The Proposed Iranian Oil Bourse
by Krassimir Petrov
I. Economics of Empires
A nation-state taxes its own citizens, while an empire taxes other nation-states. The history of empires, from Greek and Roman, to Ottoman and British, teaches that the economic foundation of every single empire is the taxation of other nations. The imperial ability to tax has always rested on a better and stronger economy, and as a consequence, a better and stronger military. One part of the subject taxes went to improve the living standards of the empire; the other part went to strengthen the military dominance necessary to enforce the collection of those taxes.
Historically, taxing the subject state has been in various forms—usually gold and silver, where those were considered money, but also slaves, soldiers, crops, cattle, or other agricultural and natural resources, whatever economic goods the empire demanded and the subject-state could deliver. Historically, imperial taxation has always been direct: the subject state handed over the economic goods directly to the empire.
For the first time in history, in the twentieth century, America was able to tax the world indirectly, through inflation. It did not enforce the direct payment of taxes like all of its predecessor empires did, but distributed instead its own fiat currency, the U.S. Dollar, to other nations in exchange for goods with the intended consequence of inflating and devaluing those dollars and paying back later each dollar with less economic goods—the difference capturing the U.S. imperial tax. Here is how this happened.
Early in the 20th century, the U.S. economy began to dominate the world economy. The U.S. dollar was tied to gold, so that the value of the dollar neither increased, nor decreased, but remained the same amount of gold. The Great Depression, with its preceding inflation from 1921 to 1929 and its subsequent ballooning government deficits, had substantially increased the amount of currency in circulation, and thus rendered the backing of U.S. dollars by gold impossible. This led Roosevelt to decouple the dollar from gold in 1932. Up to this point, the U.S. may have well dominated the world economy, but from an economic point of view, it was not an empire. The fixed value of the dollar did not allow the Americans to extract economic benefits from other countries by supplying them with dollars convertible to gold.
Economically, the American Empire was born with Bretton Woods in 1945. The U.S. dollar was not fully convertible to gold, but was made convertible to gold only to foreign governments. This established the dollar as the reserve currency of the world. It was possible, because during WWII, the United States had supplied its allies with provisions, demanding gold as payment, thus accumulating significant portion of the world’s gold. An Empire would not have been possible if, following the Bretton Woods arrangement, the dollar supply was kept limited and within the availability of gold, so as to fully exchange back dollars for gold. However, the guns-and-butter policy of the 1960’s was an imperial one: the dollar supply was relentlessly increased to finance Vietnam and LBJ’s Great Society. Most of those dollars were handed over to foreigners in exchange for economic goods, without the prospect of buying them back at the same value. The increase in dollar holdings of foreigners via persistent U.S. trade deficits was tantamount to a tax—the classical inflation tax that a country imposes on its own citizens, this time around an inflation tax that U.S. imposed on rest of the world.
When in 1970-1971 foreigners demanded payment for their dollars in gold, The U.S. Government defaulted on its payment on August 15, 1971. While the popular spin told the story of “severing the link between the dollar and gold”, in reality the denial to pay back in gold was an act of bankruptcy by the U.S. Government. Essentially, the U.S. declared itself an Empire. It had extracted an enormous amount of economic goods from the rest of the world, with no intention or ability to return those goods, and the world was powerless to respond— the world was taxed and it could not do anything about it.
From that point on, to sustain the American Empire and to continue to tax the rest of the world, the United States had to force the world to continue to accept ever-depreciating dollars in exchange for economic goods and to have the world hold more and more of those depreciating dollars. It had to give the world an economic reason to hold them, and that reason was oil.
In 1971, as it became clearer and clearer that the U.S Government would not be able to buy back its dollars in gold, it made in 1972-73 an iron-clad arrangement with Saudi Arabia to support the power of the House of Saud in exchange for accepting only U.S. dollars for its oil. The rest of OPEC was to follow suit and also accept only dollars. Because the world had to buy oil from the Arab oil countries, it had the reason to hold dollars as payment for oil. Because the world needed ever increasing quantities of oil at ever increasing oil prices, the world’s demand for dollars could only increase. Even though dollars could no longer be exchanged for gold, they were now exchangeable for oil.
The economic essence of this arrangement was that the dollar was now backed by oil. As long as that was the case, the world had to accumulate increasing amounts of dollars, because they needed those dollars to buy oil. As long as the dollar was the only acceptable payment for oil, its dominance in the world was assured, and the American Empire could continue to tax the rest of the world. If, for any reason, the dollar lost its oil backing, the American Empire would cease to exist. Thus, Imperial survival dictated that oil be sold only for dollars. It also dictated that oil reserves were spread around various sovereign states that weren’t strong enough, politically or militarily, to demand payment for oil in something else. If someone demanded a different payment, he had to be convinced, either by political pressure or military means, to change his mind.
The man that actually did demand Euro for his oil was Saddam Hussein in 2000. At first, his demand was met with ridicule, later with neglect, but as it became clearer that he meant business, political pressure was exerted to change his mind. When other countries, like Iran, wanted payment in other currencies, most notably Euro and Yen, the danger to the dollar was clear and present, and a punitive action was in order. Bush’s Shock-and-Awe in Iraq was not about Saddam’s nuclear capabilities, about defending human rights, about spreading democracy, or even about seizing oil fields; it was about defending the dollar, ergo the American Empire. It was about setting an example that anyone who demanded payment in currencies other than U.S. Dollars would be likewise punished.
