[A-List] Henry Liu on central banking 4a

["Michael Keaney" <michael.keaney@xxxxxx>]

BANKING BUNKUM
Part 4a: The Asian experience
By Henry C K Liu
Asia Times, January 17 2003

* Part 1: Monetary theology
* Part 2: The European experience
* Part 3a: The US experience
* Part 3b: More on the US experience
* Part 3c: Still more on the US experience
* Part 3d: The lessons of the US experience

Since the beginning of the new millennium, the world's three leading
economies, the United States, the European Union and Japan, have experienced
a rare synchronous slowdown while much of the developing world, including
Asia, remained mired in economic and financial difficulties that started in
Asia in 1997.

This development has rendered inoperative the strategy of having the global
economic engine stabilized by sequential boosts from the synchronized
phasing of domestic business cycles in connected yet independent economies,
like the well-timed sequential firing of a multi-cylinder internal
combustion engine. The current global economic stagnation is not an
accidental breakdown. It is the visible result of the coordinated operation
of global central banking, burning out the economic spark plugs with
super-rich gas in the form of universal and reflexive tight monetary
measures, which have produced overlapping long-term imbalances in the global
economy's major regional dynamos.

The decade-long post-bubble deflation in Japan was linked to financial
globalization that challenged the efficacy of the traditional Japanese
financial system. The Tokyo Big Bang (financial deregulation) on April 1,
1998, crowned with a Central Bank Law on the same day, was designed to boost
the value of the Japanese stock market, aiming to re-establish Tokyo's
position as one of the top three global financial centers. Once the largest
stock market in the world, Tokyo by 1998 had fallen steadily to less than
half the size of New York in contrast with the latter's astronomical
expansion. Although the Japanese had savings of about US$9 trillion in 1998,
a third of the world total, most savings were held in low-interest bank and
postal accounts on which the Japanese government traditionally relied for
low-cost capital to fund its national economic plans. The population was
aging rapidly and the government was worried there would not be enough money
in the economy to support future pensioners because of the low return on
savings.

Neo-liberal market fundamentalists pushed through a series of radical
reforms designed to change the way money traditionally flowed around the
Japanese economy, recycling more savings into the stock market to boost
yield. The government hoped to bring Tokyo back in line with the high
trading levels of London and New York, pulling the value of the recycled
savings up with it by increasing their rate of return. The reforms were
called the Big Bang after a similar exercise in Britain 12 years earlier on
October 27, 1986, which in turn was inspired by May Day in the US in 1975,
which ended fixed minimum brokerage commissions that marked the beginning of
diversification into electronic trading.

Instead of bringing new prosperity and high returns to fund exploding
pension obligations, the Tokyo Big Bang reduced Japanese banks, which
earlier had been operating with spectacular success in a national banking
regime in support of Japanese industrial policy, to near-terminal cases in a
global central banking environment. Subsidized policy loans that had served
postwar national purposes for half a century suddenly became non-performing
loans (NPLs) as defined by new international standards set by the Bank of
International Settlement (BIS), as corporate borrowers were forced by dollar
hegemony to sacrifice profit margin to expand market share, while financial
deregulation put downward pressure on the traditional norm of high
price-earning ratios of Japanese equity. The banks' traditional holding of
significant equity position in their corporate borrowers and the tradition
of a controlled domestic market caused structural problems for the Japanese
financial system in the new globalized competitive environment. The banks
were squeezed by falling cash flow from loan service payments by their
distressed debtors and by the falling market value of loan collateral and
capital held in the shares of their borrowers.

The Tokyo stock market's key Nikkei index tumbled from an all-time high of
21,552.81 recorded on June 13, 1994, to below the psychologically crucial
15,000 level in July 1995 when the yen's sharp appreciation hit
manufacturers and exporters. The Nikkei is now around 8,500 and Japanese
officials would kill to get it back to 15,000, but it seems to be an
impossible dream because global central banking has forced deregulated
markets to discount the market value of the Japanese system that had worked
so miraculously for the previous half-century. The government tried to solve
the problem with Keynesian deficit financing, only to be hit with
international credit-rating downgrades on government bonds, despite the fact
that Japan remains the world's biggest credit nation.

Concurrently in Europe, persistently high levels of unemployment and anemic
growth plagued the euro zone, whose European Central Bank (ECB) came into
being on June 1, 1998, two months after Japan's. And in the United States,
by the beginning of 2000, a steady collapse of the debt bubble began,
generated by unsustainably high consumer, business and external debt levels
that had been first engineered by the Federal Reserve (Fed) through
regulatory indulgence and then later deflated through sharp rises in
interest rates.

