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The Global Meltdown: Financialisation, Dollar Hegemony and the Sub-prime Market Collapse

An exploration of the roots of the current credit crisis in the process of financialisation, where profit-making occurs increasingly through financial channels rather than through trade and commodity production. This process and the explosion of private financial flows globally helped the United States preserve and establish its pivotal place at the centre of the international financial markets after the collapse of the Bretton Woods arrangements in 1973. It argues that the mechanisms that helped sustain growing global imbalances and preserve the role of the dollar as international money are under threat in the current crisis.

DOLLAR HEGEMONY AND THE CRISIS

The Global Meltdown: Financialisation, Dollar Hegemony and the Sub-prime Market Collapse

Ramaa Vasudevan

An exploration of the roots of the current credit crisis in the process of financialisation, where profit-making occurs increasingly through financial channels rather than through trade and commodity production. This process and the explosion of private financial flows globally helped the United States preserve and establish its pivotal place at the centre of the international financial markets after the collapse of the Bretton Woods arrangements in 1973. It argues that the mechanisms that helped sustain growing global imbalances and preserve the role of the dollar as international money are under threat in the current crisis.

Ramaa Vasudevan (Ramaa.Vasudevan@colostate.edu) is with the D epartment of Economics, Colorado State University, Colorado, US.

Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.

– Alan Greenspan, former Chairman of the US Federal Reserve, to the House Committee on Oversight and Government Reform.

T
he unfolding financial crisis has laid bare the flaws of an economic model driven by the proliferation of finance. It also reveals the vulnerability of an international financial system based on the growing debt of the US. For years, the global economy has been fuelled by US consumption and financed by growing US debt. The global appetite for dollars was sustained by the privileged role of the dollar as international money. The credit crisis has brought into stark relief the critical role of the dollar as international money.

In this paper I explore the roots of the credit crisis in the process of financialisation: the “pattern of accumulation in which profitmaking occurs increasingly through financial channels rather than through trade and commodity production” (Krippner 2005). This process of financialisation and the explosion of private financial flows globally helped the US preserve and establish its pivotal place at the centre of the international financial markets after the collapse of the Bretton Woods arrangements in 1973. The growing deficit of the US reflects its role as the banker to the world. I argue that the mechanisms that helped sustain growing global imbalances and preserve the role of the dollar as international money are under threat in the current crisis.1

The Unravelling of the Shadow Banking System

The unwinding of financial markets began with the collapse of the sub-prime mortgage market as the housing bubble lost steam. At stake in this unravelling was the model of bank operations which allowed banks to earn profits by managing “originating loans” in unregulated off-balance sheets structures, by prepackaging these into new securities – “the originate and distribute model” of asset securitisation. The complex and opaque debt i nstruments (like collateralised debt obligations or structured products) created by this process of slicing and dicing risk were supposed to disperse risk across capital investors. In reality, they helped obscure the actual sources of exposures and losses in the markets. With a pervasive mispricing of risk, the bust, when it came, spread like contagion.

The crisis spread through the shadow banking system that had been built on the shaky edifice of these sub-prime loans. This shadow system was fostered by broker-dealers, investment banks, hedge funds, private equity groups, structured investment

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Chart 1: Financial Assets and Debt in United States (Ratio of GDP)

2 4 6 8 10 Financial Assets Debt

0

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Source: US Federal Reserve.

v ehicles (SIVs) and conduits, money market funds and non-bank mortgage lenders which thrived on the huge incomes generated by the securitisation of loans (Kregel 2008). Lending in a context where banks no longer hold loans on their books depends on the willingness of capital markets to buy these securitised loans. Credit markets became “disintermediated”, that is instead of banks acting as intermediaries between savers and borrowers, the capital markets took over. The investors driving this process took on massive amounts of debt (at about 30 times their asset base), were much more highly leveraged than banks and were vulnerable to the risk of a self-fulfilling and destructive run on their liquid liabilities.

When the bottom fell out of the market for asset-backed securities it left a large gaping hole in balance sheets of the financial institutions. As these institutions began selling off “toxic” assets in a process of deleveraging to restore their balance sheets, they set off a downward spiral in prices and a drying up of credit, s ignalling what George Magnus, senior economic advisor at UBS, dubbed a “Minsky moment” (Whalen 2007).