Many have criticized Bush for staging the war in Iraq in order to seize Iraqi oil fields. However, those critics can’t explain why Bush would want to seize those fields—he could simply print dollars for nothing and use them to get all the oil in the world that he needs. He must have had some other reason to invade Iraq.
History teaches that an empire should go to war for one of two reasons: (1) to defend itself or (2) benefit from war; if not, as Paul Kennedy illustrates in his magisterial The Rise and Fall of the Great Powers, a military overstretch will drain its economic resources and precipitate its collapse. Economically speaking, in order for an empire to initiate and conduct a war, its benefits must outweigh its military and social costs. Benefits from Iraqi oil fields are hardly worth the long-term, multi-year military cost. Instead, Bush must have went into Iraq to defend his Empire. Indeed, this is the case: two months after the United States invaded Iraq, the Oil for Food Program was terminated, the Iraqi Euro accounts were switched back to dollars, and oil was sold once again only for U.S. dollars. No longer could the world buy oil from Iraq with Euro. Global dollar supremacy was once again restored. Bush descended victoriously from a fighter jet and declared the mission accomplished—he had successfully defended the U.S. dollar, and thus the American Empire.
II. Iranian Oil Bourse
The Iranian government has finally developed the ultimate “nuclear” weapon that can swiftly destroy the financial system underpinning the American Empire. That weapon is the Iranian Oil Bourse slated to open in March 2006. It will be based on a euro-oil-trading mechanism that naturally implies payment for oil in Euro. In economic terms, this represents a much greater threat to the hegemony of the dollar than Saddam’s, because it will allow anyone willing either to buy or to sell oil for Euro to transact on the exchange, thus circumventing the U.S. dollar altogether. If so, then it is likely that almost everyone will eagerly adopt this euro oil system:
· The Europeans will not have to buy and hold dollars in order to secure their payment for oil, but would instead pay with their own currencies. The adoption of the euro for oil transactions will provide the European currency with a reserve status that will benefit the European at the expense of the Americans.
· The Chinese and the Japanese will be especially eager to adopt the new exchange, because it will allow them to drastically lower their enormous dollar reserves and diversify with Euros, thus protecting themselves against the depreciation of the dollar. One portion of their dollars they will still want to hold onto; a second portion of their dollar holdings they may decide to dump outright; a third portion of their dollars they will decide to use up for future payments without replenishing those dollar holdings, but building up instead their euro reserves.
· The Russians have inherent economic interest in adopting the Euro – the bulk of their trade is with European countries, with oil-exporting countries, with China, and with Japan. Adoption of the Euro will immediately take care of the first two blocs, and will over time facilitate trade with China and Japan. Also, the Russians seemingly detest holding depreciating dollars, for they have recently found a new religion with gold. Russians have also revived their nationalism, and if embracing the Euro will stab the Americans, they will gladly do it and smugly watch the Americans bleed.
· The Arab oil-exporting countries will eagerly adopt the Euro as a means of diversifying against rising mountains of depreciating dollars. Just like the Russians, their trade is mostly with European countries, and therefore will prefer the European currency both for its stability and for avoiding currency risk, not to mention their jihad against the Infidel Enemy.
Only the British will find themselves between a rock and a hard place. They have had a strategic partnership with the U.S. forever, but have also had their natural pull from Europe. So far, they have had many reasons to stick with the winner. However, when they see their century-old partner falling, will they firmly stand behind him or will they deliver the coup de grace? Still, we should not forget that currently the two leading oil exchanges are the New York’s NYMEX and the London’s International Petroleum Exchange (IPE), even though both of them are effectively owned by the Americans. It seems more likely that the British will have to go down with the sinking ship, for otherwise they will be shooting themselves in the foot by hurting their own London IPE interests. It is here noteworthy that for all the rhetoric about the reasons for the surviving British Pound, the British most likely did not adopt the Euro namely because the Americans must have pressured them not to: otherwise the London IPE would have had to switch to Euros, thus mortally wounding the dollar and their strategic partner.
At any rate, no matter what the British decide, should the Iranian Oil Bourse accelerate, the interests that matter—those of Europeans, Chinese, Japanese, Russians, and Arabs—will eagerly adopt the Euro, thus sealing the fate of the dollar. Americans cannot allow this to happen, and if necessary, will use a vast array of strategies to halt or hobble the operation’s exchange:
· Sabotaging the Exchange—this could be a computer virus, network, communications, or server attack, various server security breaches, or a 9-11-type attack on main and backup facilities.
· Coup d’état—this is by far the best long-term strategy available to the Americans.
· Negotiating Acceptable Terms & Limitations—this is another excellent solution to the Americans. Of course, a government coup is clearly the preferred strategy, for it will ensure that the exchange does not operate at all and does not threaten American interests. However, if an attempted sabotage or coup d’etat fails, then negotiation is clearly the second-best available option.
