The Death of Money

April 1, 2014

by James Rickards

James Rickards is the author of the national bestseller Currency Wars. He is a portfolio manager at West Shore Group and an adviser on international economics and financial threats to the Department of Defense and the U.S. intelligence community.

The prospect of the dollar failing, and the international monetary system with it, looks increasingly inevitable. The dollar nearly ceased to function as the world’s reserve currency in 1978, and similar symptoms can be seen today.


Few Americans in our time recall that the dollar nearly ceased to function as the world’s reserve currency in 1978. That year the Federal Reserve dollar index declined to a distressingly low level, and the U.S. Treasury was forced to issue government bonds denominated in Swiss francs. Foreign creditors no longer trusted the U.S. dollar as a store of value. The dollar was losing purchasing power, dropping by half from 1977 to 1981; U.S. inflation was over 50 percent during those five years. Starting in 1979, the International Monetary Fund (IMF) had little choice but to mobilize its resources to issue world money (special drawing rights, or SDRs). It flooded the market with 12.1 billion SDRs to provide liquidity as global confidence in the dollar declined.

We would do well to recall those dark days. The price of gold rose 500 percent from 1977 to 1980. What began as a managed dollar devaluation in 1971, with President Richard Nixon’s abandonment of gold convertibility, became a full-scale rout by the decade’s end.

The efforts of Federal Reserve Chairman Paul Volcker and the newly elected Ronald Reagan would save the dollar. The dollar did not disappear as the world’s reserve currency after 1978, but it was a near run thing.

Now the world is back to the future.

A similar constellation of symptoms to those of 1978 can be seen in the world economy today. In July 2011 the Federal Reserve dollar index hit an all-time low, over 4 percent below the October 1978 panic level. In August 2009 the IMF once again acted as a monetary first responder and rode to the rescue with a new issuance of SDRs, equivalent to $310 billion, increasing the SDRs in circulation by 850 percent. In early September gold prices reached an all-time high, near $1,900 per ounce, up more than 200 percent from the average price in 2006, just before the new depression began.

The parallels between 1978 and recent events are eerie but imperfect. There was an element ravaging the world then that is not apparent today. It is the dog that didn’t bark: inflation. But the fact that we aren’t hearing the dog doesn’t mean it poses no danger. And from the Federal Reserve’s perspective, inflation is not a threat; indeed, higher inflation is both the Fed’s answer to the debt crisis and a policy objective.

This pro-inflation policy is an invitation to disaster, even as baffled Fed critics scratch their heads at the apparent absence of inflation in the face of unprecedented money printing by the Federal Reserve and other major central banks. Many ponder how it is that the Fed has increased the base money supply 400 percent since 2008 with practically no inflation. But two explanations are very much at hand — and they foretell the potential for collapse. The first is that the U.S. economy is structurally damaged, so the easy money cannot be put to good use. The second is that the inflation is coming. Both explanations are true — the economy is broken, and inflation is on its way.

The world economy is not yet in the “new normal.” Instead, the world is on a journey from old to new with no compass or chart. Turbulence is now the norm.

Danger comes from within and without. We have a misplaced confidence that central banks can save the day; in fact, they are ruining our markets. The value-at-risk models used by Wall Street and regulators to measure the dangers that derivatives pose are risible; they mask overleveraging, which is shamelessly transformed into grotesque compensation that is throwing our society out of balance. When the hidden costs come home to roost and taxpayers are once again stuck with the bill, the bankers will be comfortably ensconced inside their mansions and aboard their yachts. The titans will explain to credulous reporters and bought-off politicians that the new collapse was nothing they could have foreseen.

While we refuse to face truths about debts and deficits, dozens of countries all over the globe are putting pressure on the dollar. We think the gold standard is a historical relic, but there’s a contemporary scramble for gold around the world, and it may signify a move to return to the gold standard. We greatly underestimate the dangers from a cyberfinancial attack and the risks of a financial world war.

Regression analysis and correlations, so beloved by finance quants and economists, are ineffective for navigating the risks ahead. These analyses assume that the future resembles the past to an extent. History is a great teacher, but the quants’ suppositions contain fatal flaws. The first is that in looking back, they do not look far enough. The second flaw involves the quants’ failures to understand scaling dynamics that place certain risk measurements outside history. Since potential risk is an exponential function of system scale, and since the scale of financial systems measured by derivatives is unprecedented, it follows that the risk too is unprecedented.

While the word collapse as applied to the dollar sounds apocalyptic, it has an entirely pragmatic meaning. Collapse is simply the loss of confidence by citizens and central banks in the future purchasing power of the dollar. The result is that holders dump dollars, either through faster spending or through the purchase of hard assets. This rapid behavioral shift leads initially to higher interest rates, higher inflation, and the destruction of capital formation. The end result can be deflation (reminiscent of the 1930s) or inflation (reminiscent of the 1970s), or both.

The coming collapse of the dollar and the international monetary system is entirely foreseeable. This is not a provocative conclusion. The international monetary system has collapsed three times in the past century — in 1914, 1939, and 1971. Each collapse was followed by a tumultuous period. The coming collapse, like those before, may involve war, gold, or chaos, or it could involve all three. The most imminent threats to the dollar, likely to play out in the next few years, are financial warfare, deflation, hyperinflation, and market collapse. Only nations and individuals who make provision today will survive the maelstrom to come.

In place of fallacious, if popular, methods, complexity theory is the best lens for viewing present risks and likely outcomes. Capital markets are complex systems nonpareil. Complexity theory is relatively new in the history of science, but in its 60 years it has been extensively applied to weather, earthquakes, social networks, and other densely connected systems. The application of complexity theory to capital markets is still in its infancy, but it has already yielded insights into risk metrics and price dynamics that possess greater predictive power than conventional methods.

The next financial collapse will resemble nothing in history. But a more cleared-eyed view of opaque financial happenings in our world can help investors think through the best strategies.

This article is adapted from “The Death of Money: The Coming Collapse of the International Monetary System” by James Rickards, in agreement with Portfolio, an imprint of Penguin Random House. Copyright James Rickards, 2014.

Stanley Fischer To Become Next Federal Reserve Vice Chairman

December 12, 2013

Stanley Fischer, the former Bank of Israel governor and International Monetary Fund (IMF) official, is alleged to be the successor of Janet Yellen as vice chairman of the U.S. Federal Reserve.


As a professor of economics at Massachusetts Institute of Technology (MIT), he taught Fed Chairman Ben S. Bernanke, whose term ends in January 2014, and European Central Bank chief Mario Draghi.

Washington Post columnist Neil Irwin, and author of The Alchemists: Three Central Bankers and a World on Fire, explains why Stanley Fischer is the most qualified candidate for the job.

“A crisis-management veteran. Fischer has faced trial by fire, most dramatically as the deputy managing director at the IMF from 1994 to 2001. He was on the front lines dealing with of a series of emerging market crises, including in Mexico, East Asia and Russia.

In other words, if there were to be a crisis in one or more of the emerging powers like China, India or Brazil, it would be the sort of thing that Fischer has spent his career preparing for. That is doubly important right now, as money has been gushing out of emerging economies in the past few months, driving their currencies down and their borrowing costs up.”

Read full story.

Guest Editorial: The Currency War

February 21, 2011

What’s Behind the Currency War?

By Professor Dr. Antony P. Mueller

In September 2010, a short time before the international financial summit of the Group of Twenty (G20) took place in South Korea, Brazilian finance minister Guido Mantega declared that the world is experiencing a “currency war” where “devaluing currencies artificially is a global strategy.”

Dr. Antony P. Mueller is a professor of economics at the graduate business school of the University of Caxias-do-Sul (UCS) in Brazil. He is an adjunct scholar of the Ludwig von Mises Institute and president and founder of The Continental Economics Institute.

Dr. Antony P. Mueller is a professor of economics at the graduate business school of the University of Caxias-do-Sul (UCS) in Brazil. He is an adjunct scholar of the Ludwig von Mises Institute and president and founder of The Continental Economics Institute.

By announcing the outbreak of a “currency war,” Mantega wanted to draw attention to the problems caused by the ongoing exchange-rate manipulations that governments put in place in order to gain economic advantages. In this sense, “currency war” denotes the conflict among nations that arises from the deliberate manipulation of the exchange rate in order to gain international competitiveness by way of currency devaluation.

Competitive Devaluation

Calling competitive devaluation a “war” may seem like a gross exaggeration. Yet in terms of its potential of destruction, the current global financial conflict may well rank at a level similar to that of a real war.

In a wider historical perspective, the current currency war is the latest conflict in a series of acute crises of the modern international monetary system. In a world of national monetary regimes based on fiat money without physical anchors, domestic monetary instability automatically transforms into exchange-rate instability. As before, the current crisis of the international economic order is mainly the result of monetary fragilities coming from the unsound national monetary systems and reckless domestic monetary and fiscal policies.

The immediate cause of the currency war entering an acute stage is the policy of massive quantitative easing practiced by the US central bank. Whatever the original intention of this policy may have been, the consequences of the Fed’s measures include monetary expansion, low interest rates, and a weaker US dollar. With dollar interest rates approaching the “zero bound,” the United States is joining Japan in the effort to stimulate a sluggish economy with massive monetary impulses.

Until recently, the currency war was contained as a kind of financial cold war. The conflict entered its hot phase as a result of the expansive monetary policies that were put in place in the wake of the financial-market crisis that began in 2007. In defiance of the fact that the financial crisis itself was the result of the extremely expansive monetary policies in the years before, many central banks have now accelerated monetary expansion in the vain attempt to cure the disease with the same measures that had caused it in the first place.

Easy Money and International Financial Flows

What has emerged in the global financial arena over the past couple of years is the interplay among easy money, low interest rates, international trade imbalances, financial flows, and exchange-rate manipulations. The failure of attempts to cure overindebtedness with more debt, and to stimulate weak economies by giving them interest rates as low as possible, provokes a repetitive pattern of bubble and crash where each phase ends in a higher level of government debt.

A global search for higher yields has been going on not unlike what happened in the late 1960s and 1970s, when the United States inflated and the countries that had linked their exchange rates to the US dollar suffered from imported inflation. Nowadays, the formal dollar-based fixed-exchange-rate system no longer exists. It has been replaced by a system that sometimes is called “Bretton Woods II”: a series of countries, particularly in Asia this time, have pegged their exchange rates (albeit without a formal agreement) to the US dollar.

If a country wants to slow down the appreciation of its exchange rate that comes as a consequence of the financial inflows from abroad, it must intervene in the foreign-exchange markets and monetize at least a part of the foreign exchange. This way, the monetary authorities will automatically increase the domestic money stock. Additionally, under this system relatively poor countries feel forced not only to buy the debt issued by the relatively wealthy countries like the United States but also to buy these bonds at their current extremely low yields.

Under current conditions, the monetary expansion gets globalized and invades even those countries that wish to practice restrictive monetary policy. Relatively high levels of the interest rate improve the restrictive currency’s attractiveness. Thus, more and more monetary expansion happens on a global scale, which in turn provides the fuel for the next great wave of international financial flows.

The weaker countries, which compete with each other on the basis of low prices, are getting pushed to the side; it was just a matter of time until more and more governments would begin to intervene in the foreign-exchange markets by buying up foreign currencies in order to try to prevent their exchange rates from appreciating too much, too fast.

Yet using the exchange rate as a tool in order to gain economic advantage or avert damage for the domestic economy is inherently at variance with a sound global monetary order, because one country’s devaluation automatically implies the revaluation of another country’s currency and thus the advantage that one tries to obtain will be achieved by putting a burden on other countries.


By recycling the monetary equivalent of the trade surplus into the financial markets around the globe, monetary authorities in surplus countries form a symbiosis with trade-deficit countries in fabricating a worldwide monetary expansion of extreme proportions.

The paradoxical, or rather perverse, features of the current state of affairs were highlighted a short time ago when in January 2011 the monetary authorities of Turkey decided to lower the policy interest rates so as to make the inflow of foreign funds less attractive, despite a booming Turkish economy that shows plenty characteristics of a bubble.

Exchange-rate policies produce the usual spiral of interventionism: the de facto consequences tend to diverge from the original intentions, prompting further rounds of doomed interventions. This interventionist escalation is not only limited to an incessant repetition of the same failed policies, but the errors committed in one policy area also affect other parts of the economy. Thus, it is only a matter of time until errors of monetary policy lead to fiscal fiascos, and exchange-rate interventions lead to trade conflicts.

At first sight, exchange-rate intervention may appear tolerable as the legitimate pursuit of national self-interest. But exchange-rate policies are intrinsically matters that tend to stir transnational controversies. When a country’s exchange rate policy collides with the interests of the trading partners, the tit-for-tat of mutual retaliation automatically tends to lead to an escalation of the conflict. Once the process of competitive devaluation has started, a devaluation by one country invites other countries to devaluate their exchange rates as well. As a consequence, the international monetary order will eventually disintegrate, and sooner or later the conflict will go beyond currency issues and affect a wide spectrum of economic and political relations.

Therefore, because of the unsound monetary system, a peaceful international political system also is constantly at risk. Monetary conflicts provoke political confrontations. Besides the immediate costs of exchange-rate conflicts that come from the damage to international trade and investment, and thereby to the international division of labor, harm will also be done to confidence and trust in the international political arena.

The dispute about exchange rates is the consequence of contradictory tensions that are innate to the modern monetary system. In this respect the currency war is an expression of the defects that characterize an unsound and destructive financial system. The outbreak of the currency war is a symptom of a deeply flawed international monetary order.


When Brazil’s finance minister repeated his warnings in January 2011 and said that “the currency war is turning into a trade war,” Mantega sent a signal to the world that the escalation of the trade war had started. Because of the massive inflow of money from abroad, the Brazilian currency had sharply appreciated and the Brazilian economy was losing competitiveness.

In order to reduce the impact on is domestic economy, Brazil had been intervening in the foreign-exchange markets, diminishing the degree of currency appreciation. In doing so, the monetary authorities had to buy foreign currencies, mainly US dollars, in exchange for its domestic money.

By pursuing such a policy over the past couple of years, Brazil has increased its foreign-exchange reserves from around 50 billion to 300 billion US dollars. Yet even despite these foreign-exchange interventions, the Brazilian currency appreciated drastically against the US dollar and other currencies.

By various estimates, Brazilian foreign trade suffers from an exchange-rate overvaluation of around 40 percent. As a consequence, Brazil’s current account balance, which was still at surplus in 2007, has plunged into a deficit of 47.5 billion US dollars in 2010. At the same time when an artificial boom is taking place as the result of massive monetary expansion, the Brazilian economy suffers from creeping deindustrialization.

Part of the explosion of Brazil’s current-account deficit can be explained by weak demand from its trading partners, which have plunged into a prolonged recession. Yet beyond this circumstance, there has been another causal chain at work: the inflow of funds from abroad that boosts the exchange rate provides the grounds for an exorbitant increase of the country’s monetary base.