Since then, the global economic engine has been stalled in all three
cylinders by the efforts of the world's three dominant central banks to
impose on the global economy destructively inoperative monetary policies.

After allowing regulatory indulgence on the part of the US Security and
Exchange Commission (SEC) to feed a historic bubble in US asset prices
inflated by accounting fantasies, fraudulent analyses, and financial
manipulation, the Fed, reversing its loose monetary policy since 1997,
conducted a pre-election monetary tightening, repeatedly raising interest
rates in quick succession during the second half of 1999 and the first half
of 2000 to slow down the real economy. The Fed also spurred the ECB to
follow suit, despite already slow growth and high unemployment in EU member
economies.

The Fed had discovered that for the United States, domestic consumer price
stability in an expanding economy could be achieved through a
strong-currency policy that would generate a capital account surplus to
finance a current-account deficit that produced a low inflation reading
through low-cost imports, as long as key commodities, such as oil, were
denominated in US currency. For a whole decade, wealth has been created
primarily through financial acrobatics, not real economic expansion either
within the US or around the world. Conspicuous consumption along chic
shopping boulevards, cruised by gas-guzzling sport-utility vehicles, to fill
homes that rose in price by 60 percent annually, supported by the wealth
effect of a stock-market bubble that made office clerical workers
millionaires, buoyant by a trade regime that enabled a massive transfer of
wealth from the poor to the super rich, is mistaken for economic growth. Fed
chairman Alan Greenspan proudly called this US financial hegemony and told
Congress that the financial crises that hit Asia in 1997 would have
"salutary" effect on the US economy.

During the past decade, central banks worldwide have achieved unprecedented
heights of policy dominance through their function as chief guardians of
strong national currencies in globalized, unregulated financial markets.
Simultaneously, monetary authorities the world over have been promoting the
doctrine of central-bank independence from duly constituted national
governments and their national economic policies, as if populist government
and people-oriented policies are financial evils that must be resisted.
Poverty and unemployment are hailed as the foundation of sound money that
should not be jeopardized by political pressure. This elitist doctrine is
fundamentally incompatible with a political world order of independent
nation states and the principle of consent of the governed. Any nation that
forfeits its monetary prerogative also forfeits its political independence.

The ECB's institutional structure represents the ultimate real-world
application of this doctrine on a regional scale. In the name of
central-bank autonomy, the Maastricht Treaty explicitly prohibits the ECB
from seeking or taking instruction from constituent national governments, or
European Community institutions such as the European Parliament, or "any
other body", and bars constituent national governments from attempting to
influence the decisions of the ECB. Critics have pointed out that those same
rules place no reciprocal restrictions on the ECB's policy advocacy. ECB
president Wim Duisenberg has unreservedly pushed euro zone economies to
refashion their labor, product, services, capital and credit markets along
neo-liberal market-fundamentalist lines, even in economies under social
democratic governments. This has contributed to the EU's slow growth and
high unemployment. Germany, the dominant economy in the EU, has persistently
suffered high unemployment, which hit 9.7 percent in November, rising above
the politically sensitive 4 million level; in eastern Germany, the
unemployment rate was 17.6 percent.

Article 105 of the Maastricht Treaty states clearly: "The primary objective
of the European System of Central Banks shall be to maintain price
stability." The wording of the Maastricht Treaty was not so much influenced
by economic insights as it was written in a very specific political context:
to persuade an inflation-averse Germany to exchange the deutschmark for the
euro, by guaranteeing the stability of the new currency. This explains the
focus on price stability and the fact that other objectives were mentioned
separately and secondarily. The statutes of other central banks, such as the
Fed, can be changed by action of a single legislature. The ECB would require
all 15 member states and their parliaments to change the treaty that defines
the structure and institutional mandate of the ECB. This makes the ECB one
of the most independent central banks in the world. The treaty did not
define "price stability", leaving a vacuum quickly filled by the new and
independent ECB by defining price stability as "an inflation rate that does
not exceed 2 percent over the medium term", a very tight definition by any
standard. Interest-rate policy alone is an inadequate tool because a single
instrument cannot hit multiple targets. Furthermore, using interest rates to
control asset markets risks inflicting significant collateral damage on the
rest of the economy, which was exactly what happened in the past few years.

The BIS harbors latent ambitions to turn itself into a de facto World
Central Bank (WCB) with the ECB as a model, while the argument for the need
for a WCB is floated around in the upper reaches of internationalist
monetary circles.