· Joint U.N. War Resolution—this will be, no doubt, hard to secure given the interests of all other member-states of the Security Council. Feverish rhetoric about Iranians developing nuclear weapons undoubtedly serves to prepare this course of action.
· Unilateral Nuclear Strike—this is a terrible strategic choice for all the reasons associated with the next strategy, the Unilateral Total War. The Americans will likely use Israel to do their dirty nuclear job.
· Unilateral Total War—this is obviously the worst strategic choice. First, the U.S. military resources have been already depleted with two wars. Secondly, the Americans will further alienate other powerful nations. Third, major dollar-holding countries may decide to quietly retaliate by dumping their own mountains of dollars, thus preventing the U.S. from further financing its militant ambitions. Finally, Iran has strategic alliances with other powerful nations that may trigger their involvement in war; Iran reputedly has such alliance with China, India, and Russia, known as the Shanghai Cooperative Group, a.k.a. Shanghai Coop and a separate pact with Syria.
Whatever the strategic choice, from a purely economic point of view, should the Iranian Oil Bourse gain momentum, it will be eagerly embraced by major economic powers and will precipitate the demise of the dollar. The collapsing dollar will dramatically accelerate U.S. inflation and will pressure upward U.S. long-term interest rates. At this point, the Fed will find itself between Scylla and Charybdis—between deflation and hyperinflation—it will be forced fast either to take its “classical medicine” by deflating, whereby it raises interest rates, thus inducing a major economic depression, a collapse in real estate, and an implosion in bond, stock, and derivative markets, with a total financial collapse, or alternatively, to take the Weimar way out by inflating, whereby it pegs the long-bond yield, raises the Helicopters and drowns the financial system in liquidity, bailing out numerous LTCMs and hyperinflating the economy.
The Austrian theory of money, credit, and business cycles teaches us that there is no in-between Scylla and Charybdis. Sooner or later, the monetary system must swing one way or the other, forcing the Fed to make its choice. No doubt, Commander-in-Chief Ben Bernanke, a renowned scholar of the Great Depression and an adept Black Hawk pilot, will choose inflation. Helicopter Ben, oblivious to Rothbard’s America’s Great Depression, has nonetheless mastered the lessons of the Great Depression and the annihilating power of deflations. The Maestro has taught him the panacea of every single financial problem—to inflate, come hell or high water. He has even taught the Japanese his own ingenious unconventional ways to battle the deflationary liquidity trap. Like his mentor, he has dreamed of battling a Kondratieff Winter. To avoid deflation, he will resort to the printing presses; he will recall all helicopters from the 800 overseas U.S. military bases; and, if necessary, he will monetize everything in sight. His ultimate accomplishment will be the hyperinflationary destruction of the American currency and from its ashes will rise the next reserve currency of the world—that barbarous relic called gold.
4 comments:
GREAT ARTICLE on China & USD
The $1.4 Trillion Question by James Fallows
Stephen Schwarzman may think he has image problems in America. He is the co-founder and CEO of the Blackstone Group, and he threw himself a $3 million party for his 60th birthday last spring, shortly before making many hundreds of millions of dollars in his company’s IPO and finding clever ways to avoid paying taxes. That’s nothing compared with the way he looks in China. Here, he and his company are surprisingly well known, thanks to blogs, newspapers, and talk-show references. In America, Schwarzman’s perceived offense is greed—a sin we readily forgive and forget. In China, the suspicion is that he has somehow hoodwinked ordinary Chinese people out of their hard-earned cash.
Last June, China’s Blackstone investment was hailed in the American press as a sign of canny sophistication. It seemed just the kind of thing the U.S. government had in mind when it hammered China to use its new wealth as a “responsible stakeholder” among nations. By putting $3 billion of China’s national savings into the initial public offering of America’s best-known private-equity firm, the Chinese government allied itself with a big-time Western firm without raising political fears by trying to buy operating control (it bought only 8 percent of Blackstone’s shares, and nonvoting shares at that). The contrast with the Japanese and Saudis, who in their nouveau-riche phase roused irritation and envy with their showy purchases of Western brand names and landmark properties, was plain.
Six months later, it didn’t look so canny, at least not financially. China’s Blackstone holdings lost, on paper, about $1 billion, during a time when the composite index of the Shanghai Stock Exchange was soaring. At two different universities where I’ve spoken recently, students have pointed out that Schwarzman was a major Republican donor. A student at Fudan University knew a detail I didn’t: that in 2007 President Bush attended a Republican National Committee fund-raiser at Schwarzman’s apartment in Manhattan (think what he would have made of the fact that Schwarzman, who was one year behind Bush at Yale, had been a fellow member of Skull and Bones). Wasn’t the whole scheme a way to take money from the Chinese people and give it to the president’s crony?
The Blackstone case is titillating in its personal detail, but it is also an unusually clear and personalized symptom of a deeper, less publicized, and potentially much more destructive tension in U.S.–China relations. It’s not just Stephen Schwarzman’s company that the laobaixing, the ordinary Chinese masses, have been subsidizing. It’s everyone in the United States.
Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.
Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.
Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. But because of political tensions in both countries, and because of the huge and growing size of the imbalance, the arrangement now shows signs of cracking apart.