The combination of ample liquidity at home, weak demand from some trading partners abroad, and a strong exchange-rate appreciation provides the basis for an extreme import expansion that vastly exceeds exports. Unlike a country such as Germany, for example, whose industry is pretty resilient against currency appreciation, Brazil resembles in this respect the countries of the Southern periphery of the eurozone in its incapacity to cope effectively with an overvalued currency.

When, in January 2011, a new government took power in Brazil, the newly-elected president, Dilma Rousseff, declared in her inauguration speech that she will protect Brazil “from unfair competition and from the indiscriminate flow of speculative capital.” Guido Mantega, the former and new Brazilian finance minister, did not hesitate to join in when he asserted that the government has an “infinite” number of interventionist tools at its disposal with which to protect national interests. Mantega said that the government is ready to use taxation and trade measures in order to stop the deterioration of Brazil’s trade balance.


The countries that form the favored group that gets targeted by international financial flows in search of higher yields compete among themselves in order to prevent their currencies from appreciating too much, and as a group these countries compete against China in their efforts to maintain a competitive exchange rate.

China’s position forms part of a long causal chain, which includes low interest rates and monetary expansion in the United States, that fuels higher import demand. Given that China drastically devalued its exchange rate as early as in the 1980s, this country was at the forefront of gaining advantage of America’s import surge; China grabbed the golden opportunity to turn itself into the major exporter to the United States.

In order to maintain its currency at its undervalued level, the Chinese monetary authorities must buy up the excess of foreign exchange that accumulates from its trade surplus, preferably by buying US treasury notes and bonds. In this way, China became America’s main creditor. Over the past decade, China increased its foreign exchange position from a meager $165 billion in 2000 to an amount that was approaching $3 trillion at the end of 2010.

From the 1980s up to the early 1990s, China devalued its currency from less than 2 Yuan to the US dollar to an exchange rate of 9 Yuan against the US dollar. And despite its huge trade surpluses, China has only slightly revalued the Yuan ever since, establishing the current exchange rate at 6.56 Yuan per US dollar.

Over the past decade, China has become the major financier of the US budget deficit. Together with other monies flowing in from abroad, the US government was relieved from the need to cut spending. The inflow of foreign capital also allowed the US government to pay lower interest rates for its debt than it would have if only domestic supply of savings were available. Foreign imports put pressure on the price level, and the US central bank could continue monetary expansion without an immediate effect on the price-inflation rate.

If China wants to hold its competitive position through an undervalued currency, the Chinese monetary authorities must continue their policy of intervention in the foreign-exchange markets. As a consequence of buying dollars from its exporters, the domestic money supply in China continues to rise, throwing additional fuel on a domestic boom that is already in full swing.

Even more so than their Brazilian counterparts, China’s political-decision makers have failed to exert moderation or restraint when it comes to interventionist measures. As long as China’s leadership presumes that it gains from exchange-rate manipulation, its currency interventions will go on.

Global Financial Fragilities

Since the abandonment of the gold standard, the global financial system has been in disarray. All the international monetary arrangements that have been established since then have ended in crisis and finally collapsed. For almost a hundred years now, one interventionist scheme has been established and then soon fallen to pieces.

When the monetary and fiscal decision makers in the United States and Europe discarded all restraints against intervention in the wake of the financial market crisis, socialist and interventionist governments around the globe felt vindicated. They had long been convinced that only through state control could financial stability be obtained. Due to the policies adopted by Western countries in their futile attempt to overcome the financial-market crisis, the leaders of the so-called emerging economies have become even more unscrupulous interventionists.

Political leaders around the globe have shed the little that was left of support for free markets and set the controls for a way back on the road to serfdom. It is mainly due to ignorance that the modern monetary system gets labelled as a laissez-faire or free market system. In fact not only the basic “commodity” of this scheme, i.e., fiat money, but also its price and quantity are largely determined by political institutions such as central banks.

It is more than absurd when, in the face of crises and conflicts, more government intervention gets called upon: it was state intervention in the first place that laid the groundwork for the trouble to appear.

So-called “speculative” international capital flows already happened decades ago. What has changed since then is the amount of hot money and the speed with which it floats around the world. It would be wrong to describe these financial movements as an expression of free markets. The fact, for instance, that in 2010 daily transactions on the international currency market have reached a volume of four trillion US dollars is the result of unhampered fiat-money expansion and massive state intervention in the foreign-exchange markets.

The increase in the global money supply that has been going on for many years finds its complement in a global asset boom. The inflation of money drives up the price of precious metals, natural resources, and food. Once more, the world experiences a period of fake prosperity not much different from the real-estate bubble, and many other episodes, that led to previous financial crises.


The political endeavours to gain competitive advantages through exchange-rate devaluation sows mistrust among nations; and the ensuing regime uncertainties frustrate the business community. Over time the conflict over exchange rates tends to destroy the global division of labor.

Once again, the international monetary system is on the brink of a breakdown. As in the past, the main reason behind the current conflict is extreme monetary expansion. Unsound monetary systems produce turmoil not just at home but also in the international arena. Excessive monetary expansion, which is the cause of domestic malinvestment, is also the root of economic distortions at a global level.

Without a fundamental change of the monetary system itself, without a return to sound money, the international monetary system will remain in a state of permanent fragility — ever oscillating between the abyss of deflationary depression and the fake escape of hyperinflation. This is the fate of the world when nations implement fiat monetary systems and put them under political authority.

© 2011, Dr. Antony P. Mueller.

Principles for Economic Revival

September 22, 2010

Top White House economic adviser Lawrence Summers announced he will leave, allowing President Barack Obama to reshape his economic staff after midterm elections.

President Barack Obama makes his point to Lawrence Summers, left, head of the National Economic Council, and Office of Management and Budget Director Peter Orszag, seated next to Summers, during a budget meeting in the White House Roosevelt Room in the President's first week in office. Rahm Emanuel, White House Chief of Staff, is seated to the President's left (January 24, 2009)

President Barack Obama makes his point to Lawrence Summers, left, head of the National Economic Council, and Office of Management and Budget Director Peter Orszag, seated next to Summers, during a budget meeting in the White House Roosevelt Room in the President's first week in office. Rahm Emanuel, White House Chief of Staff, is seated to the President's left (Photo: Peter Souza; January 24, 2009).

The Federal Reserve said yesterday it was prepared to do more to help the U.S. economy but stopped short of announcing specific measures.

In the Wall Street Journal, George P. Shultz, Michael J. Boskin, John F. Cogan, Allan Meltzer, and John B. Taylor outline a set of policies to guide economic policymakers back to rapid growth, including lowering taxes, balancing the budget, modifying Social Security and healthcare entitlements, and a stronger monetary policy.

Read full story.

U.S. Recession Longest Since World War II

September 21, 2010

The U.S. recession lasted eighteen months and was the longest since World War II, according to the National Bureau of Economic Research, which announced yesterday that the recession ended in June 2009.

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U.S. Federal Reserve Fights to Maintain Powers

March 8, 2010

The U.S. Federal Reserve is fighting Congress to maintain its role in regulating U.S. banks amid rising internal tensions over the central bank’s reorganizing, The Wall Street Journal reports.

“The worst of the banking crisis may be long over, but the political contest over the Federal Reserve is entering a crucial phase in which its personality and role will almost certainly be redefined.

The Fed has tried to fend off very public efforts in Congress to strip it of responsibility for regulating America’s banks, but a less-visible battle has been playing out inside the central bank. The Fed has undertaken a wrenching reorganization of its army of 3,000 bank supervisors, which has centralized more power in Washington and sometimes pitted officials at the 12 regional Fed banks against those in the capital.”

Read full story.

OECD revises World Economic Outlook forecast upward

June 24, 2009

The Organization for Economic Cooperation and Development (OECD) today revised its World Economic Outlook forecast upward for the first time since 2007, indicating that the global economic slide may be approaching a bottom.

The group revised its estimates for 2009 upward, projecting a contraction of 4.1 percent rather than the 4.3 percent it projected before, and also projected slight growth in 2010, whereas before it had projected none.

Here is the text of the OECD report.

The new OECD report coincides with meetings of the U.S. Federal Reserve’s Open Market Committee today in Washington.

A blog entry in the Wall Street Journal says the focus of the Fed’s meetings will be interest rates, how to word its statement on the economy, and the Fed’s asset purchase plan.

Read full story.

U.S. Federal Reserve makes stiff warning on deficit

June 4, 2009

Speaking before the Committee on the Budget of the U.S. House of Representatives in Washington, yesterday, U.S. Federal Reserve Chairman Ben Shalom Bernanke said Washington will need to bring down long term budget deficits and said a failure to do so could lead to future debt problems.

Bernanke highlighted rising pressure on long-term interest rates as a problem.


Chairman Ben S. Bernanke
Chairman of the Board of Governors of the United States Federal Reserve
Current economic and financial conditions and the federal budget
Before the Committee on the Budget, U.S. House of Representatives, Washington, D.C.
June 3, 2009

Chairman Spratt, Ranking Member Ryan, and other members of the Committee, I am pleased to have this opportunity to offer my views on current economic and financial conditions and on issues pertaining to the federal budget.

Economic Developments and Outlook

The U.S. economy has contracted sharply since last fall, with real gross domestic product (GDP) having dropped at an average annual rate of about 6 percent during the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of nearly 6 million jobs since the beginning of 2008. The most recent information on the labor market–the number of new and continuing claims for unemployment insurance through late May – suggests that sizable job losses and further increases in unemployment are likely over the next few months.

However, the recent data also suggest that the pace of economic contraction may be slowing. Notably, consumer spending, which dropped sharply in the second half of last year, has been roughly flat since the turn of the year, and consumer sentiment has improved. In coming months, households’ spending power will be boosted by the fiscal stimulus program. Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

Activity in the housing market, after a long period of decline, has also shown some signs of bottoming. Sales of existing homes have been fairly stable since late last year, and sales of new homes seem to have flattened out in the past couple of monthly readings, though both remain at depressed levels. Meanwhile, construction of new homes has been sufficiently restrained to allow the backlog of unsold new homes to decline – a precondition for any recovery in homebuilding.

Businesses remain very cautious and continue to reduce their workforces and capital investments. On a more positive note, firms are making progress in shedding the unwanted inventories that they accumulated following last fall’s sharp downturn in sales. The Commerce Department estimates that the pace of inventory liquidation quickened in the first quarter, accounting for a sizable portion of the reported decline in real GDP in that period. As inventory stocks move into better alignment with sales, firms should become more willing to increase production.

We continue to expect overall economic activity to bottom out, and then to turn up later this year. Our assessments that consumer spending and housing demand will stabilize and that the pace of inventory liquidation will slow are key building blocks of that forecast. Final demand should also be supported by fiscal and monetary stimulus, and U.S. exports may benefit if recent signs of stabilization in foreign economic activity prove accurate. An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions; a relapse in the financial sector would be a significant drag on economic activity and could cause the incipient recovery to stall. I will provide a brief update on financial markets in a moment.

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.

Conditions in Financial Markets

Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity.

Among the markets where functioning has improved recently are those for short-term funding, including the interbank lending markets and the commercial paper market. Risk spreads in those markets appear to have moderated, and more lending is taking place at longer maturities. The better performance of short-term funding markets in part reflects the support afforded by Federal Reserve lending programs. It is encouraging that the private sector’s reliance on the Fed’s programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed our interventions. The issuance of asset-backed securities (ABS) backed by credit card, auto, and student loans has also picked up this spring, and ABS funding rates have declined, developments supported by the availability of the Federal Reserve’s Term Asset-Backed Securities Loan Facility as a market backstop.

In markets for longer-term credit, bond issuance by nonfinancial firms has been relatively strong recently, and spreads between Treasury yields and rates paid by corporate borrowers have narrowed some, though they remain wide. Mortgage rates and spreads have also been reduced by the Federal Reserve’s program of purchasing agency debt and agency mortgage-backed securities. However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen. These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings.

As you know, last month, the federal bank regulatory agencies released the results of the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine, for each of the 19 U.S.-owned bank holding companies with assets exceeding $100 billion, a capital buffer sufficient for them to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions over the next two years turn out to be worse than we currently expect. According to the findings of the SCAP exercise, under the more adverse economic outlook, losses at the 19 bank holding companies would total an estimated $600 billion during 2009 and 2010. After taking account of potential resources to absorb those losses, including expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19 institutions should raise, collectively, additional common equity of $75 billion.

Each of the 10 bank holding companies requiring an additional buffer has committed to raise this capital by November 9. We are in discussions with these firms on their capital plans, which are due by June 8. Even in advance of those plans being approved, the 10 firms have among them already raised more than $36 billion of new common equity, with a number of their offerings of common shares being over-subscribed. In addition, these firms have announced actions that would generate up to an additional $12 billon of common equity. We expect further announcements shortly as their capital plans are finalized and submitted to supervisors. The substantial progress these firms have made in meeting their required capital buffers, and their success in raising private capital, suggests that investors are gaining greater confidence in the banking system.

Fiscal Policy in the Current Economic and Financial Environment

Let me now turn to fiscal matters. As you are well aware, in February of this year, the Congress passed the American Recovery and Reinvestment Act, or ARRA, a major fiscal package aimed at strengthening near-term economic activity. The package included personal tax cuts and increases in transfer payments intended to stimulate household spending, incentives for business investment, increases in federal purchases, and federal grants for state and local governments.

Predicting the effects of these fiscal actions on economic activity is difficult, especially in light of the unusual economic circumstances that we face. For example, households confronted with declining incomes and limited access to credit might be expected to spend most of their tax cuts; then again, heightened economic uncertainties and the desire to increase precautionary saving or pay down debt might reduce households’ propensity to spend. Likewise, it is difficult to judge how quickly funds dedicated to infrastructure needs and other longer-term projects will be spent and how large any follow-on effects will be. The Congressional Budget Office (CBO) has constructed a range of estimates of the effects of the stimulus package on real GDP and employment that appropriately reflects these uncertainties. According to the CBO’s estimates, by the end of 2010, the stimulus package could boost the level of real GDP between about 1 percent and a little more than 3 percent and the level of employment by between roughly 1 million and 3-1/2 million jobs.

The increases in spending and reductions in taxes associated with the fiscal package and the financial stabilization program, along with the losses in revenues and increases in income-support payments associated with the weak economy, will widen the federal budget deficit substantially this year. The Administration recently submitted a proposed budget that projects the federal deficit to reach about $1.8 trillion this fiscal year before declining to $1.3 trillion in 2010 and roughly $900 billion in 2011. As a consequence of this elevated level of borrowing, the ratio of federal debt held by the public to nominal GDP is likely to move up from about 40 percent before the onset of the financial crisis to about 70 percent in 2011. These developments would leave the debt-to-GDP ratio at its highest level since the early 1950s, the years following the massive debt buildup during World War II.

Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8-1/2 percent of GDP today to 10 percent by 2020 and 12-1/2 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands.

Addressing the country’s fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation’s economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability–defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth – requires that spending and budget deficits be well controlled.

Clearly, the Congress and the Administration face formidable near-term challenges that must be addressed. But those near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.