Hyman Minsky (1975), while putting forward the financial instability hypothesis, had pointed to the endogenous generation of financial fragility within the capitalist financial structure. P eriods of prosperity and high returns lull investors into taking on riskier positions and greater debt. As investors take on increasing amounts of debt to finance their positions, the financial system becomes more unstable and then lenders grow cautious and cut off funds, precipitating a systemic economic contraction. Marx (1977: 235) had also argued that capitalism’s propensity to financial crisis arises “where the ever-lengthening chain of payments, and an artificial system of settling them, has been fully developed”. Financialisation, which developed as a powerful force shaping the structure of the US economy over the past three d ecades, bred such an artificial chain of payments.

Deregulation and a low interest rate regime put in place under US Federal Reserve Chairman Alan Greenspan (1987-2006) were conducive to the underpricing of risk and the growth of the shadow banking system. But even beyond the proximate causes for the profligate binge of the last decade, the crisis is rooted in the realignment of social forces after the stagflation of the 1970s (Dumenil and Levy 2004; Crotty 2008). The structural change that paved the way for a new gilded age was heralded by an

194 i nterest rate hike instituted by Federal Reserve Chairman Paul Volcker (1979-1987) in 1979 – a pivotal moment paving the way for the coup of finance. The clampdown on inflation opened opportunities for innovative “non-banking financing techniques” and the pursuit of fee commission income instead of traditional deposit banking. The successive easing of financial regulations in the US through the 1980s and 1990s culminating in the GrammLeach-Bliley Bank Reform Act, 1999 (that brought to an end the legal separation of commercial banking and investment functions in financial institutions) gradually dismantled the regulatory structure that had been put in place in response to the Great Depression with the Glass-Steagall Act of 1933.

Financialisation thus emerged as a powerful force shaping the structure of the US economy. Financial assets were less than five times the size of the US gross domestic product (GDP) in 1980, but over 10 times as large in 2007. US credit market debt rose from about 1.6 times larger than GDP in 1973 to over 3.5 times GDP by 2007 (see Chart 1). The resurgence of finance also paved the way for the extraordinary enrichment of a few while the stagnation of wages and employment squeezed the incomes of the working class. The top 1% of the population received nearly 24% of the national after-tax income in 2006 – a level that was last witnessed during the gilded age that preceded the crash of 1929 – more than double its 7.5% share in 1979 (Saez 2008).2 Both the level of debt and the extraordinary share of the richest 1% of the population of the US parallel those witnessed during the gilded age that was a prelude to the Crash of 1929. At that time, the share of debt was three times GDP and the richest 1% enjoyed nearly 23% of the income.

Chart 2: Current Account Balances of the US and Developing Countries ($ billion)

600

-800 -600 -400 -200 0 200 400 1973 1978 1983 1988 1993 1998 2003 US current account balance Developing country current account balance

-1000

But the crisis is more than a crisis of the gilded age (Henwood 2008). It is a crisis of the international financial system that is based on the hegemonic role of the dollar. Financialisation over the past three decades has bred an artificial chain of payments. The global shocks sparked by the collapse of the shadow banking system reflect the growing integration of financial markets internationally – the chain of payments has spread globally. Minsky (2008) argues that there is a “symbiotic relation between the globalisation of the world financial structure and the securitisation of financial instruments”. The growing global trade in these new instruments became the vehicle of recycling surpluses. Borrowers from emerging markets and industrialised countries alike have been tapping the market, with the former accounting for

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Chart 3: Private Capital Flows to the US and to Emerging Markets ($ billion)

0 200 400 600 800 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Net private flows to US Private flows to developing markets

-200

-400

16% of business (Gadanecz 2004). About 20% of the mortgagebacked securities and debt of Fannie and Freddie are owned by foreign investors. More than $1 trillion from around the globe were swallowed up by the US sub-prime markets (Rogoff and R einhart 2008).

Global Imbalances and the Dollar

The dismantling of the Bretton Woods system following the closing of the gold window in 1971 paved the way for increased private financial flows in the international monetary system. These private capital flows came to play a central role in the preservation of the dollar’s role as international money in the post-Bretton Woods period (Vasudevan 2008a; 2009b). The agenda of financial liberalisation was aggressively pursued through International Monetary Fund (IMF) rescue packages in the 1980s and 1990s, subjecting emerging markets to the dominance of US finance and dollar hegemony. The trend towards deregulation in the US was matched by moves to liberate economies in Latin America from the yoke of “financial repression”. This fuelled i ncreasing flows of private capital to the developing countries in the periphery.

