A New Perspective on the Global Economic Crisis IV: It is NOT the economy, stupid!

I. Introduction

In the fall of 1992, President Bill Clinton ran for office with the slogan "It is the economy, stupid!" For more than four decades, ever since the end of the Second World War, the central focus of the American Presidency had been to contain the mortal dangers of the Cold War through diplomacy and military readiness. The Reagan-Bush era highlighted the importance of an American President's deft handling of foreign policy negotiations with the Soviets, under the threat of nuclear annihilation. Unfortunately, President George Bush Sr., who had displayed consummate skills of diplomacy in the foreign policy arena right up to the 1991 Gulf War, suddenly found himself ill-equipped when the domestic economy took a turn into a severe recession. It was against this background, that Bill Clinton, then the Governor of Arkansas, demonstrated, by winning the 1992 Presidential election handily, that the American people have realized that the central focus of the American Presidency ought not be foreign policy any longer. Instead, the President ought to be focused on domestic economic concerns, from which all other policies should be derived. Over the next 16 years, professional economists throughout the world have played increasingly powerful roles in determining all aspects of government policy.

With the advent of the current economic crisis, there is once again a pressing need for a paradigm shift. The Federal Reserve and the American government have spent trillions of dollars to rescue the economy from the crisis. The 'official consensus' in the economics profession is that the crisis-management policies that were followed have been a resounding success so far. Even a highly respected economist like Professor George Akerlof has claimed publicly that rescuing the economy from a recurrence of the Great Depression is a huge achievement, implying that this is the best that modern economics could do (he has said in a CNBC interview on October 30, 2009, "we have not done fairly well, we have done extremely well", in answer to the question "so, economics has done fairly well during the crisis?"). In fact, it is on this account that uncle Ben had done a victory lap among professional economists during the Jackson Hole conference in August 2009, and had managed to get himself re-appointed as the next Chairman of the Federal Reserve.

Unfortunately, even after all this trillions of blood-letting, nearly a tenth of the population is expected to be unemployed at any given time during the next two or three years. Due to the massive destruction of wealth in the stock markets and in real estates, it is believed that consumer spending is going to stay depressed for a long time. As a result, the American economy would deliver only a 'new normal' rate of growth, significantly lower than the average rate of growth during the decades prior to the crisis. These 'new normal' views have been expressed by many famous economists, particularly, Professor Michael Spence and Professor Nouriel Roubini. Moreover, the 'official consensus' holds that the US dollar needs to depreciate in value to make American exports competitive, so that America's current account deficits can be reduced. Thus it is expected that the triple phenomena of sustained high unemployment, depreciated dollar and 'new normal' growth rate would correspond to households making adjustments for a steady reduction in the standard of living in America for many years to come.

Reflecting the 'official consensus' in the economics profession, Professor Akerlof goes on to say in his interview, "And, I think we should be prepared that, we don't know where things are going to be headed from now on. I think we should view these [the current recovery] as positive signs, but one should never go through life not being prepared for both what's the positive and the negative, and so, I'm hoping that the Congress and the public and also the Fed and the administration should be prepared for the fact that perhaps things are not going to go as well as they might, and we should be prepared to have further fiscal stimulus and further intervention by the Fed, if things, ah, ..." It is precisely through this sort of enigmatic utterances that economists have brazenly conveyed to the public that over the next ten years the public debt in America would increase by nine trillion dollars. Yet, showing a rare sign of wisdom, the general public has steadfastly refused to accept these predictions of mountainous debt. This has been made crystal clear in the recent fall of nearly 20% in President Obama's approval rating.

The crisis indicates strongly that the central concerns of government policymakers ought to shift away from economics. The tools and techniques that modern economics employs have been shown to be quite inadequate for the task of overcoming the crisis. However, it is unclear exactly how this paradigm shift would take place. One should note that even though the shift away from foreign policy to economics happened in 1992, the remnant of the Cold War military-industrial complex still continues to exert a powerful hold on the Presidency. In fact, by employing scare tactics, foreign policy experts and commentators have forced the Obama administration to fall back on the policies of the previous President George W. Bush in matters of defense and national security. Likewise, the 'official consensus' in the economics profession has the ultimate goal of tying down the Obama Presidency in various economic quagmires so that the government would be forced to do its bidding. So it is not clear as yet how the paradigm shift away from economics would happen, though it is very clear that one needs to happen soon.