Federal Reserve Transparency

Let me close today with an update on the Federal Reserve’s initiatives to enhance the transparency of our credit and liquidity programs. As I noted last month in my testimony before the Joint Economic Committee, I asked Vice Chairman Kohn to lead a review of our disclosure policies, with the goal of increasing the range of information that we make available to the public. That group has made significant progress, and we expect to begin publishing soon a monthly report on the Fed’s balance sheet and lending programs that will summarize and discuss recent developments and provide considerable new information concerning the number of borrowers at our various facilities, the concentration of borrowing, and the collateral pledged. In addition, the reports will provide quarterly updates of key elements of the Federal Reserve’s annual financial statements, including information regarding the System Open Market Account portfolio, our loan programs, and the special purpose vehicles that are consolidated on the balance sheet of the Federal Reserve Bank of New York. We hope that this information will be helpful to the Congress and others with an interest in the Federal Reserve’s actions to address the financial crisis and the economic downturn. We will continue to look for opportunities to broaden the scope of the information and supporting analysis that we provide to the public.

U.S. treasury secretary Geithner urges combined U.S.-China efforts to boost global economy

June 1, 2009

United States Secretary of the Treasury Timothy Geithner

United States Secretary of the Treasury Timothy Geithner

Timothy Geithner, in his first visit to China as U.S. Treasury Secretary, presented a plan for the United States and China to work together to rebuild the global economy and restore growth.

In a speech today at Peking University, Geithner stressed that there is much that both the United States and China need to do to rebalance the world economy. He called for China to make its currency more flexible in exchange for fiscal reforms in the United States. He also said China would need to diversify its economy beyond relying so heavily on exports for growth, and that the United States, in return, would focus on mitigating its ballooning deficit to protect massive Chinese investments in U.S. government debt.

Chinese media focused on Geithner’s implication that China should play a more significant role in global economic policymaking. China Daily says the primary goal of Geithner’s trip, which has included meetings with several leading Chinese economic policymakers, has been to reaffirm China’s faith in U.S. dollar-backed assets and still fears that U.S. budget deficit and loose monetary policy will prompt inflation, undermining Chinese holdings of both the U.S. dollar and U.S. Treasury bonds.

Below is the text of Timothy Geithner’s speech.


The United States and China, Cooperating for Recovery and Growth

 Treasury Secretary Timothy F. Geithner

Speech at Peking University – Beijing, China
June 1st, 2009

 It is a pleasure to be back in China and to join you here today at this great university. 

I first came to China, and to Peking University, in the summer of 1981 as a college student studying Mandarin. I was here with a small group of graduate and undergraduate students from across the United States. I returned the next summer to Beijing Normal University. 

We studied reasonably hard, and had the privilege of working with many talented professors, some of whom are here today. As we explored this city and traveled through Eastern China, we had the chance not just to understand more about your history and your aspirations, but also to begin to see the United States through your eyes. 

Over the decades since, we have seen the beginnings of one of the most extraordinary economic transformations in history. China is thriving.  Economic reform has brought exceptionally rapid and sustained growth in incomes. China’s emergence as a major economic force more fully integrated into the world economy has brought substantial benefits to the United States and to economies around the world.  

In recognition of our mutual interest in a positive, cooperative, and comprehensive relationship, President Hu Jintao and President Obama agreed in April to establish the Strategic and Economic Dialogue. Secretary Clinton and I will host Vice Premier Wang and State Councilor Dai in Washington this summer for our first meeting.  I have the privilege of beginning the economic discussions with a series of meetings in Beijing today and tomorrow. 

These meetings will give us a chance to discuss the risks and challenges on the economic front, to examine some of the longer term challenges we both face in laying the foundation for a more balanced and sustainable recovery, and to explore our common interest in international financial reform.

Current Challenges and Risks

 The world economy is going through the most challenging economic and financial stress in generations. 

 The International Monetary Fund predicts that the world economy will shrink this year for the first time in more than six decades. The collapse of world trade is likely to be the worst since the end of World War II. The lost output, compared to the world economy’s potential growth in a normal year, could be between three and four trillion dollars.

In the face of this challenge, China and the United States are working together to help shape a strong global strategy to contain the crisis and to lay the foundation for recovery. And these efforts, the combined effect of forceful policy actions here in China, in the United States, and in other major economies, have helped slow the pace of deterioration in growth, repair the financial system, and improve confidence. 

In fact, what distinguishes the current crisis is not just its global scale and its acute severity, but the size and speed of the global response.

At the G-20 Leaders meeting in London in April, we agreed on an unprecedented program of coordinated policy actions to support growth, to stabilize and repair the financial system, to restore the flow of credit essential for trade and investment, to mobilize financial resources for emerging market economies through the international financial institutions, and to keep markets open for trade and investment. 

That historic accord on a strategy for recovery was made possible in part by the policy actions already begun in China and the United States. 

China moved quickly as the crisis intensified with a very forceful program of investments and financial measures to strengthen domestic demand.

In the United States, in the first weeks of the new Administration, we put in place a comprehensive program of tax incentives and investments ¨C the largest peace time recovery effort since World War II – to help arrest the sharp fall in private demand. Alongside these fiscal measures, we acted to ease the housing crisis. And we have put in place a series of initiatives to bring more capital into the banking system and to restart the credit markets.  

These actions have been reinforced by similar actions in countries around the world. 

In contrast to the global crisis of the 1930s and to the major economic crises of the postwar period, the leaders of the world acted together. They acted quickly. They  took steps to provide assistance to the most vulnerable economies, even as they faced exceptional financial needs at home. They worked to keep their markets open, rather than retreating into self-defeating measures of discrimination and protection. 

And they have committed to make sure this program of initiatives is sustained until the foundation for recovery is firmly established, a commitment the IMF will monitor closely, and that we will be able to evaluate together when the G-20 Leaders meet again in the United States this fall. 

We are starting to see some initial signs of improvement. The global recession seems to be losing force. In the United States, the pace of decline in economic activity has slowed. Households are saving more, but consumer confidence has improved, and spending is starting to recover. House prices are falling at a slower pace and the inventory of unsold homes has come down significantly. Orders for goods and services are somewhat stronger. The pace of deterioration in the labor market has slowed, and new claims for unemployment insurance have started to come down a bit. 

The financial system is starting to heal. The clarity and disclosure provided by our capital assessment of major U.S. banks has helped improve market confidence in them, making it possible for banks that needed capital to raise it from private investors and to borrow without guarantees. The securities markets, including the asset backed securities markets that essentially stopped functioning late last year, have started to come back. The cost of credit has fallen substantially for businesses and for families as spreads and risk premia have narrowed.    

These are important signs of stability, and assurance that we will succeed in averting financial collapse and global deflation, but they represent only the first steps in laying the foundation for recovery. The process of repair and adjustment is going to take time. 

China, despite your own manifest challenges as a developing country, you are in an enviably strong position. But in most economies, the recession is still powerful and dangerous. Business and households in the United States, as in many countries, are still experiencing the most challenging economic and financial pressures in decades. 

The plant closures, and company restructurings that the recession is causing are painful, and this process is not yet over. The fallout from these events has been brutally indiscriminant, affecting those with little or no responsibility for the events that now buffet them, as well as on some who played key roles in bringing about our troubles.

The extent of the damage to financial systems entails significant risk that the supply of credit will be constrained for some time. The constraints on banks in many major economies will make it hard for them to compensate fully for the damage done to the basic machinery of the securitization markets, including the loss of confidence in credit ratings. After a long period where financial institutions took on too much risk, we still face the possibility that  banks and investors may take too little risk, even as the underlying economic conditions start to improve. 

And, after a long period of falling saving and substantial growth in household borrowing relative to GDP, consumer spending in the United States will be restrained for some time relative to what is typically the case in recoveries. 

 These are necessary adjustments. They will entail a longer, slower process of recovery, with a very different pattern of future growth across countries than we have seen in the past several recoveries. 

Laying the Foundation for Future Growth

 As we address this immediate financial and economic crisis, it is important that we also lay the foundations for more balanced, sustained growth of the global economy once this recovery is firmly established. 

A successful transition to a more balanced and stable global economy will require very substantial changes to economic policy and financial regulation around the world. But some of the most important of those changes will have to come in the United States and China. How successful we are in Washington and Beijing will be critically important to the economic fortunes of the rest of the world. The effectiveness of U.S. policies will depend in part on China’s, and the effectiveness of yours on ours. 

Although the United States and China start from very different positions, many of our domestic challenges are similar. In the United States, we are working to reform our health care system, to improve the quality of education, to rebuild our infrastructure, and to improve energy efficiency. These reforms are essential to boosting the productive capacity of our economy. These challenges are at the center of your reform priorities, too. 

We are both working to reform our financial systems. In the United States, our challenge is to create a more stable and more resilient financial system, with stronger protections for consumer and investors.  As we work to strengthen and redesign regulation to achieve these objectives, our challenge is to preserve the core strengths of our financial system, which are its exceptional capacity to adapt and innovate and to channel capital for investment in new technologies and innovative companies. You have the benefit of being able to learn from our shortcomings, which have proved so damaging in the present crisis, as well as from our strengths.  

Our common challenge is to recognize that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes. 

In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past. 

In China, as your leadership has recognized, growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption. Strengthening domestic demand will also strengthen China’s ability to weather fluctuations in global supply and demand.

If we are successful on these respective paths, public and private saving in the United States will increase as recovery strengthens, and as this happens, our current account deficit will come down. And in China, domestic demand will rise at a faster rate than overall GDP, led by a gradual shift to higher rates of consumption.  

Globally, recovery will have come more from a shift by high saving economies to stronger domestic demand and less from the American consumer. 

The policy framework for a successful transition to this outcome is starting to take shape.

In the United States, we are putting in place the foundations for restoring fiscal sustainability. 

The President in his initial budget to Congress made it clear that, as soon as recovery is firmly established, we are going to have to bring our fiscal deficit down to a level that is sustainable over the medium term. This will mean bringing the imbalance between our fiscal resources and expenditures down to the point – roughly three percent of GDP – where the overall level of public debt to GDP is definitively on a downward path.  The temporary investments and tax incentives we put in place in the Recovery Act to strengthen private demand will have to expire, discretionary spending will have to fall back to a more modest level relative to GDP, and we will have to be very disciplined in limiting future commitments through the reintroduction of budget disciplines, such as pay-as-you go rules.

The President also looks forward to working with Congress to further reduce our long-run fiscal deficit.

And, critical to our long-term fiscal health, we have to put in place comprehensive health care reform that will bring down the growth in health care costs, costs that are the principal driver of our long run fiscal deficit. 

The President has also proposed steps to encourage private saving, including through automatic enrollment in retirement savings accounts. 

Alongside these fiscal actions, we have designed our policies to address the financial crisis to carefully minimize risk to the taxpayer and to allow for an orderly exit or unwinding as soon as conditions permit. Across the various financial facilities put in place by the Treasury, the Federal Reserve, and the FDIC, we have been careful to set the economic terms at a level so that demand for these facilities will fade as conditions normalize and risk premia recede.  Banks have a strong incentive to replace public capital with private capital as soon as conditions permit. 

Let me be clear – the United States is committed to a strong and stable international financial system. The Obama Administration fully recognizes that the United States has a special responsibility to play in this regard, and we fully appreciate that exercising this special responsibility begins at home. As we recover from this unprecedented crisis, we will cut our fiscal deficit, we will eliminate the extraordinary governmental support that we have put in place to overcome the crisis, we will continue to preserve the openness of our economy, and we will resolutely maintain the policy framework necessary for durable and lasting sustained non-inflationary growth.

In China, the challenge is fundamentally different, and at least as complex. 

Critical to the success of your efforts to shift future growth to domestic demand are measures to raise household incomes and to reduce the need that households feel to save large amounts for precautionary reasons or to pay for major expenditures like education.  This involves strengthening the social safety net with health care reform and more complete public retirement systems, enacting financial reforms to help expand access to credit for households, and providing products that allow households to insure against risk.  These efforts can be funded through the increased collection of dividends from state-owned enterprises.

The structure of the Chinese economy will shift as domestic demand grows in importance, with a larger service sector, more emphasis on light industry, and less emphasis on heavy, capital intensive export and import-competing industries.  The resulting growth will generate greater employment, and be less energy-intensive than the current structure of Chinese industry. Allowing the market, interest rates, and other prices to function to encourage the shift in production will be particularly important.

An important part of this strategy is the government’s commitment to continue progress toward a more flexible exchange rate regime.  Greater exchange rate flexibility will help reinforce the shift in the composition of growth, encourage resource shifts to support domestic demand, and provide greater ability for monetary policy to achieve sustained growth with low inflation in the future. 

International Financial Reform

 These are some of the most important domestic economic challenge we face, and these issues will be at the core of our agenda for economic cooperation. 

But I think it is important to underscore that we also have a very strong interest in working together to strengthen the framework for international economic and financial cooperation.  

Let me highlight three important areas.

At the G-20 Leaders meeting, we committed to a series of actions to help reform and strengthen the international financial architecture.

As part of this, we agreed to put in place a stronger framework of standards for supervision and regulation of the financial system.  We expanded and strengthened the Financial Stability Forum, now renamed the Financial Stability Board.  China and other major emerging economies are now full participants, alongside the major financial centers, in this critical institution for cooperation.  We will have the chance together to help redesign global standards for capital requirements, stronger oversight of global markets like derivatives, better tools for resolving future financial crises, and measures to reduce the opportunities for regulatory arbitrage. 

We also committed to an ambitious program of reform of the IMF and other international financial institutions.  Our common objective is to reform the governance of these institutions to make them more representative of the shifting balance of economic and financial activity in the world, to strengthen their capacity to prevent future crisis, with stronger surveillance of macroeconomic, exchange rate, and financial policies, and to equip them with a stronger financial capacity to respond to future crises. We also committed to mobilize $500 billion in additional finance through the enlargement and membership expansion of the IMF’s New Arrangements to Borrow in order to provide an insurance policy for the global financial system.

As part of this process of reform, the United States will fully support having China play a role in the principal cooperative arrangements that help shape the international system, a role that is commensurate with China’s importance in the global economy.

I believe that a greater role for China is necessary for China, for the effectiveness of the international financial institutions themselves, and for the world economy. 

China is already too important to the global economy not to have a full seat at the international table, helping to define the policies that are critical to the effective functioning of the international financial system.

Second, we must cooperate to assure that the global trade and investment environment remains open, and that opportunities continue to expand.  As economies have become more open and more closely integrated, global economic growth has been stronger and more broad-based, bringing increasing numbers out of poverty, and turning developing nations into major emerging markets.    The global commitment to trade liberalization and increasingly open investment played a critical role in this process ¨C in the industrialized world, in East Asia, and, since 1978, in China.  As we go through the severe stresses of this crisis, we must not turn our backs on open trade and investment – for ourselves and for those who have yet to experience the fruits of growth and development. The United States, China, and the other members of the G20 have committed to not resort to protectionist measures by raising trade and investment barriers and to work toward a successful conclusion to the Doha Development Round. 