There have been three broad waves of large private capital inflows to the periphery since 1970 (Chart 2, p 194). The first began with the burgeoning of eurodollar markets in the 1960s and the 1970s and the aggressive pursuit of sovereign debt until the debt crisis of the 1980s. The second followed the push to financialisation through the securitisation of debt and the liberalisation of financial markets in the periphery until the Asian crisis in 1997. Most recently, since 2002, there has been a fresh wave of inflows to emerging markets. Comparing the phases of private flows to emerging markets with that of net flows to the US reveals an interesting counter-cyclical pattern until 2002 (Vasudevan 2009b). The surge of capital flows to emerging markets was also a period when there was a net outflow from the US. As the surge comes to an end in the wake of capital flight and contagion effects (the Latin American debt crisis in 1982 and the Asian crisis in 1997), private capital flows are sucked back into the US. While the US has not been immune to episodes of financial fragility in this p eriod – the savings and loan crisis in the 1980s, the collapse of Long-Term Capital Management (LTCM) in 1998 or the dotcom bust at the turn of the century – the outflow from the US in this phase of the cycle did not precipitate a financial crisis of the same

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magnitude. This counter-cyclical pattern of private capital flows to emerging markets, which has been a critical aspect of the financing of the US deficit, began to lose traction in the wake of the sub-prime crisis.3

Global imbalances continued to exacerbate through the current decade with the US absorbing 65% of global capital imports compared to 34% in 1995 (Chart 3). The new development was that developing countries turned from being current account deficit countries as in the 1980s and 1990s by acquiring increasing surpluses after 2002. By 2006, developing countries were financing more than 70% of US current account deficits (Chart 3). At the same time, after the experience of the Asian crisis, emerging markets perceived the need to increase precautionary holdings of foreign reserves to insulate their economies from the i mpact of capital flight. Reserve holdings of developing countries rose to about 37% of GDP in 2006. About 60% of these reserves are held as dollars. The periphery is no longer vulnerable to capital flight and speculative attacks to the same extent it had been in previous decades.

At the same time, the counter-cyclical pattern that characterised the earlier two waves was no longer in evidence in the run-up to the sub-prime crisis. Capital flows to both emerging markets and to the US rose after 2002. This suggests the emergence of a pattern of recycling that draws from the surplus countries in the periphery and channels these capital flows increasingly towards

Chart 4: Acquisition of US Assets by Foreigners ($ billion)

2002:I2002:III2003:I2003:III2004:I2004:III2005:I2005:III2006:I2006:III2007:I2007:III2008:I2008:III/p/ 8000 6000 4000 2000 0 –2000

–4000

Officially held US assets

Privately held US assets

US liabilities reported by US banks, not included elsewhere

US liabilities to unaffiliated foreigners reported by US nonbanking concerns

US securities other than US Treasury securities

US Treasury securities Direct investment

Inflows are positive. Source: US Bureau of Economic Analysis.

US markets – including the sub-prime markets comprising the least creditworthy and poorest borrowers in the country (Rogoff and Reinhart 2008).

The collapse of the sub-prime market then reflects mechanisms analogous to those that led to the debt crisis in the 1980s and the Asian meltdown in the 1990s. The unravelling of the shadow banking system in 2007 was exacerbated by the ebbing of private capital flows to the US. Private capital inflows to the US dropped

DOLLAR HEGEMONY AND THE CRISIS

significantly in 2007 (Chart 2). The sharpest decline was in the purchases of non-Treasury US securities (including agency bonds) and bank liabilities as foreign investors began to pull out of these markets (Chart 4, p 195). Capital began to retreat from these US markets precipitating a sale of dollar assets. The dollar plunged sharply following five years of decline in which it lost about 25% of its value against a basket of currencies.

In the initial stages of the sub-prime crisis, the impact was largely contained within the advanced capitalist core of the US, UK and Europe. Emerging markets were relatively less exposed to the market for mortgage-backed securities. Even as capital flowed out of the US, capital flows to emerging markets continued to rise, through 2007 by about 40% from its 2006 level. Commodity e xporters, in particular, were thriving on the basis of the boom in prices as the unwinding of the shadow banking system sent i nvestors scrambling for returns to the commodity futures markets.4

Global Safe Haven

Events in the first two weeks of September 2008 – the rescue of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the fire sale of Merrill Lynch and the rescue of AIG, one of the largest insurance groups – heralded the complete freezing of credit markets. Financial institutions hoarded cash and demanded ever-widening premiums before lending to one another. The commercial paper market that served as a source of shortterm funding for the corporate sector dried up. The contagion e ffects of the collapse of the sub-prime market in the US spread to Europe and then led to capital flight from eastern Europe, Latin America and Asia. The crisis of confidence that has seized financial markets has led to a flight to “safety”. At a time when markets do not have any confidence in the ability of debtors to honour their debts and have frozen lending, US Treasury bills seem the safest bet. Even as the credit machinery remained jammed and the US Treasury and the Federal Reserve were floundering through different incarnations of the bank bailout plan, the global demand for Treasury bills was growing. At the same time, there has been a cutback in foreign asset holdings, as US investors were forced to deal with the gaping holes in their balance sheets since September 2007. In the last quarter of 2008, there was a net inflow of capital as foreign assets were liquidated and capital returned to the US (Chart 5).