In an article two and a half years ago (“Countdown to a Meltdown,” July/August 2005), I described an imagined future in which a real-estate crash and shakiness in the U.S. credit markets led to panic by Chinese and other foreign investors, with unpleasant effects for years to come. The real world has recently had inklings of similar concerns. In the past six months, relative nobodies in China’s establishment were able to cause brief panics in the foreign-exchange markets merely by hinting that China might stop supplying so much money to the United States. In August, an economic researcher named He Fan, who works at the Chinese Academy of Social Sciences and did part of his doctoral research at Harvard, suggested in an op-ed piece in China Daily that if the U.S. dollar kept collapsing in value, China might move some of its holdings into stronger currencies. This was presented not as a threat but as a statement of the obvious, like saying that during a market panic, lots of people sell. The column quickly provoked alarmist stories in Europe and America suggesting that China was considering the “nuclear option”—unloading its dollars.
A few months later, a veteran Communist Party politician named Cheng Siwei suggested essentially the same thing He Fan had. Cheng, in his mid-70s, was trained as a chemical engineer and has no official role in setting Chinese economic policy. But within hours of his speech, a flurry of trading forced the dollar to what was then its lowest level against the euro and other currencies. The headline in the South China Morning Post the next day was: “Officials’ Words Shrivel U.S. Dollar.” Expressing amazement at the markets’ response, Carl Weinberg, chief economist at the High Frequency Economics advisory group, said, “This would be kind of like Congressman Charlie Rangel giving a speech telling the Fed to hike or cut interest rates.” (Cheng, like Rangel, is known for colorful comments—but he is less powerful, since Rangel after all chairs the House Ways and Means Committee.) In the following weeks, phrases like “run on the dollar” and “collapse of confidence” showed up more and more frequently in financial newsletters. The nervousness only increased when someone who does have influence, Chinese Premier Wen Jiabao, said last November, “We are worried about how to preserve the value” of China’s dollar holdings.
When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.
When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).
The dollar’s value has been high for many years—unnaturally high, in large part because of the implicit bargain with the Chinese. Living standards in China, while rising rapidly, have by the same logic been unnaturally low. To understand why this situation probably can’t go on, and what might replace it—via a dollar crash or some other event—let’s consider how this curious balance of power arose and how it works.
By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion, according to Edwin Truman of the Peterson Institute for International Economics in Washington. Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world. (In second place is Japan, whose economy is, at official exchange rates, nearly twice as large as China’s but which has only two-thirds the foreign assets; the next-largest after that are the United Arab Emirates and Russia.) China’s U.S. dollar assets probably account for about 70 percent of its foreign holdings, according to the latest analyses by Brad Setser, a former Treasury Department economist now with the Council on Foreign Relations; the rest are mainly in euros, plus some yen. Most of China’s U.S. investments are in conservative, low-yield instruments like Treasury notes and federal-agency bonds, rather than showier Blackstone-style bets. Because notes and bonds backed by the U.S. government are considered the safest investments in the world, they pay lower interest than corporate bonds, and for the past two years their annual interest payments of 4 to 5 percent have barely matched the 5-to-6-percent decline in the U.S. dollar’s value versus the RMB.
Americans sometimes debate (though not often) whether in principle it is good to rely so heavily on money controlled by a foreign government. The debate has never been more relevant, because America has never before been so deeply in debt to one country. Meanwhile, the Chinese are having a debate of their own—about whether the deal makes sense for them. Certainly China’s officials are aware that their stock purchases prop up 401(k) values, their money-market holdings keep down American interest rates, and their bond purchases do the same thing—plus allow our government to spend money without raising taxes.
“From a distance, this, to say the least, is strange,” Lawrence Summers, the former treasury secretary and president of Harvard, told me last year in Shanghai. He was referring to the oddity that a country with so many of its own needs still unmet would let “this $1 trillion go to a mature, old, rich place from a young, dynamic place.”
It’s more than strange. Some Chinese people are rich, but China as a whole is unbelievably short on many of the things that qualify countries as fully developed. Shanghai has about the same climate as Washington, D.C.—and its public schools have no heating. (Go to a classroom when it’s cold, and you’ll see 40 children, all in their winter jackets, their breath forming clouds in the air.) Beijing is more like Boston. On winter nights, thousands of people mass along the curbsides of major thoroughfares, enduring long waits and fighting their way onto hopelessly overcrowded public buses that then spend hours stuck on jammed roads. And these are the showcase cities! In rural Gansu province, I have seen schools where 18 junior-high-school girls share a single dormitory room, sleeping shoulder to shoulder, sardine-style.
Better schools, more-abundant parks, better health care, cleaner air and water, better sewers in the cities—you name it, and if it isn’t in some way connected to the factory-export economy, China hasn’t got it, or not enough. This is true at the personal level, too. The average cash income for workers in a big factory is about $160 per month. On the farm, it’s a small fraction of that. Most people in China feel they are moving up, but from a very low starting point.