In this article, I highlight this pressing need for a paradigm shift by identifying some major weaknesses of modern economics, which demonstrate that the American government could not possibly continue to formulate its policies based on economic considerations alone. The way I do this is by analyzing two recent articles by renowned economists. The first article "Death Cometh for the Greenback" by Professor Joseph Stiglitz appeared in The National Interest on October 27, 2009. The second article is a research paper, "Global Imbalances and the Financial Crisis: Products of Common Causes", by Professor Maurice Obstefeld and Professor Kenneth Rogoff, which was presented in the San Francisco Fed conference in October 2009. This paper is available on Professor Rogoff's website. At the outset, I should say that I have long admired Professor Stiglitz's writings, and that my severe criticism of his recent opinions on the crisis that I mention in this article are meant to be constructive.

In section II, I first provide an introduction to the main weakness of modern economics, namely, that there is a widespread misconception among intellectuals that economics has been modernized by re-working it on mathematical foundations. I explain why economics, modern or otherwise, can never escape being heavily influenced by the machinations of an empire. If the central concern of an economist is efficient allocation of social resources, then she could not avoid looking at her society from the perspective of an empire. Recently, prominent economists, like Professor Robert Lucas, Professor Jeremy Siegel, Professor John Cochrane, and many others have written newspaper/magazine articles to defend the efficient market hypothesis (EMH) in light of the current economic crisis of catastrophic proportions. Unfortunately, the defense put forward by these luminaries is collectively so pathetic and so appaling that it makes me wonder: with proponents like these, who needs detractors?

The fundamental flaw in their approach is to continue to use mathematical formulations to defend EMH. Unbelievably, Professor Cochrane writes, "But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse". This after more than ten trillion dollars of wealth destruction in the stock markets and the real estates in the last two years! Using the characteristics of an empire that I develop in section II, I provide a more logical framework for discussing EMH. Then the case for free-markets derives directly from the principles of liberty as propounded in the classics of the Western society. Even more fundamentally, the market mechanism is a natural biological phenomenon, as explained in my article, "A New Perspective on the Role of Markets in an Economy". In Section II, I explain why it is not so easy, perhaps well nigh impossible, to replace EMH.

In section III, I elaborate on the weaknesses of Professor Stiglitz's article mentioned above. In particular, I indicate strongly that it is dangerous to replace the dollar as the main global reserve currency with the IMF's Special Drawing Rights (SDR). I do acknowledge that the SDRs could serve an important purpose in safeguarding the reserves of poor countries that are not directly involved in a global financial crisis. This means that the SDRs could play a healthy role in the global reserve system, if they constitute up to, say, ten percent of the volume of international currency use. Two or three years ago, Professor Stiglitz's efforts to replace the greenback with the SDRs as the global reserve currency would have been commendable because the world was then stuck with the reckless policies of American isolationism and military adventurism that were being pursued by the George W. Bush administration. Moreover, assuming that the paradigm shift away from economics does take place soon enough, I discuss methods by which the problems of high unemployment, falling living standards and 'new normal' growth rate can be solved rather quickly. In that event, the US dollar would regain its importance as the main global reserve currency.