The dollar rose against a host of currencies (excluding the yen) as US investors repatriated funds and speculators turned increasingly averse to risk, launching a fire sale of a wide range higheryielding assets (deleveraging) amid the growing turmoil. The uncertain outlook of the advanced capitalist countries of the core with the spreading deflationary contagion spilled over to emerging economies. With the pricking of the commodity boom, as i nvestors fled from all forms of risk, and the further impact of r ecessionary forces that had gripped the US, UK and Europe on developing country exports, the accumulating surpluses and r eserves with emerging markets were eroded. Add to this the persistence of fragility in the financial markets and you have i nvestors pulling out of emerging markets and seeking the safety of the dollar.

Though capital began flowing back to the US after September 2008, outflows from emerging markets’ bond and equity funds reached $29.5 billion between June and September 2008 (the highest level since at least 1995). Capital flows into emerging markets could potentially plummet from around $750 billion during 2007-08 to $550 billion or so in 2009 (Jen and Andrepoulos 2008). Capital flight from the emerging markets has precipitated a fall in emerging market currencies by as much as 50%, fuelling currency crises in Iceland, Hungary, Ukraine and South Korea.

Chart 5: Acquisitions by US of Foreign Assets ($ billion)

300

200

100

0

-100

-200

-300

-400

-500

-600 US official assets (other than reserves)

US private assets US claims reported by US banks, not included elsewhere US claims on unaffiliated foreigners reported by US non-banking concerns Foreign securities Direct investment

Outflows are negative. Source: US Bureau of Economic Analysis

As the crisis spread to developing countries precipitating balance of payments problems, the US extended swap lines to South Korea, Singapore, Brazil and Mexico to the tune of $30 billion each to ease the dollar shortage. The IMF also stepped in for the first time since the meltdown began with bailout programmes to support emerging countries, including Iceland, Ukraine, Hungary and Pakistan. It also announced a new liquidity facility (SLF) in which a select few countries (who were deemed to be “good performers”) seeking short-term assistance of three months duration, could borrow up to five times their quota, with practically no strings. This select circle would again likely include Mexico, Brazil, Singapore and South Korea.

Eastern Europe and Russia, however, face more stringent conditionalities. Eastern Europe is particularly vulnerable (IMF 2008). With current account deficits approaching 7% of GDP and private capital inflows amounting to 11% of GDP in 2007, a level that exceeds that of developing countries in Asia and Latin A merica (IMF 2008), it is not surprising that a financial crisis erupted in eastern Europe. However, this region has a higher p roportion of euro denominated debt (39%) and a lower proportion of dollar denominated debt (49%) compared with other emerging market economies in 2006. For developing countries as a whole, the share of dollar denominated debt was 62% while

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euro denominated debt was only 18%. The crisis may propel these countries towards seeking membership in the European Union. Euroisation is being proposed as a panacea to Iceland and Hungary.

This could signal a strengthening of the euro challenge to the dollar. The obstacle to the euro’s path towards hegemony is twofold. While the European Central Bank (ECB) has provided s ignificant amounts of liquidity to the euro area financial systems, the region is also facing a significant recession and the difficulty of coordinating a euro-wide stimulus package poses a significant problem. The no bailout clause in the Maastricht treaty prevents the better performing countries from rescuing the more vulnerable member countries, compounding these constraints. At the same time, the varying capacity of member countries to pursue independent rescue plans has stoked sharp divergences in government bond yields that are subjecting the cohesion of the European Union to a severe test. The recent downgrades of the credit ratings of Spain, Portugal, Greece and Ireland sparked a drop in the euro along with rising spreads on national bonds (higher i nterest rates reflecting higher perceptions of risk).

While the market for longer term US government bonds has witnessed a tightening, the short-term Treasury bill market has been resilient. The large and growing demand for short-term US debt has driven down yields on short-term Treasury bills. This provides the US greater leeway in financing its deficits. The European Union is denied similar recourse since there is no comparable market for sovereign debt at the level of the Union. Every member country issues its own debt. In the absence of a provision for a joint issue of a common European bond or a common European treasury bill, the virtual monopoly of the US with its deep and liquid Treasury markets remains unchallenged.