So why is China shipping its money to America? An economist would describe the oddity by saying that China has by far the highest national savings in the world. This sounds admirable, but when taken to an extreme—as in China—it indicates an economy out of sync with the rest of the world, and one that is deliberately keeping its own people’s living standards lower than they could be. For comparison, India’s savings rate is about 25 percent, which in effect means that India’s people consume 75 percent of what they collectively produce. (Reminder from Ec 101: The savings rate is the net share of national output either exported or saved and invested for consumption in the future. Effectively, it’s what your own people produce but don’t use.) For Korea and Japan, the savings rate is typically from the high 20s to the mid-30s. Recently, America’s has at times been below zero, which means that it consumes, via imports, more than it makes.
China’s savings rate is a staggering 50 percent, which is probably unprecedented in any country in peacetime. This doesn’t mean that the average family is saving half of its earnings—though the personal savings rate in China is also very high. Much of China’s national income is “saved” almost invisibly and kept in the form of foreign assets. Until now, most Chinese have willingly put up with this, because the economy has been growing so fast that even a suppressed level of consumption makes most people richer year by year.
But saying that China has a high savings rate describes the situation without explaining it. Why should the Communist Party of China countenance a policy that takes so much wealth from the world’s poor, in their own country, and gives it to the United States? To add to the mystery, why should China be content to put so many of its holdings into dollars, knowing that the dollar is virtually guaranteed to keep losing value against the RMB? And how long can its people tolerate being denied so much of their earnings, when they and their country need so much? The Chinese government did not explicitly set out to tighten the belt on its population while offering cheap money to American homeowners. But the fact that it does results directly from explicit choices it has made—two in particular. Both arise from crucial controls the government maintains over an economy that in many other ways has become wide open. The situation may be easiest to explain by following a U.S. dollar on its journey from a customer’s hand in America to a factory in China and back again to the T-note auction in the United States.
Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.
When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.
This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.
With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.
The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.
And thus our dollar comes back home. Spent at CVS, passed to Oral-B, paid to the factory in southern China, traded for RMB at the Shenzhen bank, “surrendered” to the PBOC, passed to SAFE for investment, and then bid at auction for Treasury notes, it is ready to be reinjected into the U.S. money supply and spent again—ideally on Chinese-made goods.
At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.
One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. The obvious reason for doing this is to keep Chinese-made products cheap, so Chinese factories will stay busy. This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. And there are numerous less obvious reasons. The very act of managing a currency’s value may be a more important distorting factor than the exact rate at which it is set. As for the rate—the subject of much U.S. lecturing—given the huge difference in living standards between China and the United States, even a big rise in the RMB’s value would leave China with a price advantage over manufacturers elsewhere. (If the RMB doubled against the dollar, a factory worker might go from earning $160 per month to $320—not enough to send many jobs back to America, though enough to hurt China’s export economy.) Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could).
These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. The result, while very complicated, is to keep the buying power earned through China’s exports out of the hands of Chinese consumers as a whole. Individual Chinese people have certainly gotten their hands on a lot of buying power, notably the billionaire entrepreneurs who have attracted the world’s attention (see “Mr. Zhang Builds His Dream Town,” March 2007). But when it comes to amassing international reserves, what matters is that China as a whole spends so little of what it earns, even as some Chinese people spend a lot.
The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn’t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy. In the short run, it worries that the RMB’s value against the dollar and the euro would soar, pricing some factories in “expensive” places such as Shanghai out of business. In the long run, it views an unstable currency as a nuisance in itself, since currency fluctuation makes everything about business with the outside world more complicated. Companies have a harder time predicting overseas revenues, negotiating contracts, luring foreign investors, or predicting the costs of fuel, component parts, and other imported goods.
And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment—sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related “clean” technology, which would start to address the world pollution for which China is increasingly held responsible—would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carrefour grocery in Chongqing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves.
This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on.
The Chinese public is beginning to be aware that its government is sitting on a lot of money—money not being spent to help China directly, money not doing so well in Blackstone-style foreign investments, money invested in the ever-falling U.S. dollar. Chinese bloggers and press commentators have begun making a connection between the billions of dollars the country is sending away and the domestic needs the country has not addressed. There is more and more pressure to show that the return on foreign investments is worth China’s sacrifice—and more and more potential backlash against bets that don’t pay off. (While the Chinese government need not stand for popular election, it generally tries to reduce sources of popular discontent when it can.) The public is beginning to behave like the demanding client of an investment adviser: it wants better returns, with fewer risks.
This is the challenge facing Lou Jiwei and Gao Xiqing, who will play a larger role in the U.S. economy than Americans are accustomed to from foreigners. Lou, a longtime Communist Party official in his late 50s, is the chairman of the new China Investment Corporation, which is supposed to find creative ways to increase returns on at least $200 billion of China’s foreign assets. He is influential within the party but has little international experience. Thus the financial world’s attention has turned to Gao Xiqing, who is the CIC’s general manager.
Twenty years ago, after graduating from Duke Law School, Gao was the first Chinese citizen to pass the New York State Bar Exam. He returned to China in 1988, after several years as an associate at the New York law firm Mudge, Rose (Richard Nixon’s old firm) to teach securities law and help develop China’s newly established stock markets. By local standards, he is hip. At an economics conference in Beijing in December, other Chinese speakers wore boxy dark suits. Gao, looking fit in his mid-50s, wore a tweed jacket and black turtleneck, an Ironman-style multifunction sports watch on his wrist.