And third, one of the most critical long-term challenges that we both face is climate change.  Individually and collectively, there is an urgent need to ensure that each and every country takes meaningful action to deal with this threat.  Reducing land and forest degradation, conserving energy, and using clean technology are important objectives that complement both our efforts to achieve a new, sustainable pattern of growth and our goal of reducing greenhouse gas emissions. China and the United States already are working closely through the Strategic and Economic Dialogue in areas such as clean transportation, clean and efficient production of electricity, and the reduction of air and water pollution.  We must continue these efforts for the sake of our natio ns and the planet.


In the last few years the frequency, intensity, and importance of U.S.-China economic engagements have multiplied.  The U.S.-China Strategic and Economic Dialogue that President Obama and President Hu initiated in April is the next stage in that process.  I look forward to welcoming Vice Premier Wang, State Councilor Dai and their colleagues to Washington to participate in the first meeting of the U.S.-China Strategic and Economic Dialogue.

 Our engagement should be conducted with mutual respect for the traditions, values, and interests of China and the United States. We will make a joint effort in a concerted way “同心协力”.  We should understand that we each have a very strong stake in the health and the success of each other’s economy. 

China and the United States individually, and together, are so important in the global economy and financial system that what we do has a direct impact on the stability and strength of the international economic system.  Other nations have a legitimate interest in our policies and the ways in which we work together, and we each have an obligation to ensure that our policies and actions promote the health and stability of the global economy and financial system.

We come together because we have shared interests and responsibilities.  We also have our own national interests.   I will be a strong advocate for U.S. interests, just as I expect my counterparts to represent China.  China has benefited hugely from open trade and investment, and the ability to greatly increase its exports to the rest of the world.  In turn, we expect increased opportunities to export to and invest in the Chinese economy.   

We want China to succeed and prosper.  Chinese growth and expanding Chinese demand is a tremendous opportunity for U.S. firms and workers, just as it is in China and the rest of the world. 

Global problems will not be solved without U.S.-China cooperation.  That goes for the entire range of issues that face our world from economic recovery and financial repair to climate change and energy policy.

I look forward to working with you cooperatively, and in a spirit of mutual respect.

Theory of Integrated Macroeconomics

May 11, 2009

Prof. Solomon Budnik has developed his project of the Internet Stock Exchange for global securities settlements. This project is based on Prof. Budnik’ project and bylaws of the Alternative Int. SE solicited by the Israeli Finance Ministry.

By Professor Solomon Budnik

Professor of Comparative Law, currently chairman of the Aerospace company UTG-PRI LTD. – Tel Aviv, Israel.

Subtitle: Crisis of Unified Economic Systems and Uniform Currency. Macroeconomic Geometry.


IN RE: New advances in open economy modeling

With regard to economic modeling, it should be noted that we deal now with the expanding economic universe with ever changing space-time continuum due to ever expanding world population and consumer market. No artificial economic model could adjust to such  circumstances or fit various rigid and incompatible economic systems, particularly not the Nobel Prize in Economics gained behavioral, equilibrium, and game models.

In re:   human behavior and free market  are unpredictable, being unstable, and exercise a cumulative effect upon given economy due to mass public and monetary upheavals. For example, the economy of ill-conceived socio-communist and socialist states was and is based on social rules instead of the rule of capital, and couldn’t therefore be properly planned and predicted, as proven by history.

Astoundingly, the  economic system in USA, etc. is not capitalistic but Capitolistic, judging by politically induced state interference into free market affairs, with catastrophic results remedied by same state with trillions of dollars of misappropriated taxpayers’ money, forcing thereby future generations to slave themselves to repay that national multitrillion dollar debt to totalitarian and human rights violating China and totalitarian, racist and terrorist Arab states controlling the US State Dept. with oil dollars.

The equilibrium model is also wrong, since it contradicts the common sense, physics and geometry, for a physical or economic system doesn’t function or operate in a vacuum of economic space, and  an equilibrium can only be reached  by two corresponding systems positioned in the same economic plane, which is impossible. It means that no monetary system can reach a state of equilibrium in ever changing environment and monetary parameters. In fact, a model or a system in equilibrium is a dead, non-functional body, as is Zimbabwean Central Bank which has abolished its worthless national currency.

The  economic game model is wrong as well, since a game needs at least two players, with the end result of a  winner and a looser, or means a single player that plays with a third-party invented program (Russian and Israeli central banks that used the American FED’s model with devastating results), and usually a game theory is applied post-factum to a past event, as the Israeli economic game theorist applied his game paper to a so-called Oslo Accord and its step-by-step Israeli concessions  never matched by the opposing PA,  the Arab terror outcome of which the Israeli people and economy suffer under since 1993.

In all such circumstances, the society and the free market rebel and correct themselves via revolutions and financial downfalls, with trillions of dollars lost. Accordingly, as the Church had separated itself from the state and became a quasi financial institution above the state, the free market economy should function as a non plus ultra financial institution ruled and protected by integrated macroeconomics with a self-correcting mechanism of a three-tier stock exchange system developed by me.

Accordingly, I suggest that in order to prevent future economic depressions and collapses, the common  macroeconomics should be replaced by integrated macroeconomics (as formulated by me) separated from the monetary and fiscal economics induced and controlled by the state via central bank and the treasury which are self-conflicting bodies without taxpayers’ control.

The reason for such a change is that the capital market should be free from the state control in both


Preamble: this paper has been composed due to the fact that all previous economic theories and models have failed in the modern turbulent economic circumstances of the intertwined, dependable and unstable global markets and economic powerhouses, with unpredictable fluctuations of domestic and foreign capital.

In re: let’s reminiscent briefly on the history of the past empires, state unions and confederations that had led to the rise and fall of the British Empire (despite the gold standard of the Pound Sterling which was the primary reserve currency for much of the world in the 18th and 19th centuries, but perpetual account and fiscal deficits, financed by cheap credit and unsustainable monetary and fiscal policies used to finance wars and colonial ambitions eventually led to the pound sinking (read current U.S. economic situation), Spanish and Dutch empires, whose economics were based on colonial assets, and the fall of the Austrian-Hungarian entity. The USA had united independent states which then exist on cash injections of the Treasury and the Federal Reserve via dollar printing and the issue of now unsellable state bonds, e.g., the state of California, which has now a budget deficit of $42B, while the overall national debt per American household is now $35.000, to rise to $75.000 due to President Obama’s financial policy. Economic crisis in America happened a number of times, albeit dollar was the world reserve currency guaranteed by gold.

In post World-War II, the US dollar took over the sterling’s dominant position and became the world’s newest reserve currency. The Bretton Woods Accord, the first major economic transformation toward the end of World War II, established the International Monetary Fund (IMF) and a way to value the various currencies of the world relative to each other. All foreign currencies would trade in relationship to the US Dollar and only the US dollar (as the reserve currency) would be tied to a gold standard (meaning the value of dollars circulating must be backed by gold reserves). The Roosevelt dollar was a schizoid, two-tier dollar, whose purchasing power at home did not match its gold parity abroad. At home, it was a fiat monetary unit, not convertible to gold; abroad, it was convertible to gold at $35 per ounce.

Americans of that era learned rather quickly that the maintenance of wealth in tangible form was preferable to paper wealth, so as bank runs became more pronounced, they rushed into and hoarded gold, since a growing distrust of banks meant an equal distrust of paper money.

Executive Order 6102 of April, 1933 and the United States Gold Reserve Act of January, 1934 changed all that. The 1934 Act raised the official price of gold to 35$ per ounce from the 20.67$ paid to Americans who, under the threat of a 10,000$ fine and/or 10 years imprisonment, had been forced to turn in their gold a few months earlier.

The gold standard caused major problems in the 1960’s when France (under the London Gold Pool) called America’s bluff and demanded gold for payment of debt, rather than US dollars (they understood that USA were printing more money, to finance the Vietnam conflict and fund new social programs, than we had available in gold reserves).

Due to the rapid loss of US gold reserves, President Nixon had no choice but to abolish the Bretton Woods accord in August of 1971 and he took the US dollar off the gold standard (it was $35 per ounce then).

Ruble of the Imperial Russia had also been guaranteed by gold, but that colonial and agrarian country, notwithstanding its industrial output of the 1913, existed due to wars and foreign loans. The crash of that economically poor, on bayonets unified empire was inevitable, as well as the crash of the following Soviet empire due to its domestic and international aggression and annexation, failed Communist “planed” economy, fifteen fictitious republics on Moscow’s payroll,  one-side introduced fake ruble-dollar parity, purchases of grain abroad for dollars, arms race and non-repaid foreign loans, paid-off by Russia only recently.

And nothing have come up of  the idea of the  Belarus-Russia economic union and  unified currency, and  Belarus now lobbies the EU.

With regard to Euro, it had lost  30% of its value at the issue, and that issue and the annulment of the former European currencies has cost tens billions of dollars. The economy of the leading EU states had thereby been undermined due to the incompatibility of the different economic systems and internal state protectionism of the EU members. The economy of minor states had been damaged due to sharp discrepancies  between the low wages and 2-3 times higher prices due to joining the EU where wages are 10-20 times higher. Example: Bulgaria, Czech Republic, and Baltic States which are virtually bankrupt.

Euro keeps its mark due to free circulation of the paper money in a monetary spread now affecting the UK and Switzerland, but  Euro can fall to a critical point due to reduced  consumption and production,  credit crunch and the strengthening dollar.

EU Central Bank and the Bank of Israel (BOI) had followed suit by emulating FED’s actions applicable in USA only, i.e., by zeroing all interest earning saving deposits and to buying-in own state bonds. In  Israel, the American-led BOI had unreasonably devalued the strong shekel by 30% in favor of  weak dollar and Euro due to threats of total strike and extortion  by the leftist subversive Israeli Labor Union (so-called New Histadrut), albeit the Israeli import is 3-4 times larger then export, and BOI had bought-in the Israeli state bonds, albeit there was no huge foreign debt as in USA, had depleted the Treasury of its large  tax income of 15% on now non-existing shekel saving deposits of the bank customers, had reduced the interest rate to 0.5% thus depriving the bank clients and the banks of their earnings, and made thereby poorer  the consumers. Said erroneous and highly damaging actions had deflated the Israeli economy with no official inflation, caused mass unemployment, closed companies and factories, and caused the 20%-50% rise in travel expenses, food, gas and RE prices due to actual inflation concealed by the BOI, since  its actions are in contradiction to all written and unwritten free market rules, with negative results for Israeli economy, for the reduced money supply wasn’t compensated by a $750B stimulus  package and capital infusion in banks and companies, as in USA.

In Russia, on the contrary, its Central Bank had opted for inflation vs. deflation, and had allowed large interest rates at falling consumer and RE prices, with now value appreciating ruble, thus saving the consumer market, its money circulation and earnings on saving deposits.

Paradox but fact: dollar had appreciated against foreign currencies despite the collapse  of the U.S. economy, since all countries buy up dollars for currency reserves and support of their U.S. market dependent economies.

Hence, it is obvious in my opinion that the U.S. and EU economies and monetary expansions were based quasi on the Einstein’s formula Е = мс2, i.e. energy of the economy is equal to the money mass  multiplied by the speed of its circulation in the quadrature of the given monetary territory. But in case of  the  reduced  circulation of money, as occurs now everywhere, the economy of a state shrinks and is subject to a gravitational collapse due to a  financial black hole.

I would elaborate and picture the economic model in geometric terms of universal macroeconomics, i.e. a circle within a square. Central Bank and the SE of any state are the gravitational monetary bodies in the center of the circle of thereby attracted  economy, and distribute financial energy – the money mass and securitized wealth within the boundaries of given economic universe, whose revolving circle represents the circulation of capital. The “square” of the GDP, cornering the circle of the economy forms four corners – fields of the given financial space, representing respectively the banks, the RE market, consumption and production.

This represents my Unified Field Theory in Economics, as per Einstein’s theory in Physics, applicable to macroeconomics where accordingly monetary forces between the objects of  economy are not transmitted directly between them, but instead go through intermediary financial fields whose  interactions should be unified  (from strongest to weakest) to prevent the crisis of economy.

To substantiate: when too much monies are pumped into that system as in USA prior to the crisis, the ill fetched economy expands and depresses said fields – cornered banks, RE market, consumers and companies,  constituting the depression with corporate bankruptcies where macroeconomics enter into the conflict with the microeconomics (strongest vs. weakest). To rebound, the economy must contract to relieve the tension from said affected segments of the economy and that had happened recently in USA, proving my assumption.

 Here I also introduce the terms of the “spot” money, “intangible” money with delayed transaction and repayment, and “remote” money, the discrepancies in which had led to enormous consumers’ debt and credit crunch in USA. The matter is that the US economy and financial market were erroneously oriented toward assumed  wealth of the consumers, i.e.,  their unsecured credit cards and loans (intangible money with delayed transaction and repayment), but the actual wealth of the consumer is the real money in his pocket (spot money) and remote money in his bank saving account, so if the US credit report companies and lenders would have had checked and calculated the actual cash status of the consumers/debtors using my money terms above prior to issuing  a mortgage or a loan, the monetary and economic crisis in USA could have been avoided.

It means that apart from the usual state and corporate credit rating, the new gross consumer credit rating (GCCR) should be introduced and used to constitute the essential part of the advanced modern macroeconomics, and that is particularly applicable to REITs, Fannie and Freddie in USA. Here, my term of the General Growth Personal Income (GGPI) should be introduced (as previously applied to RE properties), and calculated by the FED or any Central Bank via IRS and Tax Authorities to keep the economy in check and prevent any crisis.

Nota bene: the problem of common macroeconomics is that it is not based on the Rule of Golden Section and the Fibonacci sequence, albeit all universal systems from the human body, plants and up to the universe are based and develop on this very same principle. To elaborate, I would define the monetary correlation between various states and economic systems in the  following approximate ratio, applying Fibonacci figures: USA to the EU as 1:2, USA – UK as 2:3, to China, Japan, India, Mexico respectively as 3:5, 5:8, 8:13, 13: 21, and so on, showing the dilution of capital, having in mind the relevant buying potential of the consumers  which is low in China and India,  in relation to  the billions of people in said states.

The expanding global economy also reflects the geometry of the Fibonacci spiral that approximates the golden spiral of the universal macroeconomics and globalization based on irrational constant of economic dynamics.

This is all because the GDP based common economy is assumed to be closed, no imports or exports occur.

So my opinion  is that any economy should be based  on  the financial pillars consolidated under one roof, i.e., the real estate market, the stock exchange and the gold trade should constitute a uniform, self-containing system, as the project developed by me, namely the Alternative Int. Stock Exchange, to include the Real Estate SE  and the Gold SE, constituting my Integrated Macroeconomic Theory.

I suggest therefore that apart from the GDP, modern economy should be linked to the Gross Foreign Product  (GFP), as termed by me, including foreign revenues of domestic companies and the offshore assets. This implies the repatriation and reinvestment of the foreign gained income and fled capital as the amortization of the domestic corporate and private assets that constitute thereby  the Cumulative Gain Product (СGP), a term  formulated by me. Said new measure  can mitigate the domestic economic crisis and attract foreign capital due to adjusted financial parameters and upgraded credit rating of the given state.