As a result, paradoxically liquidity in the US markets remains at all-time highs and money market rates little more than zero. The real problem is despite all this liquidity the credit machinery has refused to restart as banks and financial institutions wary of lending are simply stockpiling excess reserves. As investors withdrew from all forms of risk, US Treasury bills became the safe haven. In Marx’s analysis, a credit crisis manifests the breakdown of “the chain of payments” that constitutes the financial system. This breakdown creates a frenzied clamour for “money” as the safest and most liquid asset. This collapse of the credit mechanism to its monetary roots has been a classic sign of a monetary crisis in the history of capitalism.5 The US Federal Reserve is s eeking ways of trying to coax the financial system to begin lending again.

Bailing Out: At the Centre of the Storm

The US Federal Reserve lies at the heart of the bloated international financial system. The financial system has however grown much beyond commercial deposit banking and the regulatory constraints of the Federal Reserve. Part of the Federal R eserve’s response to the credit crisis has been an attempt to come to terms with the new financial landscape. This crisis is not a conventional bank run and the targets have not been banks but the securities that have replaced them as the prime generators of credit in the new financial system. The Federal Reserve has been

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groping its way towards becoming a market maker of last resort

– buying up the toxic assets of the shadow banking system that cannot find a price or a market in these turbulent times (Buiter and Sibert 2007).6 The Troubled Assets Relief Program (TARP) proposed by Treasury Secretary Henry Paulson essentially proposed setting up a $700 billion fund to buy up toxic assets. The deep aversion of the neoliberal state to direct takeovers that would recognise the losses and nationalise the battered institutions means that the state has resisted rescues in the form of d irect injection of equity into the failed banks. The acknowledgement that the plan to buy up the toxic assets was a non-starter came much after the approach had actually morphed into a weak recapitalisation plan.7

Alongside these measures that sought to revive lending by pumping liquidity into the financial system, the Federal Reserve continued to cut the target interest rates to coax banks into lending. The Federal Reserve normally regulates the volume of credit in the economy by calibrating the Federal Fund rate (the rate at which banks lend surplus funds to one another) to expand or contract credit flows. But the implosion of the financial system has greatly undermined the efficacy of traditional policy tools. The Federal Reserve has continued to reduce its target i nterest rates but there has been virtually no impact on kick starting lending.

Credit has refused to flow and investors have remained wary of lending to anyone other than governments. This slashing of rates to near zero levels was in a sense an acknowledgement that the Federal Reserve had to shift gears and would resort to a more “unconventional” monetary strategy. The Federal Reserve has an $800 billion balance sheet to operate in a $50 trillion credit market. What it has begun to do is expand the balance sheet in the hope that this would allow it to continue to affect rates across the financial markets and calibrate credit volume more effectively. The strategy for arresting the downward spiral of asset prices is to foment inflation.8 Restoring credit may be the Federal Reserve’s primary aim, but its measures are also an attempt to curb the d eflationary spiral and reassert control over the collapsing markets by intervening across a wider range of asset markets.

An important plank of this strategy is quantitative easing – the injection of short-term liquidity into the financial system by b uying Treasuries (in exchange for cash reserves) and holding them on the central bank’s balance sheet.9 Unlike Japan, which also pumped up its balance sheet (between 2001 and 2006) to r evive its economy, the Federal Reserve policy under Ben Bernanke is not restricted to the purchase of government securities but seeks to take a wider range of illiquid financial assets out of the system. It has now begun to buy private short-term and long-term securities with lower credit rating, including commercial paper, short-term assets issued by banks and companies against a v ariety of loans and longer-term assets such as bonds issued by Fannie Mae and Freddie Mac. It has also announced the possibility of the direct purchase of long-term US Treasury bonds. It is trying to bring down longer-term interest rates – what is called flattening the yield curve – to get bond finance and securitised credit flowing.10

DOLLAR HEGEMONY AND THE CRISIS

One implication is that the Federal Reserve’s balance sheet is set to expand almost without limit. Its balance sheet rose from $874 billion in August 2007 to $900 billion before the fall of L ehman. Since then it has surged to about $2.2 trillion and is set to soar to nearly $3 trillion in the current year. The share of Treasuries in this ballooning balance sheet declined from 90% to 21% as the Federal Reserve acquired more unconventional assets, i ncluding mortgage-backed securities and commercial paper, u nder its liquidity programmes like the Term Auction Facilities.