Under Lou and Gao, the CIC started with a bang with Blackstone—the wrong kind of bang. Now, many people suggest, it may be chastened enough to take a more careful approach. Indeed, that was the message it sent late last year, with news that its next round of investments would be in China’s own banks, to shore up some with credit problems. And it looks to be studying aggressive but careful ways to manage huge sums. About the time the CIC was making the Blackstone deal, its leadership and staff undertook a crash course in modern financial markets. They hired the international consulting firm McKinsey to prepare confidential reports about the way they should organize themselves and the investment principles they should apply. They hired Booz Allen Hamilton to prepare similar reports, so they could compare the two. Yet another consulting firm, Towers Perrin, provided advice, especially about staffing and pay. The CIC leaders commissioned studies of other large state-run investment funds—in Norway, Singapore, the Gulf States, Alaska—to see which approaches worked and which didn’t. They were fascinated by the way America’s richest universities managed their endowments, and ordered multiple copies of Pioneering Portfolio Management, by David Swensen, who as Yale’s chief investment officer has guided its endowment to sustained and rapid growth. Last summer, teams from the CIC made long study visits to Yale and Duke universities, among others.
Gao Xiqing and other CIC officials have avoided discussing their plans publicly. “If you tell people ahead of time what you’re going to do—well, you just can’t operate that way in a market system,” he said at his Beijing appearance. “What I can say is, we’ll play by the international rules, and we’ll be responsible investors.” Gao emphasized several times how much the CIC had to learn: “We’re the new kids on the block. Because of media attention, there is huge pressure on us—we’re already under water now.” The words “under water” were in natural-sounding English, and clearly referred to Blackstone.
Others familiar with the CIC say that its officials are coming to appreciate the unusual problems they will face. For instance: any investment group needs to be responsible to outside supervisors, and the trick for the CIC will be to make itself accountable to Communist Party leadership without becoming a mere conduit for favored investment choices by party bosses. How can it attract the best talent? Does it want to staff up quickly, to match its quickly mounting assets, by bidding for financial managers on the world market—where many of the candidates are high-priced, not fluent in Chinese, and reluctant to move to Beijing? Or can it afford to take the time to home-grow its own staff?
While the CIC is figuring out its own future, outsiders are trying to figure out the CIC—and also SAFE, which will continue handling many of China’s assets. As far as anyone can tell, the starting point for both is risk avoidance. No more Blackstones. No more CNOOC-Unocals. (In 2005, the Chinese state oil firm CNOOC attempted to buy U.S.–based Unocal. It withdrew the offer in the face of intense political opposition to the deal in America.) One person involved with the CIC said that its officials had seen recent Lou Dobbs broadcasts criticizing “Communist China” and were “shellshocked” about the political resentment their investments might encounter in the United States. For all these reasons the Chinese leadership, as another person put it, “has a strong preference to follow someone else’s lead, not in an imitative way” but as an unobtrusive minority partner wherever possible. It will follow the lead of others for now, that is, while the CIC takes its first steps as a gigantic international financial investor.
The latest analyses by Brad Setser suggest that despite all the talk about abandoning the dollar, China is still putting about as large a share of its money into dollars as ever, somewhere between 65 and 70 percent of its foreign earnings. “Politically, the last thing they want is to signal a loss of faith in the dollar,” Andy Rothman, of the financial firm CLSA, told me; that would lead to a surge in the RMB, which would hurt Chinese exporters, not to mention the damage it would cause to China’s vast existing dollar assets.
The problem is that these and other foreign observers must guess at China’s aims, rather than knowing for sure. As Rothman put it, “The opaqueness about intentions and goals is always the issue.” The mini-panics last year took hold precisely because no one could be sure that SAFE was not about to change course.
The uncertainty arises in part from the limited track record of China’s new financial leadership. As one American financier pointed out to me: “The man in charge of the whole thing”—Lou Jiwei—“has never bought a share of stock, never bought a car, never bought a house.” Another foreign financier said, after meeting some CIC staffers, “By Chinese terms, these are very sophisticated people.” But, he went on to say, in a professional sense none of them had lived through the financial crises of the last generation: the U.S. market crash of 1987, the “Asian flu” of the late 1990s, the collapse of the Internet bubble soon afterward. The Chinese economy was affected by all these upheavals, but the likes of Gao Xiqing were not fully exposed to their lessons, sheltered as they were within Chinese institutions.
Foreign observers also suggest that, even after exposure to the Lou Dobbs clips, the Chinese financial leadership may not yet fully grasp how suspicious other countries are likely to be of China’s financial intentions, for reasons both fair and unfair. The unfair reason is all-purpose nervousness about any new rising power. “They need to understand, and they don’t, that everything they do will be seen as political,” a financier with extensive experience in both China and America told me. “Whatever they buy, whatever they say, whatever they do will be seen as China Inc.”