Asia is home to 58 percent of the world's 6.25 billion people, with 43
percent of Asians living in East Asia and 37 percent in China alone.
According to US Central Intelligence Agency (CIA) data, the US economy
accounts for 21 percent of gross world product (GWP - $47 trillion in 2001),
the EU accounts for 20 percent and Japan accounts for 7.3 percent. The three
leading economies together account for $22 trillion - 47.3 percent of GWP.

China, the second-largest economy in the world based on purchasing power
parity (PPP; 12 percent of GWP), and seventh on a nominal basis ($1.3
trillion in 2001, 2.8 percent of GWP) is an exception to global trends of
slow growth, continuing its rapid annual growth, officially announced as 7.3
percent in 2001 and 8 percent in 2002. Yet lest we should get carried away
by statistics, the Chinese per capita gross domestic product (GDP) of about
$900 in 2001 remains solidly in the less-developed-countries (LDC) category,
way below Japan's $32,500. Of the 129 countries covered by the World
Development Report, China ranked 76th in per capita GDP on a nominal basis
and 68th on a PPP basis, a modest climb. China's economic strength rests
purely on its size. China also adopted a Central Bank Law in 1995 and gave
the People's Bank of China central-bank status, but the Chinese economy has
remained a growth economy mostly because its currency is not freely
convertible and its financial market is not open, and its central bank not
fully independent.

There is increasing evidence that the crisis in the Japanese banking system
is not the cause but merely the symptom of that nation's economic malaise.
This malaise can largely be traced to the Japanese economy's over-dependence
on export for dollars, which in turn has resulted from the disadvantaged
structural financial position Japan has allowed itself to fall into in the
global financial system. BIS regulations, which force traditional Japanese
national banking in support of a strong economy to shift toward central
banking in support of a strong national currency, are a big part of that
structural disadvantage. This is the reason Japan has been resistant to US
demands for bank reform. The NPL problem in Japanese banks traces directly
to BIS regulations. This is also true for all of Asia, particularly South
Korea, and increasingly China. No doubt Japan needs to reform its banking
system, but it is highly debatable that the reform needs to go along the
line proposed by US neo-liberals, or that bank reform alone will lift the
Japanese economy out of its decade-long doldrums (see The BIS vs national
banks, May 14, 2002).

All these problems contributed to and in turn were magnified by structural
flaws and disorders in the international financial architecture and global
trade, notably misaligned currency values and interest rate disparities.
This has led to escalating mismatches between productive capacity and
effective demand, which has been exacerbated by a "free trade" regime that
has degenerated into a mad scramble for dollars that the United States can
print at will. The whole world lives on an over-reliance on export to a US
consumer market fueled by debt sustained by dollar hegemony. The ABC of the
global economy is now expressed as America prints dollars to Buy the world's
products on Credit provided by the world's producers. The US is exempt from
a day of reckoning, since the US only has to print more dollars, as Fed
Board member Ben Bernanke pronounced recently. Foreign creditors will only
devalue their massive dollar holdings if they try to collect from the US
economy. It is the ultimate demonstration of debtor power, with the debtor
holding the power to print currency in which the debt is denominated. Asia,
because of its largest population of low-wage workers, is holding the
shortest end of the biggest global trade stick.

The Asian financial crisis that began in 1997 had its genesis in Mexico,
incubated by a decade of globalization of financial markets. The currency
crisis that started in Mexico in 1982, in Britain in 1992, again in Mexico
in 1994, in Asia in 1997, spreading to Russia and Latin America since and
finally hitting both the EU and the US in 2000, and the deeper structural
financial challenges facing the entire global economy, have been the
inevitable result of the Fed, the ECB and the Bank of Japan applying their
unified institutional mandates of domestic price stability through domestic
interest-rate policies that have destabilized the post-Bretton Woods
international finance architecture.

The Mexican financial crisis of 1982 set the pattern for subsequent
financial crises around the world. To recycle petrodollars beginning in
1973, US banks had sought out select LDCs, such as Brazil, Mexico,
Argentina, South Korea, Taiwan, the Philippines, Indonesia, etc, for
predatory lending. By 1980, LDCs had accumulated $400 billion in foreign
debt, more than their combined GDP. In 1982, impacted by the Fed under Paul
Volcker raising dollar interest rates sharply in 1979 to fight inflation in
the United States, Mexico was put in a position of not being able to meet
its obligations to service $80 billion in dollar-denominated short-term debt
obligations to foreign, mostly US, banks out of a GDP of $106 billion. Debt
service payments reached 62.8 percent of export value in 1979. Exports
accounted for 12 percent of GDP while government expenditures accounted for
11 percent, which included public-education expenditure of 5.2 percent.
Mexico was paying more in interest to foreign banks than it did to educate
its young. Mexican foreign reserves had fallen to less than $200 million and
capital was leaving the country at the rate of $100 million a day. Against
this background, neo-liberal economists were claiming that poverty was being
eradicated in Mexico by "free" trade, a claim they made the world over.