The ballooning of the Federal Reserve’s balance sheet should in the normal course generate ripple effects through the financial system and lead to a bloated supply of monetary assets – an i ncrease in the money supply. But the seizure of the credit markets means that this bloated monetary base is not translating into an inflationary pressure but being hoarded in the form of excess reserves posted by the banks at the Federal Reserve. From normal levels of around $7 billion, the reserves deposited are currently pushing $1 trillion and excess reserves are likely to climb to roughly 10% of total bank assets.

The problem is that the credit crisis has resulted in a collapse of the paper edifice of the bloated financial system to its fundamental monetary roots. The breakdown in the financial system has prompted investors and banks to seek the safety of monetary assets. The low-yielding Treasury bills are indistinguishable from money in a context where money is the debt of the state. The injection of liquidity is not enough to revive credit flows since what we are witnessing is an insatiable demand for money. The flows into the Federal Reserve funds market have dwindled since banks have a greater incentive to stockpile reserves rather than lend to other banks.

At the same time the Federal Reserve is taking on even more credit risk while purchasing illiquid private assets. If the credit easing works, and the economy picks up and inflation returns, the Federal Reserve will come under pressure to sell assets into the market, to mop up the excess money it has created in fighting deflation – a pressure that would be exacerbated in the face of burgeoning public debt. In a sense, this policy is an invitation to investors to bet the policy will fail and the slump will persist so that interest rates remain on the floor. By reassuring investors that it will hold overnight lending rates at near zero for the foreseeable future, the Federal Reserve has essentially given traders a cost-free way to borrow overnight and invest the proceeds in higher yielding assets. The implicit hope is that the increased borrowing will be used to purchase higher-risk financial assets and restart the securities markets inside the US. In other words, foster another bubble. Already the financial press is warning of the possibilities of a Treasuries bubble.11 Japan’s pursuit of quantitative easing had stoked a bond bubble.

There is the further danger that this policy would propel a flight of currency from dollar markets. Japan’s deployment of quantitative easing fostered the persistent depreciation of the yen as cheap yen loans were transferred out into higher yielding assets in high interest overvalued currency markets – what is known as carry trade. However, in the case of a country with a large deficit like the US, one would normally expect such a c urrency flight to precipitate a currency crisis.

The Future of the Dollar

But the US despite being a debtor country is in a unique position. Right now its Treasuries are a globally sought safe haven but once confidence is restored to the credit markets, funds would seek out higher returns and flee the markets. Already the announcement of the zero-interest rate policy and quantitative easing set off a plunge of the dollar after four months in which the US currency recorded its biggest gains since 2002.12

The market for Treasuries is likely to face a glut of bills in search of buyers as the government’s need for finance continues to expand. The increasing debt overhang may also undermine confidence in US Treasuries. Given that foreign holdings represent a significant proportion of the stockholdings of Treasuries, the collapse in Treasuries prices would manifest itself in a collapse of the US dollar as inflation soars and foreign demand for Treasuries flags. As of now, the demand for US Treasuries seems to be holding, but the underlying movements are less benign. I nitially, the fall in demand for risky US corporate assets and agency bonds was offset by a rise in demand for both short-term and long-term Treasuries. In November 2008, the demand for long-term Treasuries fell, with a net outflow of $21.7 billion. So far, the recent drop off in the demand for long-term Treasuries is being offset by the shift to short-term Treasuries by both central banks and private investors.

The biggest holder of US Treasuries is now China which has finally outpaced Japan (which till 2007 was the largest foreign holder of US Treasury securities). By November 2008, China’s holdings of Treasury securities had reached $681 billion (22% of total foreign holdings) compared to Japan’s holdings of $577 b illion. China has in a sense been locked into dollar holdings b ecause selling off its mountain of Treasuries would precipitate a crash of the dollar and a collapse of its (dollar) asset base. This “balance of financial terror” underlay the arrangement where China stockpiled dollar reserves to pursue its strategy of export-led growth (Summers 2004). The manner in which C hinese surpluses are deployed in any new Bretton Woods type negotiations would be critical to the attempt to restore the i nternational system under dollar hegemony. If these reserves are channelled through private markets, that could help r estore the US to the centre of a growing web of private capital flows and the dollar to its hegemonic position along with the r esurgence of finance.

