoil in the region. In international finance, a game of musical chair in financial risk is in full force in which the players are handcuffed together through inter-linking hedges. This game can cause serious systemic rupture when the music stops. It is time for world leaders to propose plans to deal realistically with the serious situation, and stop denying its existence.

The globalization of the U.S. finance sector also contributed to the growth of the U.S. economy through the export of capital and inflation to the developing countries. Cross border sales and purchases of equity and bonds by American investors have risen from 9% of GDP in 1980 to 164% in 1996. But uncertainties loom large as the injurious impacts from the Asian crises, which are mere symptoms of a structurally flawed global financial architecture, begin to hit the U.S. economy. While the US dollar is currently strong, a downward correction is a high possibility within the next three years. While short-term fundamentals favor the US dollar, long term fundamentals are increasingly negative. U.S. trade and current account deficits are likely to each US$250-300 billion in 1998. Net debtor position of the U.S. will exceed US$1.8 trillion. Whenever foreign-held dollar reserves are sold, an equivalent of U.S. owned assets are liquidated immediately at market price. If the amount sold is large enough, it will cause a recession or even depression in the U.S., as in 1929-32, which the post-war Bretton Woods system of fixed exchange rates was designed to prevent from occurring again. In 1995, after the Federal Reserve started to hike interest rates in 1994 and sharply curtailed its own purchase of Treasury bills, triggering the Mexico peso crisis and a subsequent U.S. slowdown, the Bank of Japan initiated a program to buy $100 billion of US treasuries. China bought $80 billion. Hong Kong and Singapore bought $22 billion each. 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 U.S. dollar reserves. These recycled dollars pushed up stock prices in America. A sharp correction of the stock market accompanied by an abrupt slowdown of the US economy is a matter of when and not if. Also, the new euro will pose a direct challenge to the US dollar as the preferred currency for international trade. The financial world is in the process of shifting from a dollar-centered system to a bipolar dollar-euro system. Just like the post-war corrections in U.S. markets in 1971-73, 1978-79, 1985-87, which critically stalled the U.S. economy because the contributing currency overvaluations were permitted to go too far and for too long, the next correction will have equally severe economic consequences.This means that just when the Asian economies are working themselves out from the damages of the current crises, the U.S. economy may stall and the US dollar may fall in value Five years after the 1929 crash, Franklin D. Roosevelt was forced in 1934 to eased monetary policy through a 59% devaluation of the US dollar against gold. The Asian financial crises are not mere passing storms or cyclical phases. They are the opening acts of a historic restructuring of the global economic system in which the stakes are very high. Economic globalization requires enlightened nationalism to keep it fair and just. As Lenin insightfully hypothesized, Western imperialism provided the escape valve that postponed the deterministic evolution of capitalism into socialism as predicted by Marx. The collapse of Western imperialism, brought about by the rise of nationalism, heralded the advent of a wave of socialist economies after World War II in newly independent former colonies and semi-colonial territories, without the historical prerequisite of having first gone through capitalism. The historical relationship between capitalism and socialism is that capitalism is efficient in creating wealth and socialism is necessary for sharing the wealth that capitalism creates in order for society to be more just and stable. As such, the ripe candidates for socialist systems are the industrialized nations that have already benefited from the productive efficiency of capitalism, not the poor countries that have been ravaged by a century of Western imperialism. There is no economic benefit in socializing poverty. Most reasonable thinkers now accept that capitalism and socialism are not concepts adverse to each other, but are complimentary approaches to keep society prosperous and just. Each nation, according to its historical conditions, must seek the proper mix of these approaches to fit its own developmental needs. Indiscriminate global imposition of Western market criteria is not workable or desirable. After the demise of political imperialism, capitalism manages to gain another new lease on life through the transformation of the newly setup socialist planned economies into capitalist market economies via the expansion of world trade. Some political economists view unbalanced and unregulated world trade as a new form of economic imperialism, benign in appearance, rationalized under the laws of modern economics that hold sacred the principle of maximizing return on capital and the operational dynamics of free markets that favors the strong and perpetually condemns the weak. These concepts give the West an inherently unfair advantage against the capital-starved and ill-equipped third world. The international division of labor as currently constituted in globalization has been driven by wage competition between countries with a race to the bottom effect. Countries also compete to reduce taxes, welfare benefits, environmental protection and trade regulations in the name of efficiency in a global market economy. Technology, lowering the cost of communication