A Mexican default would have threatened the survival of the largest
commercial banks in the United States, namely Citibank, Chase, Chemical,
Bank of America, Bankers Trust, Manufacturer Hanover, etc. To negotiate new
loans for Mexico, all creditors would have to agree and participate, so that
the new loans would not just go pay off some holdout creditors at the
expense of the others. Many other creditor banks were smaller US regional
banks that had only limited exposure to Mexico, and they did not want to
"throw good money after bad" merely to bail out the major money center
banks. The big banks had to lobby the Fed to step in as crisis manager to
keep the smaller banks in line for the good of the system, notwithstanding
that the crisis had been caused largely by the Fed's failure to impose
prudent limits on the money center banks' frenzied lending to the Third
World in the previous decade and Volcker's sudden high-interest-rate shock
treatment in 1979, instead of traditional Fed gradualism that would have
given the banks time to adjust their loan portfolios. Third World economies
were falling likes flies from the weight of debts that suddenly became
prohibitive to service, not much different from private businesses in the
United States, except that countries could not go bankrupt to wipe out debt
the way private business could in the US. Volcker's triumph over domestic
inflation was bought with the destabilization of the international financial
system, whose banks had acted like loan sharks in the Third World with Fed
approval. The International Monetary Fund then came in to take over the
impaired bank loans with austerity "conditionalities" forced on the debtor
economies, while the foreign banks went home whole with the IMF new money.

As a result, Third World economies, including those in Asia, fell into a
debt spiral, having to borrow new money from the IMF to service the old
debts, being forced by new loan "conditionalities" to forgo any hope of
future prosperity. Living standards kept declining while foreign debts kept
piling higher, leading to even higher unemployment and more bankruptcies.

US banks, while continuing to advocate free markets and financial
deregulation, were at the same time falling into total dependence on
government bailouts, both domestically and internationally. US taxpayers
were footing the bill the Fed incurred in bailing out its constituent banks,
through higher government budget deficits, which contributed to higher
inflation, which led to higher interest rates, which in turn intensified the
Third World debt spiral, in one huge vicious circle.

By the late 1980s, Mexico had temporarily resolved its debt crisis, though
not its debt spiral, and was able to resume a Ponzi-scheme economic growth,
relying to a great extent on rising foreign investment. To attract more
foreign capital, the Mexican government, coached by neo-liberal
market-fundamentalist economists, undertook major economic reforms in the
early 1990s designed to make its economy more open to foreign investment,
more "efficient", and more "competitive", neo-liberal code words for
disguised neo-imperialism. These reforms included privatizing state-owned
enterprises, removing trade barriers that protected domestic producers,
eliminating restrictions on foreign investment, and reducing inflation by to
lerating higher unemployment and pushing down already low wages and limiting
government spending on social programs by marketizing them. Most important,
it suspended exchange control within a fixed-foreign-exchange-rate regime.

This was in essence a Washington Consensus solution and much copied all over
Asia in the early 1990s. In effect, it was a suicidal policy masked by the
giddy expansion typical of the early phase of a Ponzi scheme. The new
foreign investment was used to provide spectacular returns on earlier
foreign investment with the help of central-bank support of overvalued fixed
exchange rates, while neo-liberal economists were falling over one another
congratulating themselves on their brilliant theoretical insight and giving
one another awards at insider dinners, while collecting fat consultant fees
from banks and governments. Star academics at Harvard, Massachusetts
Institute of Technology (MIT), Chicago and Stanford, multiple snake heads of
the academic Medusa, as well as those in prestigious policy-analysis
institutions with unabashed ideological preferences that served as waiting
lounges for policy specialists of the loyal opposition, busily turned out
star disciples from the Third World elite who, armed with awe-inspiring
foreign certificates and diplomas, would return to their home countries to
form influential policy-making establishments, particularly in central
banks, to promote this scandalous game of snake-oil economics. Every year,
sponsored by the IMF and the World Bank, central bankers gathered in
Washington, housed in luxurious hotel suites served by fleets of limousines
to reassure one another of their monetary magic, communicating through
opaque press releases couched in cryptic jargon.