At the same time, the global recessionary forces that have been let loose along with the credit crisis have sparked a protectionist backlash and a clamour for greater regulation and supervision of international flows. The constriction of international private c apital flows would undermine the privileged position of the US at the heart of the international financial system. The deep and liquid market for government bonds does postpone the moment of reckoning since the US can continue to finance its deficits through Treasury issuance. A slowdown in China’s export-led boom, with exports dropping by about 17% in 2007, would however mean a flagging demand for US Treasuries. Further, the ballooning of public debt (as public dissaving outpaces private dissaving in the US) could also spark a collapse of the dollar and the market for Treasuries.

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The twin challenges for the US imperial agenda are a restora-counter flows of private capital into the US offset the shortfall in tion of the domestic economy and a refashioning of the battered foreign demand for Treasuries. Rising protectionism and a global financial architecture to preserve the hegemony of the g lobal refocusing on d omestic stimulus plans are not conducive d ollar. Without a comprehensive fiscal stimulus plan, the policy to such an agenda. of quantitative easing is unlikely to revive investment spending The current conjuncture also opens the possibility of far-reaching as the thirst for liquidity just consigns the new funds into hoards structural reforms of the international financial architecture that of cash reserves. The very different passages of the fiscal would allow developing countries greater autonomy and greater s timulus bill and the bank bailout package through the US Con-protection from the dominance of speculative financial flows. gress and Senate suggest that real constraints on the stimulus While the proposed expansion of the regional swap lines in Asia are political rather than financial. However, to be able to pursue under the Chiang Mai initiative to a $120 billion emergency pool the fiscal stimulus while ignoring the external constraint of is a step in this direction it is not clear whether the full potential trade deficits, the US would have to preserve the international of such a reform will be harnessed by developing countries. The role of the dollar along with a re-establishment of the interna-crisis is in that sense also an opportunity for refashioning the tional line of credit that it enjoyed for the past three decades. global financial system in a manner that is more conducive to a Financing the external deficit would depend on establishing progressive developmental agenda.

Notes 8 This was the policy that Irving Fisher urged on International Monetary Fund (2008): “Global Finan-Franklin Roosevelt during the Great Depression cial Stability Report”, Washington DC.

1 This paper presents a more detailed exposition of (Kregel 2000). It was also the basis of the decision Jen, S and S Andrepoulos (2008): “Risks of a Sharp the argument made in Vasudevan (2009a).

to devalue the dollar by raising the price of gold. Reduction in Capital Flows to Emerging Markets”, 2 This group received 70 times as much in average Ben S Bernanke, who cut his professional teeth Global Economic Forum, Morgan Stanley, after-tax income as the bottom one-fifth of housestudying the Great Depression, argued “The de-29 September.

holds in 2005 – the widest such income gap on

valuation and the rapid increase in money supply

Kregel, J (2000): “Krugman on the Liquidity Trap: record, with data available back to 1979 when, the

it permitted ended the US deflation remarkably

Why Inflation Won’t Bring Recovery in Japan”, richest households made 23 times as much as the quickly” (Bernanke 2002).

Jerome Levy Economics Institute, Working Paper poorest households.

9 Ben S Bernanke in a speech at the National Press No 298.

3 The critical role of these counter-cyclical patterns

Club Luncheon, National Press Club, Washington

– (2008): “Minsky’s Cushions of Safety: Systemic in preserving dollar hegemony is explored in

DC on 18 February 2009 called the US Federal Re-

Risk and the Crisis in the US Subprime Mortgage V asudevan (2009b).

serve’s unconventional monetary approach policy

Market”, The Levy Economics Institute of Bard 4 The speculative actions of arbitragers, manipula

a policy of “credit easing” rather than quantita-

College, Public Policy Brief 93.

tors, hedgers, speculators, and index investors

tive easing, distinguishing it from the approach of

Krippner, G (2005): “The Financialisation of the US promoted the commodity bubble at a time when the Bank of Japan.

Economy”, Socio-Economic Review, 3(2).

speculators were seeking profitable investments

10 Operation Twist in the 1960s was a similar attempt

as the market for collateralised debt obligations Marx, K (1977): Capital Vol I (New York: Vintage

that sought to stem capital outflows. The operation,

crashed Wray (2008). Books).

which involved the purchase of long-term Treasury 5 Marx (1977: 235-36) has a remarkably prescient Minsky, H (1975): John Maynard Keynes (New York:

bonds and the sale of short-term Treasury bills, analysis of monetary crisis. Columbia University Press).

sought to attract short-term funds and strengthen “… Whenever there is a general and extensive dis-the US capital account by changing the term struc

– (2008): “Securitisation”, The Levy Economics turbance of this mechanism, no matter what its ture of interest rates, raising the short-term rate