The fair reason for concern is, again, the transparency problem. Twice in the past year, China has in nonfinancial ways demonstrated the ripples that a nontransparent policy creates. Last January, its military intentionally shot down one of its own satellites, filling orbital paths with debris. The exercise greatly alarmed the U.S. military, because of what seemed to be an implied threat to America’s crucial space sensors. For several days, the Chinese government said nothing at all about the test, and nearly a year later, foreign analysts still debate whether it was a deliberate provocation, the result of a misunderstanding, or a freelance effort by the military. In November, China denied a U.S. Navy aircraft carrier, the Kitty Hawk, routine permission to dock in Hong Kong for Thanksgiving, even though many Navy families had gone there for a reunion. In each case, the most ominous aspect is that outsiders could not really be sure what the Chinese leadership had in mind. Were these deliberate taunts or shows of strength? The results of factional feuding within the leadership? Simple miscalculations? In the absence of clear official explanations no one really knew, and many assumed the worst.
So it could be with finance, unless China becomes as transparent as it is rich. Chinese officials say they will move in that direction, but they’re in no hurry. Last fall, Edwin Truman prepared a good-governance scorecard for dozens of “sovereign wealth” funds—government-run investment funds like SAFE and the CIC. He compared funds from Singapore, Korea, Norway, and elsewhere, ranking them on governing structure, openness, and similar qualities. China’s funds ended up in the lower third of his list—better-run than Iran’s, Sudan’s, or Algeria’s, but worse than Mexico’s, Russia’s, or Kuwait’s. China received no points in the “governance” category and half a point out of a possible 12 for “transparency and accountability.”
Foreigners (ordinary Chinese too, for that matter) can’t be sure about the mixture of political and strictly economic motives behind future investment decisions the Chinese might make. When China’s president, Hu Jintao, visited Seattle two years ago, he announced a large purchase of Boeing aircraft. When France’s new president, Nicolas Sarkozy, visited China late last year, Hu announced an even larger purchase of Airbuses. Every Chinese order for an airplane is a political as well as commercial decision. Brad Setser says that the Chinese government probably believed that it would get “credit” for the Blackstone purchase in whatever negotiations came up next with the United States, in the same way it would get credit for choosing Boeing. This is another twist to the Kremlinology of trying to discern China’s investment strategy.
Where the money goes, other kinds of power follow. Just ask Mikhail Gorbachev, as he reflects on the role bankruptcy played in bringing down the Soviet empire. While Japan’s great wealth has not yet made it a major diplomatic actor, and China has so far shied from, rather than seized, opportunities to influence events outside its immediate realm, time and money could change that. China’s military is too weak to challenge the U.S. directly even in the Taiwan Straits, let alone anyplace else. That, too, could change.
A Balance of Terror
Let’s take these fears about a rich, strong China to their logical extreme. The U.S. and Chinese governments are always disagreeing—about trade, foreign policy, the environment. Someday the disagreement could be severe. Taiwan, Tibet, North Korea, Iran—the possibilities are many, though Taiwan always heads the list. Perhaps a crackdown within China. Perhaps another accident, like the U.S. bombing of China’s embassy in Belgrade nine years ago, which everyone in China still believes was intentional and which no prudent American ever mentions here.
Whatever the provocation, China would consider its levers and weapons and find one stronger than all the rest—one no other country in the world can wield. Without China’s billion dollars a day, the United States could not keep its economy stable or spare the dollar from collapse.
Would the Chinese use that weapon? The reasonable answer is no, because they would wound themselves grievously, too. Their years of national savings are held in the same dollars that would be ruined; in a panic, they’d get only a small share out before the value fell. Besides, their factories depend on customers with dollars to spend.
But that “reassuring” answer is actually frightening. Lawrence Summers calls today’s arrangement “the balance of financial terror,” and says that it is flawed in the same way that the “mutually assured destruction” of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can’t afford to stop feeding dollars to Americans, because China’s own dollar holdings would be devastated if it did. As long as that logic holds, the system works. As soon as it doesn’t, we have a big problem.
What might poke a giant hole in that logic? Not necessarily a titanic struggle over the future of Taiwan. A simple mistake, for one thing. Another speech by Cheng Siwei—perhaps in response to a provocation by Lou Dobbs. A rumor that the oil economies are moving out of dollars for good, setting their prices in euros. Leaked suggestions that the Chinese government is hoping to buy Intel, leading to angry denunciations on the Capitol floor, leading to news that the Chinese will sit out the next Treasury auction. As many world tragedies have been caused by miscalculation as by malice.
Or pent-up political tensions, on all sides. China’s lopsided growth—ahead in exports, behind in schooling, the environment, and everything else—makes the country socially less stable as it grows richer. Meanwhile, its expansion disrupts industries and provokes tensions in the rest of the world. The billions of dollars China pumps into the United States each week strangely seem to make it harder rather than easier for Americans to face their own structural problems. One day, something snaps. Suppose the CIC makes another bad bet—not another Blackstone but another WorldCom, with billions of dollars of Chinese people’s assets irretrievably wiped out. They will need someone to blame, and Americans, for their part, are already primed to blame China back.
So, the shock comes. Does it inevitably cause a cataclysm? No one can know until it’s too late. The important question to ask about the U.S.–China relationship, the economist Eswar Prasad, of Cornell, recently wrote in a paper about financial imbalances, is whether it has “enough flexibility to withstand and recover from large shocks, either internal or external.” He suggested that the contained tensions were so great that the answer could be no.