In section IV, I analyze the Obstefeld/Rogoff paper. Both the Stiglitz article and the Obstefeld/Rogoff paper share a fundamentally weak perspective, which perspective in fact, enjoys a near-total adherence within the economics profession. This weakness concerns the discrepancy in the methods that economists apply to explain exchange rate fluctuations, and the methods that they apply to explain asset price fluctuations within national boundaries (like stock prices, residential prices, etc). To make this discussion clear, I quote a full paragraph from the Stiglitz article in Section III, before going on to explain why the advent of the current crisis requires addressing this discrepancy urgently. Moreover, addressing this discrepancy is a much simpler approach to exchange rates than the IMF issuing SDRs worth hundreds of billions of dollars. Then I continue this line of reasoning in Section IV to explain why the approach taken in the Obstefeld/Rogoff paper of looking at the East Asian Financial Crisis of 1997-98 as the starting point of the current financial crisis (in view of the sudden increases in global imbalances then) is inadequate and misleading. I develop a much broader framework for analyzing global imbalances. My arguments in Sections III and IV depend crucially on the characteristics of an empire that I develop in Section II.

II. It is not so easy to replace the Efficient Market Hypothesis (EMH)

No civilization worth its name would wager on efficiency as its central concern, most definitely not economic efficiency. It is an empire that is pre-occupied with economic efficiency at every instance. An empire lives and dies by its efficiency. Given this context of an empire, with its pre-occupation with economic efficiency, such an empire-based society could aim to break free from the restrictions that being an empire imposes. The civilizing influence of a liberal tradition is usually the moving force behind this thirst for freedom. History teaches us that to evolve into a civilization, a society need not necessarily start from being an empire. Nor is it necessary that every empire would evolve into a civilization. However, with the security provided by the infrastructure of an empire, an empire-based society has a good chance of becoming a civilization. With the satisfaction of the basic needs of its people that comes with being an empire, the empire-based society learns to aspire, from within, for the achievements of a civilization. Towards this end, the society could provide the utmost liberty to its people, so that they could achieve specialization of skills by pursuing their individual interests. It is with this twin concern of an empire and a liberal society that a theory of efficient markets could be founded.

The efficient market hypothesis could not be defended exclusively on principles of liberty, much less on purely mathematical formulations (see my article, "In response to 'What is the Deficit Endgame?'"). As explained above, consideration of efficiency or any other issue that can be formulated with quantitative precision, is hardly the foremost concern of a society. They are only the means by which a society aspires to the achievements of a civilization. The general version of the efficient market hypothesis says, among other things, that the market mechanism would provide the most efficient allocation of social resources, and that for this reason, the government should avoid any intervention in the functioning of the economy, but should instead let the markets operate freely on the economy. Thus the market strives for efficiency under the civilizing influence of the liberal tradition. No government, no employer, no state, no community, no police, no ruler could deny the liberties of the individual. She is free to participate in the market activities in her own interest and of her own choice. One consequence of the current economic crisis is that the version of the efficient market hypothesis that was advocated by the Chicago School, based purely on mathematical formulations, has been heavily discredited.

With the massive destruction of wealth that the current crisis has wrought, it is clear that the functioning of the markets in recent times has been far from efficient. It was John Maynard Keynes who first provided a mathematically-complete theory that explained why the markets could be stuck in a sub-optimal (i.e., inefficient) mode of operation for a prolonged period of time, may be even for several years. The validity of Keynesian theory was borne out by the experiences of the Great Depression. For example, if nearly a quarter of the population can be unemployed for several years, as happened during the Great Depression, that is clearly a huge inefficiency. To kick the market mechanism out of its sub-optimal rut, Keynes advocated direct government intervention in the economy through massive spending, in addition to the pro-active relaxation of the monetary policy by the central bank. Moreover, if the markets were left to their own devices during this sub-optimal rut, then from time to time there could be widespread panic in the markets, at which times there would be massive and persistent destruction of wealth.

Precisely in view of this reason, the government's spending should be administered without any considerations of efficiency whatsoever, according to Keynesian theory. The government could simply employ thousands of people to build a dam, and if it gets washed away, that is bloody well fine. All that matters is that the wheels of the economy are kept turning at their usual speed. What does a couple of trillions matter when spent in such a noble cause? Now, the problem is that, as mentioned above, an empire lives and dies by its efficiency. If the government at the center of the empire would need to overlook considerations of economic efficiency for several years at a time, even if only on rare occasions, occasions occurring once every century or so, even then, who would bear the consequences of this inefficiency? This is the gaping hole in Keynesian theory. By adopting a mathematical foundation, Keynesian theory pretends that considerations of efficiency do not matter. But, in fact, the empire is nothing if it does not transfer wealth destruction from its center to the periphery very efficiently, no matter whether it functions under Keynesian theory or otherwise. The consequences of Keynesian theory cannot be separated from colonial exploitation.