In re: Concerning the collapse of major U.S. and EU investment banks, with heavy losses at the NYSE,  Russian, EU and Asian stock exchanges and monetary systems and to mitigate the economic and financial situation, I have devised the  project  of the innovative Alternative  Int. Stock Exchange  (AISE), to be established in Jerusalem, to include the Real Estate Stock Exchange and the Gold Exchange to secure investors’ assets and gains. Said project is based on my previous project and bylaws of the Tel Aviv Alternative Stock Exchange solicited by the Israeli Finance Ministry.

Said uniquely integrated three-tier financial system would attract large capital due to innovative self-compensating triple index which is not entirely GDP oriented, as the world economies are based  erroneously upon, leading to collapses, so the Israeli economic and financial system would thereby be based on our introduced GFP as well, thus securing the stability of capital and market and bringing the economy out of recession.

Reprinted with kindly permission of Solomon Budnik. (C) 2009 by Solomon Budnik. All Rights Reserved.

A Question for the Economists

April 7, 2009

In an op-ed in The Weekly Standard, Harvey C. Mansfield, Professor of political science at Harvard University, wrote on the failure of economists to predict crises.

“One group of those involved in the present financial crisis has so far escaped notice – the economists. They are masters in the science of prediction, but as a group, if not to a man, they failed to predict a crisis that has wiped out nearly half the wealth invested in the stock market and elsewhere (measured of course from the peak). The economists did no better than their unscientific rivals, the stock pickers, who are in the business of prediction.

Perhaps we need a second look not merely at the existing models by which economists predict but at the very idea of prediction as the goal of social science. Economists had been in the habit of asserting that they had come a long way since the Depression, that such an event could not happen again. Yet people are now actually speaking of another Depression as possible. Maybe we know how to avoid the Depression we had, but what about a new one with a new character we do not recognize? Isn’t our present crisis new? Isn’t every crisis new – since surprise is the essence of crisis? If prediction were reliable, we would be prepared for every chance, and our lives would be crisis-free and much duller.”

Read full story.

Will the U.S. Federal Reserve Become a Systemic Risk Regulator?

March 20, 2009

Treasury Secretary Timothy Geithner has said that the Obama administration will move forward with an overhaul of financial regulation, less than a year after an abortive blueprint for financial regulation from the previous administration.

A massive financial crisis and hundreds of billions of dollars in bailouts for financial firms were interposed between these two attempts, fundamentally altering the terms of discussion.

Some observers claim that companies like AIG and Citigroup became too big to fail – that is, “systemically significant” – and thus require special regulation. The Obama administration’s plan will include a keystone role for the U.S. Federal Reserve in monitoring and addressing broad or systemic economic risks.

In a op-ed in The Wall Street Journal, former chairman of the Federal Reserve Alan Greenspan argues that state capitalism is not the right prescription to the current financial crisis: “However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system’s precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud – not increased micromanagement by government entities.”

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G-20-Finance Ministers Meeting

March 16, 2009

News reports indicate a meeting of finance ministers from the G-20 countries, laying the groundwork for a major April 2nd, 2009 heads-of-state summit addressing the financial crisis, produced agreement in several areas.

Australia’s representative at the meetings said: “Everybody agreed: It’s fiscal stimulus plus. We’ve got to do something about the flow of credit in the financial system; we’ve got to reform our international financial institutions.”

Reportedly the delegates reached general agreement on the need both to boost International Monetary Fund (IMF) resources in the short-term and to reshape the fund in the longer term, including a timetable to increase the voting rights of emerging economies.

Reuters reports the group also agreed to boost funding to the Asian Development Bank (ADB) by $100 billion, bringing the bank’s war chest to $150 billion total.

Stock Markets Show Signs of Stability

March 14, 2009

The Wall Street Journal leads its Economy rubric with some rare economic good news: this week was the stock market’s best since November 2008, prompting speculation that the economy could finally be close to bottoming out.

“There is a real economy out there, and it has a chance of doing better,” said one eased trader.

Read full story.

There is no better alternative than capitalism

March 12, 2009

Dr. Allan H. Meltzer, economist and professor of Political Economy at Carnegie Mellon University’s Tepper School of Business in Pittsburgh, delivered the eighth lecture in the 2008-2009 Bradley Lecture series on March 9, 2009, at the American Enterprise Institute in Washington D.C.


Why Capitalism?
by Dr. Allan H. Meltzer

Newspaper headlines during the peak of the housing-credit crisis called it “the end of capitalism” or the end of American capitalism. As often, they greatly overstated and misstated by projecting a serious, temporary decline as a permanent loss of wealth. Capitalist systems have weathered many more serious problems.

Capitalism as a guiding system for economic activity has spread over the centuries to now encompass most of the world’s economies. This spread occurred despite almost continuous hostility from many intellectuals and, in recent decades, military threat from avowedly Communist countries.

Capitalist systems are neither rigid nor identical. They differ, change, and adapt. Their common feature is that the means of production are mainly owned by individuals; economic activity takes place in markets, and individuals are free to choose to greater or lesser degree what they do, where they work, and how they allocate their income and wealth. Capitalism is an institutional arrangement for producing goods and services. The success of this arrangement requires a legal foundation based on the rule of law that protects rights to property and in the first instance aligns rewards to values produced. It provides incentives to participants to act in ways that produce desired outcomes. Like any system, it has successes and failures. It is the only system that increases both growth and freedom.

Critics of capitalism emphasize the unequal distribution of income generated by the market system; frequent periods of unemployment and instability; and rewards for selfishness instead of beneficial, cooperative activity. Some favor heavy regulation to achieve social goals. Others favor putting control of resource allocation and ownership of resources under public, or government, control. They talk about equity and fairness, but it is mainly wealth redistribution that they seek. And none has found a path to sustained growth and personal freedom.

Many defenders of capitalism present the system as a moral system. It is morally right for people to use their resources as they choose. The problem with the moral defense of capitalism is that it must neglect or dismiss the venal, often illegal, activity that occurs from time to time as well as expedient, self-serving decisions. All people are not honest all of the time. Greed leads people astray. Further, generally accepted moral principles have not brought agreement about specific decisions. People who share common moral principles often disagree about their application. The death penalty and abortion are among many ever-present examples.

The rule of law is the principal partial substitute for a moral code. To function efficiently or even to function at all, a capitalist system requires rules. The law must protect individuals and property, enforce contracts, sustain belief in systemic stability over time, and respond to political and social pressures.

The great German philosopher Immanuel Kant recognized why we cannot rely on a moral defense of capitalism. Kant (1784) wrote that “out of timber so crooked as that from which man is made, nothing entirely straight can be carved.” Everyone is not honest. Periodic scandals reinforce this point.

Private and public officials often break the law. Kant’s dictum applies as much to public as to private officials. We cannot escape criminality by choosing Socialism. More likely, we increase it. Siemens was convicted of bribing officials in several countries. Enron, Worldcom, and Madoff are recent examples of unethical and illegal corporate behavior. Watergate and Russian takeover of oil companies are examples of public malfeasance. There are too many examples to enumerate.

Capitalism survives and spreads because it recognizes Kant’s principle. People differ. Some give bibles, but some sell pornography. Unlike its alternatives, capitalism does not take a utopian view of economic organization. It does not replace man’s choices with someone’s idea of perfection. It permits choices that bring change and that allow for rejection of changes after experiencing outcomes. It recognizes that all changes are not improvements and are not welcomed by everyone. Differences are accommodated often easily.

Socialism and other utopian systems are more rigid. They represent someone’s belief in the aims that “good people” should embrace. Movies are too violent. They must change. Television is too banal. It must improve. But the change is always from individual choice to an imposed choice. Freedom allows people choices that violate someone’s idea of social norms or right conduct; Socialism restricts choice to those that officials permit. Capitalism accepts that some dislike the outcomes resulting from choice in a market economy. It does not seek utopia because it recognizes that individual tastes and desires differ, as Kant recognized. A good society permits markets to accommodate differences.

Freedom to choose brings more satisfaction to people in many areas, including nonmarket choices. Nothing assures that these choices meet everyone’s idea of good, wholesome, or moral. They do not. Choice in a capitalist system satisfies many; it meets the profits test. The market responds to demand.

Europeans have state-supported churches. Organized religion is weak. Most of the public rejects the religious monopoly by not participating. The United States has many different churches. James Madison believed that competing churches would be stronger than a state church. Each would appeal to its members and attract others. Time proved Madison right. Competition brings choice in religion as in commercial markets. Churches offer services to attract and keep members.

Capitalism does not solve all problems efficiently. Long ago, John Locke recognized that some services call for collective action. His example was police power, and he showed that society was better served if everyone paid taxes to support a public service–the police or night watchman. Thus he created a reason for collective action in place of individual choice for certain types of activity called public goods. This ruled out a complete system of market allocation without intervention.

Once we accept that collective action is the preferred means of allocating part of our resources, we introduce a government with the power to tax. The system becomes a mixed capitalist system.

It is revealing, but odd, that recent criticisms of financial market outcomes blamed unregulated markets and deregulation as a cause of the financial crisis. All financial markets have been regulated for decades. Very little deregulation occurred after 1999, when investment banks and commercial banks were permitted to merge. Separation was mandated in the United States in 1933. No other country followed, and no one explained why ending separation contributed to a crisis. Further, critics overlooked that regulation–the so-called Basel Agreement–required banks to hold more reserves if they increased risk. The banks responded to the regulation by putting risky assets in off-balance sheet entities, thereby avoiding regulation. In practice, the Basel regulation increased financial risk.

A mixed system requires a rule for distributing responsibility and authority between the public and private sectors. Most capitalist countries answer by choosing to have a democratic capitalist system. Voters choose the tax rate and the size of government. Voters choose the activities left to the market system, but they often decide to let governments set rules to regulate market behavior. The capitalist system that we have is democratic capitalism.

Democratic Capitalism

Voters need not, and do not, limit collective action to providing public goods such as defense or protection. In practice, democratic capitalism does not make a clear separation between private and public responsibility and authority. Voters can increase or reduce government’s role. Voters can vote to redistribute income and elect governments that increase regulation of private-sector activities. Elections often require a choice between one party that favors economic growth achieved by lower tax rates and less government regulation and another that emphasizes programs for redistributing income and expanding government’s role and size. Many of these programs create or extend publicly supplied private goods. Some examples are education, health care, or nursery schools. These programs often provide services that the market can supply by offering prices below what the market charges. The cost is shifted to other taxpayers, current and future. The desire to expand access to these services does not require supply by public agencies.

Democratic capitalism allows voters to favor higher growth at some times and more redistribution at others. This responds to the critics of capitalism who emphasize “fairness,” a word that is hard to define precisely. Its meaning varies. Most often it is used to avoid mention of redistribution. Proponents of fairness usually favor increased public supply of private goods paid for by taxes or debt issues and increased spending for welfare.

Democratic capitalism introduces a means of treating the Kantian problem. Excesses by owners or managers of capital assets may be followed by regulations that seek to restrict actions judged to be socially undesirable. Or voters can tax actions or outcomes that they dislike. Recent attacks on smokers and smoking shows how changes in public attitudes affect legislation. Despite past and current failure to outlaw alcohol and narcotics, the public chose to restrict cigarettes.

Regulation to achieve social objectives faces two large problems. The first law of regulation says that lawyers and bureaucrats develop regulations but markets learn to circumvent costly regulations. Outcomes often differ from plans. AEI senior fellow Robert Hahn taught me recently that this is known as the “Peltzman Effect.”

Circumvention occurs in many regulated markets. The Basel Agreement increased risk, as noted above. The object of campaign finance reform was to remove the allegedly noxious influence of money in politics and limit presidential candidates to an amount of spending decided by regulators. As the recent presidential election demonstrated, it failed. The election was more costly, and only one of the major party candidates accepted taxpayer money and a limit on spending. The legislation limited spending by candidates and parties but not by interest groups. One result was to further weaken political parties and increase the influence of single-issue groups. Parties work to harmonize divergent interests. Specialized groups often work to magnify differences, making policy compromise more difficult. This was not the outcome that proponents of McCain-Feingold or similar legislation promised.

Regulation is socially useful if it aligns private and social costs. This is the message of the “night watchman”; collective action can reduce or remove external diseconomies by equating private and social costs. Regulations that do that increase efficiency. But not all regulations are of that kind. If there were a second law of regulation, I believe it would state that the aim of regulation in a market economy should be to equate private and social costs. Failure to do so is an invitation to find ways of circumventing regulation. It is sufficient but not necessary. Many inefficient regulations survive for indefinitely long periods. Often they reward a group powerful enough to sustain them. Think of agricultural subsidies for high-income farmers as one of a multitude of programs that persist and grow. Peltzman (2004) offers another reason. A large literature discusses and documents “capture” of regulatory agencies by the regulated. Under democratic capitalism, costly distortions of this kind seem unavoidable. Regulation may persist by imposing strong penalties against circumvention. More research on the political economy of regulation and persistence is needed.

Democratic capitalism causes countries to alternate between more and less intrusive government. Voters’ central tendency changes as more voters prefer more redistribution or less, higher or slower growth. Often these changes reflect past results. Periods of low growth encourage voters to favor policies that reduce tax rates and regulation. Periods of sustained growth, however, often spread the distribution of income. Voters may elect larger transfers and increased current or future tax rates, as in Meltzer and Richard (1981).

Raising tax rates or regulation shifts control of resource allocation from private to public managers. This does not avoid the Kantian problem. The same general problems arise, though the form differs. Neither the public nor the private sector holds only virtuous people. The many examples of corruption, bribery, and misfeasance cited above are a small sample. Offenses like bribery involve both public and private agents. Bribery is common in many countries.

Public-sector regulators are inclined to be more cautious and more anxious to avoid failure than entrepreneurial capitalists. Decades ago Professor Sam Peltzman showed that the Food and Drug Administration placed excess weight on avoiding drugs and medications that might have harmful effects and gave less than optimal weight to avoiding the loss from restricting drugs that would benefit patients. That bias continues. The political outcome differs from the outcome that people would choose in the marketplace. And like all regulation, rulemaking and rule enforcement is open to pressure from interested groups.

Regulation is the source of several problems. “Capture” by regulated entities occurs frequently. The Federal Reserve often acts as guardian of the New York banks’ interests. The Federal Aviation Administration discourages and even punishes employees who call for strict enforcement of safety rules. There are many other examples.

Well-run companies plan for the long term. Governments typically follow the political cycle, a much shorter term. Private-sector companies make investments that increase employment, productivity and output. Public spending responds to public pressures for redistribution. AIDS receives substantial funding in response to active advocates. Other diseases that lack advocates receive less. Although much spending is defended or promoted as a way to help the poorest citizens, large spending programs transfer especially to the middle class. That’s where most voters are.

Democratic government introduces a separate way to allocate resources. Generally, those who succeed in the marketplace favor market allocation. Those who do not succeed favor allocation at the polling place. They are joined by those who dislike capitalism or prefer more emphasis on “social justice” and less on market efficiency. Actual social outcomes are a compromise between the two aims.