Today’s American system values upheaval; it’s been a while since we’ve seen too much of it. But Americans who lived through the Depression knew the pain real disruption can bring. Today’s Chinese, looking back on their country’s last century, know, too. With a lack of tragic imagination, Americans have drifted into an arrangement that is comfortable while it lasts, and could last for a while more. But not much longer.
Years ago, the Chinese might have averted today’s pressures by choosing a slower and more balanced approach to growth. If they had it to do over again, I suspect they would in fact choose just the same path—they have gained so much, including the assets they can use to do what they have left undone, whenever the government chooses to spend them. The same is not true, I suspect, for the United States, which might have chosen a very different path: less reliance on China’s subsidies, more reliance on paying as we go. But it’s a little late for those thoughts now. What’s left is to prepare for what we find at the end of the path we have taken.
The Profile of a Third World Country:
How Bush Destroyed the Dollar
By PAUL CRAIG ROBERTS
It is difficult to know where Bush has accomplished the most destruction, the Iraqi economy or the US economy.
In the current issue of Manufacturing & Technology News, Washington economist Charles McMillion observes that seven years of Bush has seen the federal debt increase by two-thirds while US household debt doubled.
This massive Keynesian stimulus produced pitiful economic results. Median real income has declined. The labor force participation rate has declined. Job growth has been pathetic, with 28% of the new jobs being in the government sector. All the new private sector jobs are accounted for by private education and health care bureaucracies, bars and restaurants. Three and a quarter million manufacturing jobs and a half million supervisory jobs were lost. The number of manufacturing jobs has fallen to the level of 65 years ago.
This is the profile of a third world economy.
The "new economy" has been running a trade deficit in advanced technology products since 2002. The US trade deficit in manufactured goods dwarfs the US trade deficit in oil. The US does not earn enough to pay its import bill, and it doesn't save enough to finance the government's budget deficit.
To finance its deficits, America looks to the kindness of foreigners to continue to accept the outpouring of dollars and dollar-denominated debt.
The dollars are accepted, because the dollar is the world's reserve currency.
At the meeting of the World Economic Forum at Davos, Switzerland, this week, billionaire currency trader George Soros warned that the dollar's reserve currency role was drawing to an end: "The current crisis is not only the bust that follows the housing boom, it's basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency. Now the rest of the world is increasingly unwilling to accumulate dollars."
If the world is unwilling to continue to accumulate dollars, the US will not be able to finance its trade deficit or its budget deficit. As both are seriously out of balance, the implication is for yet more decline in the dollar's exchange value and a sharp rise in prices.
Economists have romanticized globalism, taking delight in the myriad of foreign components in US brand name products. This is fine for a country whose trade is in balance or whose currency has the reserve currency role. It is a terrible dependency for a country such as the US that has been busy at work offshoring its economy while destroying the exchange value of its currency.
As the dollar sheds value and loses its privileged position as reserve currency, US living standards will take a serious knock.
If the US government cannot balance its budget by cutting its spending or by raising taxes, the day when it can no longer borrow will see the government paying its bills by printing money like a third world banana republic. Inflation and more exchange rate depreciation will be the order of the day.
Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review. He is coauthor of The Tyranny of Good Intentions.He can be reached at: PaulCraigRoberts@yahoo.com
The Dots add up to WAR!
Dot #1: IRAN issues following press release...
Iran Oil Bourse to deal blow to dollar MK/JG/RE/HAR, Iran Press TV. The long-awaited Iranian Oil Bourse, a place for trading oil, petrochemicals and gas in various non-dollar currencies, will soon open. Iran's Finance Minister Davoud Danesh-Jafari told reporters the bourse will be inaugurated during the anniversary of the Islamic Revolution (February 1-11) at the latest. "All preparations have been made to launch the bourse; it will open during the Ten-Day Dawn (the ceremonies marking the victory of the 1979 Islamic Revolution in Iran)," he said. The Minister had earlier stated that the Oil Bourse is located on the Persian Gulf island of Kish. Some expert opinions hold inauguration of the bourse could significantly devalue the greenback. (4 January 2008)
Dot #2: Article found on Energy Bulletin
Iran was scheduled to inaugurate its Oil Bourse this coming week. That probably isn't going to happen because all internet access in Iran was cut over the weekend (the undersea cables were chopped). This was mentioned on Wikipedia for a day... but now the article links and coverage have disappeared. Iran is in total internet blackout at the moment. Any further information is appreciated. 3 Feb 2008.
DOT #3: Speculation about NATO ops
Sounds more like a NATO op if it was intentional. Terror networks are always using the internet to broadcast their propaganda. There is not much reason for them to do stop that. I'd say its a NATO op if it really was intentional and we were speculating here. - USA Today reader comments
SPECULATIVE CONCLUSIONS:
Multiple sea telecomminication cables where cut in an attempt to block IRAN from opening its Oil Bourse during the Ten-Day Dawn ceremonies.
There is now a de facto state of War between the U.S. and IRAN.
3rd Internet cable reported cut in Mideast
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