Wednesday, August 19, 2015
High Inequality and Deflation 2015: Rigged Globalization
The above chart shows the massive cash hoarding undertaken in order to influence the price of exports from developing countries. While the crash of 2008 momentarily slowed the growth of world currency reserves, they promptly soared after mid-2009 as nations desperately sought to grow through exports at the expense of the price-competitiveness of other nations.
Of course, the best nation for consumption and imports is by far the USA so it is only natural that exporting nations seek to accumulate dollars to make their manufacturing sector more price competitive in dollar terms, as depicted above, showing about 2/3 of all reserves are held in dollar denominated instruments.
Today currency reserves amount to about $12 trillion--and thus represent a substantial use of the world's total capital. Essentially, developing nations face incentives to buy dollars in order to weaken their currency and strengthen the dollar because reserves subsidize the export sector of their economies. The US dollar is the ideal reserve currency because the market for dollar assets is deep and liquid.
In theory, and to some degree in practice, currency reserves serve a legitimate purpose for developing countries. Countries accumulating foreign currency reserves can use them to defend the value of their currency in the event their currency is subject to speculative attack or any financial crisis causes currency disruptions. By selling foreign currency reserves, such as dollars, they can restrict the supply of their own national currency and cause it increase in value relative to the dollar. It can be very important to defend the value of a national currency because the vast majority of international debt is denominated in dollars. This means that if a currency dives in value relative to the dollar debt burdens can increase often dramatically. As a result nations cannot allow the value of their currency to dive or public and private debt burdens can spiral out of control and a financial crisis may ensue.
Fine. But, economists have shown again and again that the degree of reserve accumulation cannot be explained by the need to defend a currency's value in time of crisis. Instead, they have identified 20 nations that clearly accumulate currency reserves to lower the cost of their exports to the US and other developed nations. This currency manipulation through constant accumulation of dollar reserves is highly costly to the global economy.
According to Maurice Obstfeld and Kenneth Rogoff the accumulation of currency reserves was "intimately connected" to the financial crisis because it allowed the US "to borrow cheaply abroad and thereby finance its unsustainable housing bubble." The stronger dollar meant lower cost exports, lower inflation and thus lower interest rates. The constant purchase of dollar denominated assets (no country holds actual currency as currency reserves opting instead for the safest and most liquid dollar-denominated assets) also lower interest rates in the US as well as the developed world. I explained this dynamic in detail in chapter 4 of Lawless Capitalism.
Today, this festering problem with our global economy appears to be spawning global deflation throughout emerging markets and even into China and Japan. Basically, by accumulating reserves central banks in exporting countries divert investment from their own economies in order to purchase low-yielding debt of developing countries. Over the long term this suppressed investments hobbles their growth.
Meanwhile, in the developed world, currency reserves mean more debt and fewer jobs as is evident (see chart above demonstrating the role of the Euro in reserves). In the US and the Eurozone, economists estimate that the entire output gap experienced since the financial crisis can be attributed to currency reserves. Experts estimate that the US alone has lost up to 5.8 million jobs.
Thus growing currency reserves are a powerful deflationary force.
As Nobel laureate Joesph Stiglitz stated in 2010: "the UN Commission of Experts on Reforms of the International Monetary and Financial System highlighted the ways in which the dollar reserve system contributed to global financial instability and a weak global economy. While many of its arguments were already well known—Triffin had noted that the reserve currency country got increasingly in debt as others’ held more of its IOU’s as part of their reserves,and Keynes had noted that the build-up of reserves by surplus countries led to weaknesses in global aggregate demand—the crisis gave them increased salience." Stiglitz also argues there is a remarkably "simple" solution to this issue--to expand the use of special drawing rights issued by the IMF. This would serve as a mechanism for broadening the burden of the reserve currency.
I extended this concept to argue in favor of a more aggressive investment approach for these reserves by creating a global development bank for currency reserves to fund infrastructure projects like schools, universities, water supplies, green energy platforms, and to actualize economic human rights.
Nevertheless, such common sense solutions have gained no traction in the wake of the financial crisis. Instead, as is evident in the chart above reserve accumulation has proceeded apace. Why?
High Inequality. When a small group controls massive wealth they can dictate law for their profit regardless of costs to society as a whole. This irrational model of globalization fattens transnational corporate profits--and by extension executive compensation. They produce cheap in China and sell cheap in the US because the dollar is the reserve currency. I formalized this basic point in American Corporate Governance Law and Globalization.
In sum, globalization has been hijacked and sabotaged by powerful interests in the US that profit from the deflationary forces unleashed by the constant accumulation of massive currency reserves.