and managing complexity, now allows central control of highly decentralized operations worldwide. Trade and foreign investment have preempted economic development and aid as the main paths for undeveloped nations to modernize and to prosper. Yet globalization of trade and finance has its critics in both developed and developing countries, but for different reasons. In theory, free international movement of capital through integrated financial markets in a global economy allows efficient allocation of funds towards investments of highest productivity. But truly free markets do not exist in the real world, and even if they do, they operate under narrowly single-dimensional rules and historical biases, all of which aim toward maximizing return on capital without due regard for local social, political or environmental consequences or individual national aspirations. Moreover, global financial market pressures tend to supplant the traditional roles local political leaders and government institutions play in formulating macroeconomic policies that safeguard individual national interests. Despite all the noise the United State makes about the benefits of world trade, US export of $564.7 billion (FOB) constitutes only 7.6% of its GDP of $7.6 trillion (1996) and US import of $771 billion (CIF) constitutes 10.1% of GDP. Export to all of Asia amounts to only 2.4% of its GDP of which Japan constitutes 1%. Thus the U.S. can sustain a strong bargaining position in setting the terms of trade on a take it or leave it basis. Excessive reliance on world trade may not be in a country's best national interest, simply because national governments are forced to surrender their power to manage their economy to world market forces, or international trade institutions and agreements. It is an argument put forward not only by the developing nations, but also by isolationists in America, with sufficient public support to deprive President Clinton of his ?fast track? authority to settle trade disputes. In contrast, Hong Kong export of $197.2 billion constitutes 121% of its GDP of $163.6 billion (1996), and HK import of $217 billion constitutes 130% of its GDP. It is obvious that a rupture in world trade will impact Hong Kong differently than the U.S. While Hong Kong has no viable alternative to total dependence on trade, it should bear in mind that it is now part of China, and that Hong Kong's national interest is part and partial of that of China where the issue of trade policy in relation to national independence has not been definitive resolved. When capital is mobile, governments are able to enjoy the benefits of fixed exchange rate stability only if they are willing to forego the empowerment of managing the economy through the setting of domestic interest rates and the supply and liquidity of money. This means when global capital flow into a country, local interest rate will fall, sometimes to negative rates, distorting the orderly development of the affected economy. For example, beginning in the mid-1980's, Hong Kong's currency board mechanism created persistent negative local interest rates, causing abnormal investment flows into the property sector, resulting in unrealistic price inflation that became a major problem in the current downturn. Conversely, when investors begin to pull out of a country or sell its currency, local interest will have to rise to counter the flow in order to maintain the exchange rate peg. This invariably weakens the banking and financial system, eventually causing bank failures and institutional bankruptcies. This happened to Hong Kong in October 1997, with disastrous long-term consequences that are yet to unfold fully. Hong Kong will be plagued by excessively high interest rates until the currency board mechanism is abandoned or until the US dollar falls. There will be no sustainable long-term economic recovery for Hong Kong until the HK Monetary Authority regains its power to set monetary policies. Pegging a currency's exchange rate to another currency does not automatically make an economy more stable. If domestic economic policies are inconsistent with the chosen exchange rate, a fixed rate can itself lead to instability. Small economies with less sophisticated financial markets face greater risk from opening to international capital. Sudden capital flight can create economic havoc, as in the European currencies crises of 1992-93, in Mexico in 1994 and in Thailand in July 1997. In the last quarter of 1997, institutional panic caused an abrupt drop of private capital flow, in excess of US$100 billion, to the five most affected countries: South Korea, Indonesia, Thailand, Malaysia and the Philippines. South Korea alone saw its capital flow drop by US$50 billion as compared to 1996. The region experienced a net outflow of US$15 billion in 1998, after a net outflow of capital of US$12.1 billion in 1997. And contagion effects can hit countries in an economic region and eventually the entire global system. As the economies of the lending nations contract, banks will withdraw urgently needed funds from other healthy economies where liquid markets still operate, thus forcing the healthy economies to collapse. This happened to the Hong Kong market in October 1997. Manipulative attacks on currency/interest rates/equity/futeres occured in Hong Kong at the end of August 1998. It will happen again and again before recovery is in sight. The threat of Japanese banks retrieving capital from other countries has begun and, the prospect of withdrawing from the U.S., is very real. Japan has entered a prolonged phase of serious deflation. When that happens, U.S. interest rates will skyrocket.

Henry C.K. Liu

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