Alternatives to Capitalism

Critics of capitalism emphasize their dislike of greed and self-interest. They talk a great deal about social justice and fairness, but they do not propose an acceptable alternative to achieve their ends. The alternatives that have been tried are types of Socialism or Communism or other types of authoritarian rule.

Anti-capitalist proposals suffer from two crippling drawbacks. First, they ignore the Kantian principle about human imperfection. Second, they ignore individual differences. In place of individual choice under capitalism, they substitute rigid direction done to achieve some proclaimed end such as equality, fairness, or justice. These ends are not precise and, most important, individuals differ about what is fair and just. In practice, the rulers’ choices are enforced, often using fear, terror, prison, or other punishment. The history of the twentieth century illustrates how enforcement of promised ends became the justification for deplorable means. And the ends were not realized.

Transferring resource allocation decisions to government bureaus does not eliminate crime, greed, self-dealing, conflict of interest, and corruption. Experience tells us these problems remain. The form may change, but as Kant recognized, the problems continue. Ludwig von Mises recognized in the 1920s that fixing prices and planning resource use omitted an essential part of the allocation problem. Capitalism allocates by letting relative prices adjust to equal the tradeoffs expressed by buyers’ demands. Fixing prices eliminates the possibility of efficient allocation and replaces consumer choice with official decisions. Some gain, but others lose; the losers want to make choices other than those that are dictated to them.

Not all Socialist societies have been brutal. In the nineteenth century, followers of Robert Owen, the Amana people, and many others chose a Socialist system. Israeli pioneers chose a collectivist system, the kibbutz. None of these arrangements produced sustainable growth. None survived. All faced the problem of imposing allocative decisions that satisfied the decision-making group, sometimes a majority, often not. Capitalism recognizes that where individual wants differ, the market responds to the mass; minorities are free to develop their favored outcome. Walk down the aisles of a modern supermarket. There are products that satisfy many different tastes or beliefs.

Theodor Adorno was a leading critic of postwar capitalism as it developed in his native Germany, in Europe, and in the United States. He found the popular culture vulgar, and he distrusted the workers’ choices. He wanted a Socialism that he hoped would uphold the values he shared with other intellectuals. Capitalism, he said, valued work too highly and true leisure too little. He disliked jazz, so he was not opposed to Hitler’s ban in the 1930s. But Adorno offered no way of achieving the culture he desired other than to impose his tastes on others and ban all choices he disliked. This appealed to people who shared his view. Many preferred American pop culture whenever they had the right to choose.

Capitalism permits choices and the freedom to make them. Some radio stations play jazz, some offer opera and symphonies, and many play pop music. Under capitalism, advertisers choose what they sponsor, and they sponsor programs that people choose to hear or watch. Under Socialism, the public watches and hears what someone chooses for them. The public had little choice. In Western Europe change did not come until boats outside territorial limits offered choice.

The Templeton Foundation recently ran an advertisement reporting the answers several prominent intellectuals gave to the question: “Does the free market corrode moral character?” Several respondents recognized that free markets operate within a political system, a legal framework, and the rule of law. The slave trade and slavery became illegal in the nineteenth century. Before this a majority enslaved a minority. This is a major blot on the morality of democratic choice that public opinion and the law eventually removed. In the United States those who benefitted did not abandon slave owning until forced by a war.

Most respondents to the Templeton question took a mixed stand. The philosopher John Gray recognized that greed and envy are driving forces under capitalism, but they often produce growth and raise living standards so that many benefit. But greed leads to outcomes like Enron and WorldCom that critics take as a characteristic of the system rather than as a characteristic of some individuals that remains under Socialism. Michael Walzer recognized that political activity also corrodes moral character, but he claimed it was regulated more effectively. One of the respondents discussed whether capitalism was more or less likely to foster or sustain moral abuses than other social arrangements. Bernard-Henri Levy maintained that alternatives to the market such as fascism and Communism were far worse.

None of the respondents mentioned Kant’s view that mankind includes a range of individuals who differ in their moral character. Institutional and social arrangements like democracy and capitalism influence the moral choices individuals make or reject. No democratic capitalist country produced any crimes comparable to the murders committed by Hitler’s Germany, Mao’s China, or Lenin and Stalin’s Soviet Union.

As Lord Acton warned, concentrated power corrupts officials. Some use concentrated power to impose their will. Some allow their comrades to act as tyrants. Others proclaim that ends such as equality justify force to control opposition. Communism proclaimed a vision of equality that it never approached. It was unattainable because individuals differ about what is good. And what is good to them and for them is not the same as what is socially desirable to critics of capitalism.

Kant’s principle warns that utopian visions are unattainable. Capitalism does not offer a vision of perfection and harmony. Democratic capitalism combines freedom, opportunity, growth, and progress with restrictions on less desirable behavior. It creates societies that treat men and women as they are, not as in some utopian vision. In The Open Society and Its Enemies, Karl Popper showed why utopian visions become totalitarian. All deviations from the utopian ideal must be prevented.

The Enrons, WorldComs, and others of that kind show that dishonest individuals rise along with honest individuals. Those who use these examples to criticize capitalism do not use the same standard to criticize all governments as failed arrangements when a Watergate or bribery is uncovered. Nor do they criticize government when politicians promise but do not produce or achieve. We live after twenty-five to forty years of talk about energy, education, healthcare, and drugs. Governments promise and propose, but little if any progress is visible on these issues.

In the last year we experienced some major errors by government or its agents. Here are some examples. The Federal Reserve “rescued” American International Group (AIG) by using billions of taxpayer dollars. AIG had three profitable divisions, including a highly successful insurance company. Bankruptcy court would have been a better outcome. Last August, the government lost six nuclear warheads that were later found on B-52 bombers flying over the United States. Congress approved purchases of ethanol made from corn that raised the world price of food but did not reduce pollution. And government loaned money to General Motors and Chrysler followed by loans to an auto finance company that immediately offered zero interest rate loans to borrowers with poor credit ratings. Government promises to spend for old age pensions and health care far exceed any feasible revenues to pay for the promises. Does Congress develop a feasible plan? The estimated present value of the unfunded health care promises is $70 trillion to $80 trillion dollars. No private plan would be allowed to operate this way.

Growth and Progress

After World War II, and especially after 1960, the developed countries led by the United States worked to raise growth rates in poor countries of the world. There were two experiments. The former Soviet Union and its fellow Communist countries controlled property and directed resource use according to plans developed by a central bureaucracy. Capitalist countries relied on opening to the international market and to resource allocation based on market demand and individual choice.

The results are clear. Capitalism and the market system proved much more effective at development and poverty reduction than planning systems, whether by a democratically chosen government, as in India, or by an authoritarian regime, as in the Soviet Union or China. There is not a single example of sustained successful growth under traditional Communism. The contrast was clear at the end of the 1980s in comparison between North and South Korea, East and West Germany, and China compared to the Chinese diasporas in Asia. The Indian government tried to apply the Socialist principles taught to many of its leaders at the London School of Economics.

Recent research compared growth in countries ordered according to an index of freedom. The index had thirty-eight observable components compiled in five categories measuring size of government, legal structure, access to sound money, openness to trade and exchange, and regulation (Gwartney and Larson, 1996). They found that per-capita income rose at a compound rate of 3.44 percent in the freest countries, compared to average growth of 0.37 percent in “not free” countries. Intermediate countries had intermediate growth, 1.67 percent. The authors suggested why these differences persisted. Freer countries had higher rates of investment, higher productivity growth, more foreign direct investment, and stricter adherence to the rule of law.

There can be no better recognition of the failure of these alternatives to capitalism and the market system than their abandonment by their practitioners. India, China, and most of the former Communist countries opened their economies. China and others joined the world trading system. China and India permitted and even encouraged private ownership of resources, including capital.

The result was a dramatic reduction in poverty. Many more people improved their living standards than in fifty years of development under government planning, regulation, foreign aid, and resource allocation. Capitalism and the market proved far better than the state at reducing poverty and raising living standards. Critics of capitalism turned to other reasons for opposition. Margaret Thatcher (1993, 625) described their reaction to her success at reforming the British economy, increasing productivity, and reducing inflation.

Deprived for the moment at least of the opportunity to chastise the Government and blame free enterprise capitalism for failing to create jobs and raise living standards, the left turned their attention to non-economic issues. The idea that the state was the engine of economic progress was discredited–and even more so as the failures of Communism became more widely known. But was the price of capitalist prosperity too high? Was it not resulting in gross and offensive materialism, traffic congestion and pollution? . . . [W]as not the ‘quality of life’ being threatened? . . . I found all this misguided and hypocritical. If Socialism had produced economic success the same critics would have been celebrating in the streets.

Socialism as a development model faces several obstacles. One is the reduced ability to recognize mistakes and act on that knowledge. A venture capitalist knows that all of his investments will not succeed. He must decide whether to advance more capital or close the firm. The capitalist facing the loss of his own investment makes a decision based on his estimate of expected future return. The Socialist uses different criteria. Admitting error is personally costly and requires layoffs. Faced with uncertainty about future outcomes, the Socialist and the capitalist choose different outcomes. There is a risk of shutting down an enterprise that becomes profitable and the risk of supporting a failing enterprise. Workers, voters, lose employment. On average the capitalist is more willing to close. The concentration of successful innovation in capitalist countries suggests that the capitalist strategy produces better results for society as well as for investors.

Capitalism rewards innovators, so it encourages innovation from many people willing to invest in their ideas. Socialism concentrates decision-making in a small group. Fewer new ideas develop. Freedom to fail or to gain drives innovation, change, and progress.

Some of the innovations are inconsistent with religious or moral standards. Critics of capitalism seize upon these changes to condemn the basic choices that capitalism and freedom permit. The critics prefer to impose their preferences in place of market-driven choices. Democratic systems do not sustain for long the rules imposed to control the public’s choices.

When I first moved to Pennsylvania fifty years ago, many rules and prohibitions remained. Most retail stores had to close on Sunday. Bars could not sell drinks on Sunday. Gradually public pressure induced changes to satisfy consumer choice.

These simple examples show a fundamental problem. Many private trade-offs differ from the socially imposed trade-off. Those who wish to impose standards or rules that do not have public support either give way or resort to coercion. The proponents of rules or resource allocation that they favor, whether from religious or Socialist orthodoxy or from some other source, have three choices. Convince a majority to support their direction, resort to coercion, or accept democratic choices and change or remove regulations. Regulation is most likely to last if it equates private and social cost.

Kant does not assure us that any of the three outcomes will always be wise or good. On the contrary, he tells us that we cannot always depend on our leaders to pursue our interests instead of their own.

Socialism, or any system based on an orthodoxy or plan for promoting “good,” inevitably begins with persuasion and ends with coercion. Any deviation from orthodoxy is a step away from “the good.” F. A. Hayek’s Road to Serfdom showed why government planning is inconsistent with democratic choice.

Democratic capitalism is not a rigid orthodoxy. People can choose more redistribution or less. They can change their votes. Some countries choose a larger welfare state with greater redistribution. Others choose a smaller public sector and a higher rate of growth. A remarkable feature of democratic capitalism is that its outcomes are relatively stable. There are always critics who favor more redistribution and express concern for unmet “social needs.” At the same time, some critics want lower tax rates, less current redistribution, and more growth. Major changes are infrequent.

Democratic capitalism persists and spreads because it is not a system of imposed morality. It is the only system we have discovered that offers mankind outcomes not as perfected according to some utopian standard but as adoptable to the mankind Kant described.

Income Distribution

In a democratic capitalist system, the distribution of income is a major policy issue. There are fewer rich than poor or middle class. Fifty percent of the votes decide an election. The income of the median voter lies below the mean income, so a majority of the voters can redistribute income. Early in the history of the American republic, Alexis de Tocqueville warned about the temptation for the voting majority to tax the incomes of those above the mean.

Experience suggests that there are many examples of redistributive policy allegedly carried out to benefit the poor. One problem is that the poor are not the same as the lowest 10 or 20 percent of the statistical income distribution. People can be in the lowest tail temporarily. Also, many of the poor do not vote, but older people and middle-income people do. They get more attention from politicians.

Angus Maddison, the leading researcher on the history of economic growth, found that by the year 1000, Asian countries led all others in per-capita income. By 1820, the capitalist economies of Western Europe and the United States reached twice the Asian average. By 1950, the difference was wider. Several Asian countries adopted capitalist methods. The gap narrowed. After Japan and South Korea showed that growth was a capitalist, not a western, force others followed. Eventually China and India accepted capitalist methods.

Critics complain repeatedly about differences in income between highest and lowest income groups. U.S. data show that since 1975 household income at the ninetieth percentile (in 2003 dollars) rose faster than household income at the tenth highest percentile in every five-year period except 1990-95. Relative (real) income of the ninetieth percentile rose from 10.8 times the tenth percentile to 13.7 times. Comparisons that use median household income are misleading. Many more households have only a single person (earner) or a retired single person.

Sweden is often used as a model of humane capitalism. There is no doubt that Sweden tried hard to redistribute income. In 1975, the top 1 percent of consumer units received 2.8 percent of real disposable income. By 2000, the top 1 percent increased its share to 8.8 percent.
A recent comprehensive study of Swedish income distribution during the twentieth century concluded: “Our findings suggest that top income shares in Sweden, like many other Western countries, decreased significantly over the first eighty years of the century. . . . Most of this decrease happened before 1950, that is, before expansion of the Swedish welfare state. As in many other countries, most of the fall was due to decreasing shares in the very top (the top one percent), while the income share of the lower half of the top decile … has been extraordinarily stable. Most of the fall is explained by decreased income from capital.”

Income redistribution is easier to promise than to achieve in practice by activist policies. Many countries have tried, but Roine and Waldenstrom show that the broad contour of the share of the top percentile is very similar in the seven countries they examined. All countries experienced a large decline in the share of the top decile from about 1910 to 1980. The range drops from 20-25 percent to 5-10 percent in 1980. This is followed by a rise. By 2004, major differences appear, perhaps reflecting the importance of new technology and the quality of educational attainment in different countries. The top decile received about 15 percent in the United States and 13 percent in Canada and the United Kingdom but about 8 percent in Sweden and 5 percent in the Netherlands.

Data on income distribution have many flaws. People underreport, and accurate sampling is difficult. The share of income from capital varies across countries. People move within the distribution, so the lowest 10 percent and the highest 10 percent are not the same people over time. The proportion of divorced, separated, or single mothers has increased. The lowest 10 percent includes a disproportionate number of families of this kind. Their relative poverty cannot be blamed on capitalism. On the contrary, capitalist growth facilitated such choices.

Educational attainment increased in importance as a source of income in the latter part of the twentieth century. Low educational attainment and broken family structure are related. Differences in educational attainment work to spread the income distribution. Education as a cause of growth in capitalist countries also contributes to spreading the income distribution.