History provides many relevant examples. In awarding Professor Amartya Sen the 1998 Nobel Memorial prize in Economics, the Nobel Committee cited his work on the Bengal famine of the 1940s. Millions of people died of starvation during this famine, even though there was enough food production in India during that time. Sen's work demonstrated that the problem was not one of production but of distribution. It is not very hard to investigate, with modern facilities for computation and data gathering, as to what extent, the famine in Bengal resulted from the 'economic adjustments' that the advanced countries made to overcome the depression of the 30s and the onset of the Second World War. Another example is the famine in Ireland during the mid-1800s that was caused by the imperial machinations of the British empire. Sixty four years after the Second World War, the developing countries have thought long and hard, and have built their own defenses against colonial exploitation. This time some of them have hundreds of billions of dollars in foreign currency reserves and are exploring possibilities for reverse-colonization, or at least that is the fear that seems to be driving economists in Western countries. It would be far wiser to stick with the efficient market hypothesis, under the newly refined view that the EMH has to be super-imposed on the infrastructure of an empire.

III. It is dangerous to replace the US dollar as the global reserve currency with the IMF's SDR

The Stiglitz article and the Rogoff/Obstefeld paper both share a common weakness of perspective, which is in fact, widespread among the economics profession. To explain this weakness, I quote a full paragraph from Professor Stiglitz's article mentioned above:

"The strength of the dollar is determined by the laws of supply and demand, just like the value of any asset. The demand for a currency is based on the return to holding the asset relative to other assets, e.g., the interest rate received from a dollar asset, like a Treasury bill, plus the expected capital gain or loss. Demand today (and thus the value today) depends critically on expectations about the value tomorrow, but the value tomorrow will, in turn, depend on expectations of the day after. Prices are inexorably linked to expectations of the future, both near and far. If investors, or even people as a whole, believe that sometime in the future there is going to be high inflation, then those who hold dollars will be able to buy less with those dollars. The demand for dollars then--and now--will decrease, and hence (holding everything else constant) so will the value of the dollar at the present moment."

Thus in Professor Stiglitz's opinion, the value of the dollar is determined by laws of supply and demand. Demand, in turn, is determined by the return to holding a claim on the dollar, relative to holding claims on other assets. And the return on holding a claim on the dollar is estimated by expectations about the future. In normal times, this is how any other asset is also valued. However, in determining whether the market is overvaluing a company stock, or if a housing bubble is in the making, there are indicators based on 'intrinsic value' of the underlying asset that the experts rely on. For example, market participants simply do not value a company share based on expectations of earnings and price appreciation all the time. In times of uncertainty, the underlying assets of the company, namely plant, machinery, buildings, cash reserves, book value, managerial expertise, market share, technical know-how, etc, are examined. Likewise, in mortgage securitization markets, during boom times, trading is done on just the return on the mortgage security. However, when a bubble is forming, the bubble is investigated based on the valuation of the underlying asset also -- cost of construction of houses, house price to rent ratio, rise in house prices, etc. In stark contrast, for exchange rate valuations, the economics profession simply does not want to rely on any 'intrinsic value' of the claim on the currency.