Institute of Bard College Policy Note. cause, money becomes suddenly and immediately while keeping the long-term rate unchanged. The Rogoff, K and C Reinhart (2008): “Is the US Sub-prime transformed, from its merely ideal shape of mon-failure of this policy to curb the capital efflux Market Crisis So Different”, American Economics

ey of account, into hard cash … On the eve of the prompted the institution of capital controls. Review, 98, 2 (May). crisis, the bourgeois, with the self-sufficiency that 11 John Kemp, “Fed Unleashes Greatest Bubble of Saez, E (2008): “Striking It Richer: The Evolution of springs from intoxicating prosperity, declares All”, Reuters, 17 December 2008. http://www.re-Top Incomes in the United States”, University of money to be a vain imagination. Commodities uters.com/article/reutersComService4/ Berkeley, accessed on 5 January 2009, (http://

alone are money. But now the cry is everywhere: idUSTRE4BG3C920081217?sp=true www.econ.berkeley.edu/~saez/saez-UStopinmoney alone is a commodity! ... Hence, in such comes-2006prel.pdf).

12 John Kemp, “Fed Cut Sparks Dollar Dive”, Reuters,

events, the form under which money appears is of 18 December 2008. http://www.reuters.com/ar-Sherman, A and A Dine (2007): “New CBO Data Shows no importance. The money famine continues, t i c l e/ re u t er sCo mS er v i ce 4/ Inequality Continues to Widen”, Centre for Budget whether payments have to be made in gold or in idUSTRE4B44L720081218?sp=true Priorities, 23 January.

credit money such as bank-notes.”

Summers, L (2004): “The United States and the Global This analysis foreshadows Keynes’ discussion of Adjustment”, Third Annual Stavros S Niarchos the liquidity trap where investor confidence has References Lecture (Washington DC: Institute for Interbeen severely battered and the preference for

Bernanke, B (2002): “Deflation: Making Sure ‘It’ national Economics).

l iquidity is absolute.

Doesn’t Happen Here”, Remarks before the Vasudevan, R (2008a): “Finance, Imperialism and the 6 The market maker of last resort function can be N ational Economists Club, Washington DC, Hegemony of the Dollar”, invited article, Monthlyfulfilled in two ways. First, as a buyer of a wide

21 November. Review, April.

range of distressed private sector securities. Sec-Buiter, W and A Sibert (2007): “The Central Bank as – (2008b): “The Borrower of Last Resort: Internaond, by lending against a wide range of illiquid the Market Maker of Last Resort: From Lender of tional Adjustment and Liquidity in Historical Perprivate sector securities. Thus in March 2008, the Last Resort to Market Maker of Last Resort”, ac-spective, Journal of Economic Issues.

US central bank allowed dealers to use their noncessed 4 January 2008, (http://www.voxeu.org/ – (2009a): “The Credit Crisis: Is the International agency mortgage-backed securities for Treasuries

index.php?q=node/459). Role of the Dollar at Stake?” Monthly Review as collateral for loans of central bank cash (of up

Crotty, J (2008): “Structural Causes of the Global (forthcoming).

to a total of $200 billion) through the Term Securities Lending Facility (TSLF).

Financial Crisis: A Critical Assessment of the – (2009b): “The Dollar, Financialisation and the ‘New Financial Architecture’”, Political Economy Subprime Crisis”, Review of Radical Political 7 Paul Paulson while conceding that the approach

Research Institute. E conomy (forthcoming).

had to change towards a direct equity injection one since the TARP had failed in its remit of buy-

Dumenil, G and D Levy (2004): Capital Resurgent Whalen, C (2007): “The US Credit Crunch of 2007: A ing up distressed assets, testified, “I will never

(Cambridge: Harvard University Press). Minsky Moment”, Levy Economics Institute of apologise for changing an approach when the

Gadanecz (2004): “The Syndicated Loan Market: Bard College, Public Policy Brief 92. facts change”, New York Times, 12 November Structure, Development and Implications”, BIS Wray, R (2008): “The Commodity Bubble: Money 2008. The irony lies in the echo of Keynes’ famous Manager Capitalism and the Financialisation of

Quarterly Review, December, 75-89. remark, “When the facts change, I change my Henwood, D (2008): “Crisis of a Gilded Age”, Nation, Commodities”, Levy Economics Institute of Bard mind. What do you do, sir?” 24 September. College, Public Policy Brief 96.

Economic & Political Weekly

EPW
march 28, 2009 vol xliv no 13 199

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