There is no better alternative than capitalism as a social system for providing growth and personal freedom. The alternatives offer less freedom and lower growth. The “better alternatives” that people imagine are almost always someone’s idea of utopia. Libraries are full of books on utopia. Those that have been tried have not survived or flourished. The most common reason for failure is that one person or group’s utopian ideal is unsatisfactory for others who live subject to its rules. Either the rules change or they are enforced by authorities. Capitalism, particularly democratic capitalism, includes the means for orderly change.

Critics of capitalism look for viable alternatives to support. They do not recognize that, unlike Socialism, capitalism is adaptive, not rigid. Private ownership of the means of production flourishes in many different cultures. Recently critics of capitalism discovered the success of Chinese capitalism as an alternative to American capitalism. Its main feature is mercantilist policies supported by rigid controls on capital. China’s progress takes advantage of an American or western model–the open trading system–and the willingness of the United States to run a current account balance. China is surely more authoritarian than Japan or western countries, a political difference that previously occurred in Meiji Japan, Korea, and Taiwan. Growth in these countries produced a middle class followed by demands for political freedom. China is in the early stages of development following the successful path pioneered by Japan, Korea, Taiwan, Hong Kong, and others who chose export-led growth under trade rules. Sustained economic growth led to social and political freedom in Japan, Korea, and Taiwan. Perhaps China will follow.

Capitalism continues to spread. It is the only system humans have found in which personal freedom, progress, and opportunities coexist. Most of the faults and flaws on which critics dwell are human faults, as Kant recognized. Capitalism is the only system that adapts to all manner of cultural and institutional differences. It continues to spread and adapt and will for the foreseeable future.

Security Challenges Arising from the Global Financial Crisis

March 11, 2009
Statement of Richard Nathan Haass, former Director of Policy Planning in the U.S. State Department, current President of the Council on Foreign Relations, before the Committee on Armed Services of the U.S. House of Representatives
Washington DC, March 11, 2009

Mr. Chairman,

Thank you for this opportunity to testify before the House Committee on Armed Services on security challenges arising from the global financial crisis. Let me first commend you and your colleagues for holding this hearing. Most of the analysis and commentary on the global economic crisis has focused on the economic consequences.

This is understandable, but it is not sufficient. The world does not consist of stovepipes, and what happens in the economic realm affects political and strategic policies and realities alike. It is also important to say at the outset that this crisis, which began in the housing sector in the United States, is now more than a financial crisis. It is a full-fledged economic crisis. It is also more than an American crisis. It is truly global.

I would add, too, that the crisis is unlike any challenge we have seen in the past. It is qualitatively different than the sort of cyclical downturn that capitalism produces periodically. This crisis promises to be one of great depth, duration, and consequence. This crisis was not inevitable. It was the result of flawed policies, poor decisions, and questionable behavior.

It is important that this point be fully understood lest the conclusion be widely drawn that market economies are to be avoided. The problem lies with the practice of capitalism, not the model. Nevertheless, the perception is otherwise, and one consequence of the economic crisis is that market economies have lost much of their luster and the United States has lost much of its credibility in this realm.

It is inconceivable in these circumstances to imagine an American official preaching the virtues of the Washington Consensus. This is unfortunate, as open economies continue to have more to offer the developing world than the alternatives. It also adds to the importance that the U.S. economy get back on track lest a lasting casualty of the crisis be modern capitalism itself.

The impact of the economic crisis will be varied and go far beyond the image of capitalism and the reputation of the United States. Director of National Intelligence Dennis Blair was all too correct when he testified recently that the primary near-term security concern of the United States is the global economic crisis and its geopolitical implications. The crisis will have impact on conditions within states, on the policies of states, on relations between states, and on the thinking of those who run states. I have already alluded to this last consideration.

Here I would only add that initial reactions around the world to the crisis appear to have evolved, from some initial gloating at America’s expense to resentment of the United States for having spawned this crisis to, increasingly, hopes that the American recovery arrives sooner and proves to be more robust than is predicted. This change of heart is not due to any change of thinking about the United States but rather to increased understanding that the recovery of others will to a significant extent depend on recovery in the United States. In a global world, what happens here affects developments elsewhere and vice versa. Decoupling in either direction is rarely a serious possibility. The crisis is clearly affecting the developed world, mostly as a result of the centrality of banking-related problems and the high degree of integration that exists among the economies of the developed world. Iceland’s government has fallen; others may over time. Many governments (including several in Central and Eastern Europe but outside the Eurozone) will require substantial loans.

The economies of Japan, much of Europe, and the United States are all contracting. World economic growth, which averaged 4 to 5 percent over the past decade, will be anemic this year even if it manages to be positive, which is increasingly unlikely. It is worth noting that the most recent World Bank projection predicts negative growth for 2009. Change of this sort will have consequences. There will likely be fewer resources available for defense and foreign assistance. Reduced availability of resources for defense makes it even more critical that U.S. planners determine priorities. Preparing to fight a large-scale conventional war is arguably not the highest priority given the enormous gap between the relevant military capabilities of the United States and others and the greater likelihood that security-related challenges will come from terrorism and asymmetric warfare. State-capacity building, the sort of activity the United States is doing in Iraq, Afghanistan, and Pakistan, will continue to place a heavy burden on U.S. military and civilian assets.

Also remaining highly relevant (and deserving to be a funding priority) will be standoff capabilities designed to destroy targets associated with terrorism and weapons of mass destruction. Developing states may appear to be better off than wealthier countries at first glance. Their growth on average is down by half from previous years, but still positive. Appearances, however, can be deceptive. This growth is measured from a low base in absolute and relative terms. The reduction in growth in some instances has been dramatic. Developing country exports are down as demand is down in the developed world.

Also reduced are aid flows and most importantly investment flows to the developing world. Commodity prices are much lower, a boon to those who rely on imports but a major problem for the many who are dependent on the income from one or two exports. A few countries merit specific mention. One is China. China’s economic success over the past few decades constitutes one of history’s great examples of poverty eradication. This process, one that has involved the migration of millions of people every year from poor rural areas to cities, will slow considerably. The already large number of domestic political protests in China over such issues as land confiscation, corruption, environmental degradation, and public health, is likely to grow. Absent renewed robust economic growth, the chances are high that the government will react by clamping down even more on the population lest economic frustration lead to meaningful political unrest.

Russia is in a different position, one characteristic of countries dependent on raw material exports for much of their wealth. The Russian economy is contracting after a period of boom. As is the case with China, this suggests the likely assertion of greater political control. But Russia is not as fully integrated as China is with the world economy. There is thus a greater (although impossible to quantify) chance that Russia’s leaders will turn to the time-honored resort of manufacturing an overseas crisis to divert attention than will China’s.

The same holds true for Iran and Venezuela, two countries that are heavily reliant on energy exports and whose foreign policies have been counterproductive (to say the least) from the U.S. perspective. But at the same time, it is possible that one or both will pull in their horns. Venezuela is already showing some signs of this, with its more welcoming stance toward international oil companies. This may well be simply a tactical adjustment to immediate needs.

And at least in principle, Iran’s government might find it more difficult to make the case to its own people for its continued pursuit of a nuclear weapons option if the Iranian people understood that it was costing them dearly with respect to their standard of living. Iraq is another oil producing country whose wealth is closely associated with the price of oil. Here the effects are sure to be unwanted. There is the danger that disorder will increase as unemployment rises, prospects for sharing revenue shrink, and the ability of the central government to dispense cash to build broad national support diminishes. In light of the multiple challenges already facing the United States, the last thing the Obama administration needs is the specter of an unravelling Iraq.

Two other countries are worth highlighting. One is Pakistan. Pakistan’s economic performance is down sharply for many reasons, including a decrease in both foreign investment in the country and exports from Pakistan to other countries. Pakistan has little margin for error; the possibility that it could fail is all too real. The worsened economic situation makes governing all that much more difficult. The consequences of a failed Pakistan for the global struggle against terrorism, for attempts to prevent further nuclear proliferation, for the effort to promote stability in Afghanistan, and for India’s future are difficult to exaggerate. North Korea is a second nuclear-armed state whose stability is worsened by the economic crisis.

At issue is the extent to which South Korea (along with China and Japan) can provide resources to the North to help stave off collapse. Another serious consequence of the global economic crisis, one that affects both developed and developing countries, is the reality that protectionism is on the rise. One realm is trade; some seventeen of the twenty governments set to meet in London early next month have increased barriers to trade since they met late last year. Negotiated free trade agreements with Colombia, Panama, and South Korea continue to languish in the U.S. Congress. The president lacks the Trade Promotion Authority essential for the negotiation of complex, multilateral trade accords. Prospects for a Doha round global trade pact appear remote. The volume of world trade is down for the first time in decades. The economic but also strategic costs of this trend are high. Trade is a major source of political as well as economic integration; one reason China acts as responsibly as it does in the political sphere is because of its need to export its products lest potentially destabilizing unemployment jump sharply. Trade has other virtues as well. More than anything else, trade is a principal engine of global economic growth. The completion of the Doha round might be worth as much as $500 billion to the world in expanded economic activity. One-fourth of this expanded output would occur in the United States. This is the purest form of stimulus.

For the United States, exports are a source of millions of relatively high-paying jobs; imports are anti-inflationary and spur innovation. Alas, the economic crisis will make it difficult if not impossible to conclude new trade pacts and to gain the requisite domestic support for them. Economic nationalism is on the rise, and when this happens, the will and the ability of political leaders to support policies that are perceived to hurt large numbers of their citizens (but which in reality help many more) invariably goes down. What is more, the economic crisis may also make it more difficult to reach agreement on a global climate change pact when representatives of most of the world’s countries gather in Copenhagen late this year. Developed and developing countries alike will resist commitments that appear to or in fact do sacrifice near-term economic growth for long-term environmental benefit. What, then, should be done to limit the adverse strategic effects of an economic crisis that is certain to get worse and persist for some time?

The United States – the Obama administration and the Congress – should resist protectionism. “Buy America” provisions in the stimulus legislation will increase costs to American consumers and all but make certain that other countries will follow suit, thereby reducing the prospects for American firms to sell abroad. More American jobs are likely to be sacrificed than preserved. Increased protectionism will also dilute the strategic benefits that stem from trade and its ability to contribute to international stability by giving governments a stake in stability. Similar arguments hold as to why “lend national” provisions are counterproductive. Bringing countries into the world trading system (best done through WTO accession) makes strategic sense, too, as it gives them a stake in maintaining order at the same time it opens government decision-making to greater degrees of transparency. Recession cannot become this country’s energy policy or a reason not to decrease U.S. consumption of oil, imported or otherwise. Lower prices will dilute any economic incentive to consume less oil. Regulatory policy will be the principal means of discouraging demand and encouraging the development of alternative energy sources and technologies. Reduced demand is essential for strategic reasons (so as not to leave the United States highly dependent on imports and so that countries such as Russia, Venezuela, and Iran do not benefit from dollar inflows), for environmental reasons, and for economic reasons, i.e., not to increase the U.S. balance of payments deficit. The goal should be to use this moment of temporarily-reduced prices to decrease the chances we as a country again find ourselves in a world of high energy prices once the recession recedes.

The United States should work with other developed and reserve-rich countries to increase the capacity of the IMF to assist governments in need of temporary loans. Current capacity falls short of what is and will be needed. It would be helpful if aid budgets were not victims of the economic crisis. Aid is needed on a large scale not just for humanitarian reasons (to fight disease, etc.) but also to build the human capital that is the foundation of economic development. Aid will also be a necessary substitute in the short and medium run for investment. Absent such flows we are likely to see greater misery and an increased number of failing or failed states. The upcoming G-20 summit in London provides an opportunity to adopt or encourage some useful measures in many of these realms. It is essential that others, including Europe and Japan, take steps to stimulate their economies. It is equally important, though, that guidelines be promulgated so that stimulus programs do not become a convenient mechanism for unwarranted subsidies and “buy national” provisions that are simply protectionist measures by another name.

The London meeting is also an opportunity to increase IMF capacity, to generate commitments to provide aid to developing countries, and to agree on at least some regulatory principles for national banking and financial systems. There is not time, however, to try to rebuild the architecture of the international economic system, solve the problems caused by countries that run chronic surpluses, or revamp the system of exchange rates. Let me close with two final thoughts. Much of this hearing and statement is focused on the question of the consequences of the economic crisis for global security. But it is important to keep in mind that the relationship is not only one way. Developments in the political world can and will have an effect on the global economy.

Imagine for a second the economic consequences of, say, a Taiwan crisis or fighting between India and Pakistan or an armed confrontation with Iran over its nuclear ambitions. This last possibility is the most worrying in the near term and underscores the importance of trying to negotiate limits on Iran’s enrichment program lest the United States be confronted with the unsavory option of either living with an Iranian near or actual nuclear weapons capability or mounting a preventive military strike that, whatever it accomplished, would be sure to trigger a wider crisis that could well lead to energy prices several times their current level.

Finally, getting through this economic crisis should not be confused with restoring prolonged calm in the markets or sustainable growth. Enormous stimulus measures here at home coupled with equally unprecedented increases in the current account deficit and national debt make it all but certain that down the road the United States will confront not just renewed inflation but quite possibly a dollar crisis as well. At some point central banks and other holders of dollars will have secnd thoughts about continuing to add to their dollar holdings, currently larger than ever given the desire for a safe harbor. Ongoing U.S. requirements for debt financing, however, will likely mean that interest rates would need to be raised, something that could choke off a recovery. This underscores the importance of limiting stimulus packages to what is truly essential to reviving economic activity and to taking other measures (such as entitlement reform and the already discussed steps to reduce oil use) lest the current crisis give way to another one.

Keynes and the triumph of hope over economics

February 27, 2009


In a Financial Times op-ed, Benn Steil, author of Money, Markets, and Sovereignty, satirizes the tendency of economists to cite John Maynard Keynes in support of dramatic fiscal interventions where cold analysis should give us pause.

“Citing Keynes gives us special licence to talk economics without using any. To paraphrase the lawyers’ dictum, when the facts are on our side, we pound the facts; when theory is on our side, we pound theory; and when neither the facts nor theory are on our side, we pound Keynes – and to great effect.

Keynes, not coincidentally, had nothing to say about the proper components of fiscal stimulus. This allows him to be cited with great effect by both paternal progressives (who favour government spending) and caring conservatives (who favour middle-class tax cuts).”

Read full story.

Folgt auf die Finanzkrise ein Bürgerkrieg?

February 26, 2009

Das Volk rebelliert nämlich nie allein deshalb, weil es einen schweren Sack schleppen muss, es lehnt sich nie gegen die Ausbeutung auf, denn es kennt kein Leben ohne Ausbeutung. Das Volk empört sich erst dann, wenn ihm jemand plötzlich und unvermutet einen zweiten Sack aufzubürden versucht. Er rebelliert, weil er spürt, dass du ihm mit diesem zweiten Sack betrügen wolltest, du hast ihn wie ein stumpfes Tier behandelt, den Rest seiner geschändeten Würde in den Schmutz getreten, ihn zum Idioten gemacht. Der Mensch langt nicht nach dem Beil, um seinen Geldbeutel zu verteidigen, sondern seine Würde. (Aus dem Roman König der Könige von Ryszard Kapuściński)

Steht der Zusammenbruch der öffentlichen Ordnung kurz bevor, nachdem die globale Finanzkrise die Ohnmacht der Politik (die mit einer unanständigen Umverteilung von Steuergeldern für die oberen Zehntausend reagiert, anstatt das System grundlegend zu verändern) entlarvt hat? Den genauen Zeitpunkt und die Form des kommenden Bürgerkriegs kann man noch nicht voraussehen. Dass er kommen wird, steht jedenfalls fest. Wann und wie er kommen wird, liegt noch verborgen im Schoße der Zukunft.