One plausible indicator of 'intrinsic value' in currency valuations is the per capita GDP of the country that issues the currency. The Western liberal tradition holds all human lives to be equally valuable and equally worthy of opportunities provided under the law. So, there is a powerful motivation for holding per capita GDP as the measure of a currency's worth. Other plausible indicators for the intrinsic value are per capita GDP in purchasing power terms, human welfare index, law and order, financial wealth per capita, etc. Yet, the economics profession makes such a hue and cry that China's currency is under-valued, as if the future of civilization depends on it. China has, in fact, followed the ratio of per capita GDP (in dollar terms) between America and China as the guideline for 'regulating' the dollar-yuan exchange rate. The economics profession brings a great sense of purpose in avoiding any discussion about 'intrinsic value' in exchange rate valuations. It is not by coincidence that exchange rate markets are much more volatile than domestic markets. This extra volatility is an important mechanism by which an empire transmits great destruction of wealth from its center to the rest of the world. In contrast to liberal principles, an empire does not believe that all human lives are equal. The people of the empire are of far greater importance than the rest. Historically, empires have shown strong predilection to annihilate, enslave or colonize the rest of the world.

Thus Professor Stiglitz's efforts to replace the dollar with the IMF's SDR aims to redress some of the injustices mentioned above. However, introducing trillions of dollars worth of the IMF's SDRs is quite dangerous. First of all, different parts of the world are growing at vastly different rates; the value of trade activity fluctuates heavily with the prices of commodities; political environments keep changing all the time. How is the IMF going to decide how to vary its allocation of SDRs to the member countries according to the rapid economic changes happening around the world? Secondly, the IMF as an institution is run by bureaucrats. What is to prevent the influence of vested interests in the administration of these SDRs, worth billions of dollars? Thirdly, what if member countries get into disputes over the value of SDRs? Countries going to war over balance of payment issues are not unknown in history. Fourthly, does the IMF have the resources to prevent counterfeiting of the SDRs? Moreover, assuming that the paradigm shift away from economics does take place soon enough, then it seems quite possible that the US economy could achieve a robust recovery. That would solve the problems of high unemployment, depreciated dollar and 'new normal' growth rather quickly. In that case, the US dollar would regain its importance as the main global reserve currency.

We suggest a method for tackling unemployment effectively: with a new President in office, many regions of the rest of the world have become far safer for Americans to live and work in. Consequently, the American government could negotiate treaties that would ensure the safety of Americans working abroad. Millions of Americans could be employed abroad, for example, as teachers of the English language, sports coaches, political and media consultants, skilled factory workers, mid-career managers, hi-tech engineers, fashion designers, company executives, and so on. By enlisting the forces of globalization in its favor, America can bring powerful downward pressures on the unemployment rate which has been forecast to remain high at 10% for at least the next two or three years. Especially the manufacturing industry which has been taking massive job losses can send its skilled workers to factories abroad. In these ways, tens of millions of Americans can find employment. This is a far cheaper approach than spending trillions of dollars to resuscitate entire industries within America. Once the unemployment problem is solved, there is no doubt that hi-tech, green energy and health care industries could drive robust growth.

IV. Main Cause of the Financial Crisis

Of the total world population of 6.7 billion, less than 1.3 billion resides in the advanced countries (US, Canada, Europe, Oceania). With the end of the Cold War, the process of globalization brought billions of people from Asia, Latin America and Africa into the workforce of an increasingly connected global economy. This sudden inflow of labor put strong downward pressures on the cost of labor in the advanced countries. On the other hand, ever since the end of the Second World War or even much earlier, the financial capital of the world has been largely concentrated in the advanced countries. The developing countries hardly have any accumulation of capital. They do not have any social security system. Their pension systems are very rudimentary, being nothing more than remnants of the colonial era. Only through trade surpluses could they ever have managed to build any reserves. So, the advanced countries have a strong comparative advantage in the global supply of financial capital.

Thus the growth driver for the advanced countries would be the interest that they can charge from the developing countries for lending out their finance capital. In addition, the advanced countries could employ their lead in technological know-how as a source of economic growth by acting as knowledge-providers for globalization. Since most of the financial capital of the world is accumulated in the advanced countries, the central banks of these countries have powerful influences on the global interest rates on financial capital. By following a policy that aims to keep global interest rates high, the Fed could enable American financial companies to make a lot of money in interest charges. Instead, uncle Ben follows the bizarre policy of keeping domestic interest rate indefinitely at zero in ever-hopeful prayer of realizing growth in the domestic economy, while unemployment stays high. Moreover, rather than enable the already existing accumulated capital of America to generate growth opportunities, uncle Ben is flooding the economy with newly printed money.