Es ist zumindest die ziemlich apokalyptische Prophezeiung der europäischen Denkfabrik European Laboratory of Political Anticipation LEAP/Europe 2020, die in einer Pressemitteilung vom 18. Februar 2009 verkündet wurde.

Ein ähnliches düsteres Szenario prognostiziert ebenfalls Igor Panarin, Dekan der Fakultät Internationale Beziehungen der Diplomatischen Akademie des russischen Außenministeriums: ” Der US-Dollar ist durch nichts mehr gedeckt. Die Außenverschuldung ist lawinenartig gewachsen: 1980 hatte es noch keine gegeben, 1998, als ich meine Prognose aufstellte, lag sie bei zwei Billionen Dollar, heute beträgt sie mehr als elf Billionen Dollar. Das ist eine Pyramide, die unbedingt einstürzen wird. Millionen von Bürgern haben ihre Ersparnisse eingebüßt. Die Preise und die Arbeitslosigkeit werden steigen. General Motors und Ford stehen am Rande des Zusammenbruchs. Das bedeutet, dass ganze Städte arbeitslos werden.”


Pressemitteilung European Laboratory of Political Anticipation LEAP/Europe 2020

Seit Februar 2006 vertrat LEAP/E2020 die Auffassung, dass die umfassende weltweite Krise in vier Grundphasen ablaufen würde, nämlich die Anfangsphase, die Beschleunigungsphase, die Aufprallphase und die Dekantierungsphase. Die Ereignisse der letzten zwei Jahre fügten sich hervorragend in dieses Schema. Jedoch müssen wir uns endlich in die Einsicht finden, dass die Regierenden unfähig sind, die wahre Natur der Krise zu verstehen. Denn seit nunmehr mehr als einem Jahr bekämpft die Politik mit ihren Maßnahmen nur die Symptome der Krise, nicht aber die Ursachen.

Deshalb gehen wir heute davon aus, dass mit dem vierten Quartal 2009 eine fünfte Phase der Krise einsetzen wird, in der die öffentliche Ordnung zerfallen wird.

Nach der Auffassung von LEAP/E2020 werden zwei bedeutende Phänomene diese neue Phase der Krise prägen; die kommenden Ereignisse werden damit in zwei parallelen Entwicklungen ablaufen:

A. Die zwei bedeutenden Phänomene:

1. Das Wegbrechen der globalen Finanzbasis (Dollar + Schulden)
2. Die sich beschleunigende Divergenz der Interessen der großen Staaten und der internationalen Organisationen

B. Die zwei parallelen Entwicklungen:

1. Die rasche Auflösung des gesamten gegenwärtigen internationalen Systems
2. Die Auflösung der Handlungsfähigkeit der mächtigen Staaten und großen internationalen Organisationen

Wir hatten gehofft, dass die Dekantierungsphase den Regierenden dieser Welt ermöglichen würde, die Schlussfolgerungen aus dem Zusammenbruch der Nachkriegsweltordnung zu ziehen. Man kann heute mit größtem Bedauern nur feststellen, dass solcher Optimismus nicht mehr zu rechtfertigen ist.

In den USA wie auch in Europa, in China oder in Japan handeln die Regierenden, als ob die Weltordnung nur von einer vorüber gehenden Krise erfasst wäre und es genügen würde, noch etwas Treibstoff (Liquidität, also weitere Schulden) und weitere Tinkturen (Leitzinssenkungen, staatlicher Aufkauf von wertlosen Forderungen, Konjunkturförderprogramme zu Gunsten insolventer Industriezweige) in das System zu gießen, um den Motor wieder zum Anspringen zu bringen. Sie wollen einfach nicht verstehen, dass, wie der Begriff der umfassenden weltweiten Krise, den LEAP/E2020 im Februar 2006 prägte, zu vermittelt versucht, die Weltordnung nicht mehr funktionsfähig ist. Statt verzweifelt zu versuchen, diese am Boden liegende, unrettbare Weltordnung zu retten, muss endlich die Schaffung einer neuen Weltordnung angegangen werden.

Geschichte wartet nicht, bis die Menschen für sie bereit sind. Da die Schaffung der neuen Weltordnung nicht vorausschauend und planend möglich war, wird der Zerfall der öffentlichen Ordnung während dieser fünften Phase der Krise die Welt in ein solches Chaos stürzen, dass die neue Weltordnung als Zufallsprodukt und Improvisation entstehen wird. Die beiden parallelen Entwicklungen, die wir in dieser 32. Ausgabe des GEAB beschreiben, werden für einige der großen Staaten und internationalen Organisationen tragisch sein.

Nach unserer Auffassung verbleibt nur ein sehr kleines Zeitfenster, während dem das Schlimmste noch vermieden werden kann, nämlich bis zum Sommer 2009. Dann wird die Zahlungsunfähigkeit erst Großbritanniens und dann der Vereinigten Staaten die Grundlagen des bestehenden Systems zusammen stürzen lassen und Chaos ausbrechen.

Wir gehen sehr konkret davon aus, dass der geplante G20-Gipfel April 2009 die letzte Chance für die bestehende Weltordnung ist, die aktuell wirkenden Kräfte so auszurichten, dass der Übergang in die neue Weltordnung sich mit dem geringst möglichen Schaden vollzieht.

Wenn ihnen das nicht gelingt, wird den Mächtigen der aktuellen Weltordnung die Kontrolle über die Ereignisse vollständig entgleiten, und zwar nicht nur auf globaler Ebene, sondern für einige von ihnen auch in ihren eigenen Ländern; die Welt wird in die Phase, in der die öffentliche Ordnung zusammen bricht, gleiten wie ein Schiff, dessen Ruder gebrochen ist. Am Ausgang dieser Phase des Zusammenbruchs der öffentlichen Ordnung wird die Welt mehr dem Europa von 1913 ähneln als der Welt, an deren reale Existenz die meisten noch bis 2007 glaubten.

Die meisten der von der Krise betroffenen Staaten, unter ihnen die mächtigsten dieser Erde, versuchten verzweifelt, das immer weiter anwachsende Gewicht der Krise zu schultern; sie verstanden nicht, dass sie damit die Gefahr herauf beschworen, unter dieser Last zusammen zu brechen. Sie vergaßen, dass Staaten, von Menschen geschaffen, nur solange Bestand haben, wie sich eine Mehrheit dieser Menschen mit ihnen identifiziert. In dieser 32. Ausgabe des GEAB wird LEAP/E2020 seine Analysen über die Auswirkungen dieser Phase des Zusammenbruchs der öffentlichen Ordnung auf die USA und die EU vorlegen.

Es wird für alle, Privatpersonen wie Wirtschaftsführer, dringlich, sich auf eine sehr schwierige Zeit vorzubereiten, in der ganze Bereiche unserer Gesellschaft wegbrechen werden und zumindest zeitweise oder sogar dauerhaft aufhören werden, Bestandteile der Gesellschaft zu bilden.

So wird z.B. der Zerfall des Weltwährungssystems im Sommer 2009 nicht nur den Dollar (und aller Geldanlagen in Dollar) zusammen brechen lassen, sondern das Vertrauen in alle Papierwährungen (also ohne Gold- oder Silberdeckung) massiv unterminieren. Alle Empfehlungen in dieser Ausgabe des GEAB sollen auf diese Situation vorbereiten.

Weiterhin gehen wir davon aus, dass die Staaten, die besonders monolithisch, besonders mächtig, besonders zentralistisch sind, diejenigen sein werden, die von der fünften Phase der umfassenden weltweiten Krise besonders massiv betroffen sein werden. Weitere Staaten, die unter dem Schutz dieser Staaten stehen, werden ihre Schutzmächte verlieren und damit dem Chaos in ihren Regionen ausgeliefert sein.

Fed Chairman Bernanke’s Promise

October 14, 2008

In an op-ed in The Wall Street Journal, Ben Bernanke, chairman of the U.S. Federal Reserve, writes that the tools put in place to combat the financial crisis, together with the underlying power and resilience of the American economy, will help to restore confidence to the financial system and place the economy back on a path to vigorous growth.

“History teaches us that government engagement in times of severe financial crisis often arrives very late, usually at a point at which most financial institutions are insolvent or nearly so. In these conditions, the consequences and costs of inertia and inaction can be staggering. Fortunately, that is not the situation we face today.”

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Ralf Dahrendorf zur Finanzkrise

October 11, 2008

Während Europäer allzu schnell die freie Marktwirtschaft begraben und den Staatssozialismus einführen wollen, äußert sich im Gespräch mit Patrick Bahners und Alexander Cammann die Galionsfigur des europäischen Liberalismus Ralf Dahrendorf zur globalen Finanzkrise, und plädiert für eine Erneuerung des Kapitalismus:

“Zur Freiheit gehören die Krisen der Freiheit. Und dass die Freiheit des Marktes Regeln, braucht, habe ich immer vertreten. Der Finanzkapitalismus hatte sich zuletzt verselbständigt: für bestimmte Innovationen, die Spekulation auf Schulden oder Indexentwicklungen, hatte sich ein ungeregelter Handel entwickelt. Das war noch kein Markt – und es war auf Dauer so nicht durchzuhalten. Jetzt werden sich die verbleibenden Banken und Investmenthäuser Regeln suchen. Für diese neuartige Ökonomie wird ein Markt mit Regeln entstehen.”

Vollständiges Gespräch lesen.

Bloody Party on financial markets has just begun

October 10, 2008

The Central Banks have lost control, market panic spreads and several exchanges suspend trading.

Yesterday’s rapid sell-off on Wall Street, which dragged the Dow Jones Industrial Average down more than 7 percent in late trading, kicked off a wave of global selling today that some analysts termed a panic selling.

Japan’s Nikkei index plunged nearly 10 percent, as did London’s FTSE index at market open, before making a slight recovery to losses of around 8 percent. In Asia, markets in Hong Kong, South Korea, India Thailand, Indonesia, Australia were among those that suffered major losses.

Shares also fell sharply across Europe, with Germany and France each showing early losses over 7 percent. Russia, Indonesia, Iceland, Austria, and Thailand all halted trading after steep losses.

The New York Times reports the United States and UK appear to be converging on coordinating global action to end the decline. The article says the idea that governments should inject money into banks in return for partial ownership and guarantees of loan repayment will be closely examined when IMF finance ministers meet tomorrow.

The Wall Street Journal reports the U.S. Treasury has begun a process of interviewing financial executives to gauge interest in new programs aimed at injecting capital into banks.

European economy goes into recession

October 9, 2008

European and Asian markets stabilized today, showing sober gains following unprecedented coordinated interest rate cuts by many of the world’s major central banks. Russian stock markets, which had suffered worse losses than any major market, gained 17 percent.

Meanwhile, the International Monetary Fund (IMF) said it projects Europe is headed toward a recession and that the continent’s banking system is currently under “extraordinary financial stress”.

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Globalised Economy

October 8, 2008

In the International Herald Tribune, Paul Kennedy, director of International Security Studies at Yale University, and author of the bestseller The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500 to 2000, comments on how the consequences of the financial crisis are affecting all parts of an increasingly globalised economy.

“Even the rising Chinese superpower is being blasted by these distant capitalistic convulsions. How could its Finance Ministry, seduced by the advice of Wall Street bankers and consultants to place billions of dollars into American so-called ‘safe havens,’ not be badly shaken by the financial tumults of the past few weeks?

Should China trust the Yankee capitalist system? What will happen to its vital exports to that enormous, volatile consumer market? Already The People’s Daily in Beijing has published a noteworthy piece by the economist Shi Jianxun calling upon the world to create ‘a diversified currency and financial system and (a) fair and just financial order that is not dependent on the United States.’ Where goes the dollar then, and its reputation as a safe haven?”

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Coordinated interest rate cuts by central banks worldwide to stop breakdown in financial markets

October 8, 2008

Following a bloody Tuesday on Wall Street, in which the Dow Jones Industrial Average dropped more than 500 points, over 5 percent of its value, Middle Eastern markets also collapsed today, with Egypt’s main index falling 16 percent and Saudi Arabia’ s falling over 8 percent.

Japanese markets fell over 9 percent in early trading, and Hong Kong’s main index fell over 8 percent. Markets in UK, France, and Germany all suffered heavy losses as well.

Great Britain also announced a rescue plan the Financial Times says amounts to a part-nationalization of the country’s banks.

In response to the growing crisis, the U.S. Federal Reserve, Bank of England, European Central Bank, and other major central banks all cut interest rates this morning in a coordinated move.

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Russia Call to Action On Financial Crisis

October 7, 2008

President Medvedev records his video at the Kremlin. Photo: © ITAR TASS

While the severe global crisis of confidence in financial markets continues to grow, and with a succession of EU countries announcing individual rescue plans, the Wall Street Journal reports on greater call for a coordinated response to the crisis threatening the bloc’s financial system.

Iceland, one of the countries hardest hit due to its highly developed banking sector, says it has arranged for a 4 billion euro bailout package from Russia, though the Financial Times reports Russia thus far has denied reports of the loan.

Russian President Dmitri Medvedev issued a call for coordinated global action to confront credit problems and said he would present a plan for how to tackle the crisis in meetings later this week in France.

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Europe’s Financial Storm

October 6, 2008

Stocks fell sharply in Asia and Europe this morning as fears over breakdown in the European financial system spread out.

The slowdown came as Germany took what the Financial Times calls a “dramatic move” by saying it would guarantee all funds in German bank accounts – currently worth nearly 570 billion euros – to protect against panic withdrawals. The Economist reports a number of European central banks have started taking similar moves and looks at some of the fallout in European financial markets.

In an editorial, the Guardian comments that the financial storm is now on Europe’s doorstep. As this crisis turns from a financial to an economic one, government intervention will surely become more the rule than the exception.

An editorial in The Wall Street Journal says that the only thing more predictable than European Schadenfreude at American economic trouble is how quickly it falls away amid Europe’s own big problems.

In the Sydney Morning Herald, columnist Paul Sheehan comments on a book written five years ago by George Soros, warning about the dangers of excessive debt and asks why nothing was done until the financial system was on the brink of collapse.

China’s Financial System

October 6, 2008

China’s Prime Minister Wen Jiabao said China’s financial system as a whole has proven well buffered to the financial concerns elsewhere in the world.

He says Chinese financial firms have generally increased their strength during the course of the crisis.

The Wall Street Journal looks at how East Asian central bankers, including China’s, have responded to the U.S. bailout plan.

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