The total value of the financial wealth of America has ranged between 45 and 65 trillion dollars during the 2000s. Out of this, total securitization (residential and commercial mortgages, credit card, auto-loans, student-loans, business loans, etc) has ranged between 10 to 30 trillion dollars. The gross US issuance of agency MBS alone during the period 2001-05 totaled more than 6.5 trillion dollars (http://en.wikipedia.org/wiki/Mortgage-backed_security). Thus the accumulated capital of America had been engaged in rapidly turning America's fixed assets into highly liquid financial assets through the process of securitization. In contrast, US current account deficit has only ranged from 400 to 800 billion dollars per annum during 2004-07, even less during earlier periods. Thus the main cause of the financial crisis is the excessive speed of the process of securitization. Because America's own accumulated capital had been invested in the highly lucrative process of securitization, there was a vacuum -- a need for capital to finance America's fiscal deficits. This need was filled by the Asian countries' purchase of treasuries (primarily China) to shore up their own foreign currency reserves.

Why do some developing countries like China hold massive foreign currency reserves ($2 trillion currently)? As mentioned above, the advanced countries hold the predominant share of the world's financial capital. In the 1990s, they had invested vast sums of this money in the fast growing economies in East Asia, both in fixed income as well as risky securities. Due to the rapid growth of the East Asian countries, the investments accumulated profits very fast. However, these Asian economies were not mature enough to absorb all the trillions of dollars of capital waiting to be invested. So, they showed signs of overheating. Meanwhile, starting from the mid-90s, the tech boom had taken hold in earnest in the US. So, all the capital invested in the Asian countries had to leave at once. When the accumulation of profits was also taken into account, much more dollars had to go back from the Asian countries than the amounts that came in. Consequently the East Asian countries experienced currency crises and defaults on their debt. It is to avoid the recurrence of this problem of sudden flight of foreign investments that the developing countries are accumulating large foreign currency reserves.

The current generation of leading economic policymakers, which includes Professors Paul Krugman, Barry Eichengreen, Kenneth Rogoff, Maurice Obstefeld, Ben Bernanke, Bradford DeLong, Martin Feldstein and Larry Summers, have grown up learning exclusively the type of economics that is useful in the administration of an empire. They believe that the permanent treasures of the empire are safely locked up in its center. Their job, according to them, is to simply conduct economic interactions with the rest of the world using the 'marginal resources' of the empire. It is for this reason that they advocate strongly that America's current account deficit should be redressed through the depreciation of the dollar. They would not want to take the total accumulated capital of America into consideration. They have also come to believe, especially through the works of Professor Eichengreen, that maintaining a strong dollar had been a major cause of the Great Depression. Hence they would like to get the current value of the dollar depreciated at the first opportunity.

Unfortunately, they don't realize that during the Great Depression there was hardly any accumulated capital in the whole world. Whereas today the 45 to 65 trillion dollars of financial wealth inside America would lose value if the dollar is depreciated. This would be reflected directly in the standard of living of Americans in the coming years. Moreover, with the massive destruction of wealth in the stock markets and the real estates, it is no longer possible to conduct the affairs of the empire 'at the margin'. It is also not possible to transmit trillions of dollars of losses to the rest of the world through temporary exchange rate volatility. These high risk games are not without consequences. The rest of the world has seen this movie before. They know how to make sure that the much larger accumulated capital inside America would take a big hit too.

"I am often asked why economies get themselves into such a bind again and again throughout economic history. Unfortunately, as Reinhart and I document empirically for hundreds of financial crises, covering 66 countries and eight centuries, the answer is all too simple: arrogance and ignorance." -Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

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Sorry Prof...

You're busted.

-the answer is an all too simple trick... deceptive and engineered.