Mexico's devaluation of the peso in December 1994 precipitated another
crisis in the country's financial institutions and markets that caused an
abrupt collapse of a "booming" economy that had not benefited Mexico as much
as foreign capital. Within Mexico, most of the benefit went to the elite
comprador class at the expense of the general population, particularly the
poor but even the middle class. International and domestic investors,
reacting to falling confidence in the peso, sold Mexican equity and debt
securities. Foreign-currency reserves at the Bank of Mexico, the nation's
central bank, were insufficient to meet the massive demand of disillusioned
investors seeking to convert pesos to dollars. In response to the crisis,
the United States organized a financial rescue package of up to $50 billion
in funds from the US, Canada, the IMF and the BIS. The multilateral rescue
package was intended to enable Mexico to avoid defaulting on its debt
obligations, and thereby overcome its short-term liquidity crisis, and to
prevent the crisis from spreading to other emerging markets through
contagion. It was not to help a Mexican economy hemorrhaging from a bankrupt
monetary policy, one that allowed international investors to collect their
phantom Ponzi peso profits in real dollars. The Mexican rescue package in
1995 created moral hazard on a global scale.

In the weekend before Mexico's pending default, the US government took the
lead in developing a rescue package. The package put together by the Fed
under Alan Greenspan and the Treasury under Robert Rubin, a former
co-chairman of Goldman Sachs and a consummate bond trader, included
short-term currency swaps from the Fed and the Exchange Stabilization Fund
(ESF), a commitment from Mexico to an IMF-imposed economic austerity program
for $4 billion in IMF loans, and a moratorium on Mexico's principal payments
to foreign commercial banks, mostly US, with Fed regulatory forbearance on
bank capital adjustments that affected bank profits. It also included $5
billion in additional commercial bank loans, additional liquidity support
from central banks in Europe and Japan, and prepayment by the US to Mexico
for $1 billion in oil, and a $1 billion line of credit from the US
Department of Agriculture.
The ESF was established by Section 20 of the Gold Reserve Act of January
1934, with a $2-billion initial appropriation. Its resources has been
subsequently augmented by special drawing rights (SDR) allocations by the
IMF and through its income over the years from interest on short-term
investments and loans, and net gains on foreign currencies. The ESF engages
in monetary transactions in which one asset is exchanged for another, such
as foreign currencies for dollars, and can also be used to provide direct
loans and guarantees to other countries. ESF operations are under the
control of the Secretary of the Treasury, subject to the approval of the
president. ESF operations include providing resources for exchange-market
intervention. The ESF has also been used to provide short-term swaps and
guarantees to foreign countries needing financial assistance for short-term
currency stabilization. The short-term nature of these transactions has been
emphasized by amendments to the ESF statute requiring the president to
notify Congress if a loan or credit guarantee is made to a country for more
than six months in any 12-month period.

It was Bear Stearns chief economist Wayne Angell, a former Fed governor and
advisor to then Senate majority leader Bob Dole, who first came up with the
idea of using the ESF to prop up the collapsing Mexican peso. Bear Stearns
had significant exposure to peso debts. Senator Robert Bennett, a freshman
Republican from Utah, took Angell's proposal to Greenspan and Rubin, who
both rejected the idea at first, shocked at the blatant circumvention of
constitutional procedures that this strategy represented, which would invite
certain reprisal from Congress. Congress had implicitly rejected a rescue
package that January when the initial proposal of extending Mexico $40
billion in loan guarantees could not get enough favorable votes. The
chairman of the Fed advised Bennett that the idea would only work if
Congress's silence could be guaranteed. Bennett went to Dole and convinced
him that the whole scam would work if the majority leader would simply block
all efforts to bring this use of taxpayers' money to a vote. It would all
happen by executive fiat. The next step was to persuade Dole and his
counterpart in the House, Speaker Newt Gingrich. They consulted several
state governors, notably then Texas governor George W Bush, who
enthusiastically endorsed the idea of a bailout to subsidize the border
region in his state. Greenspan, who historically opposed bailouts of the
private sector for fear of incurring moral hazard, was clearly in a position
to stop this one. Instead, he used his considerable power and influence to
help the process along when key players balked.

The peso bailout would lead to a series of similar situations in which
private investors got themselves into trouble, vindicating the moral-hazard
principle that predicts such people will take undue risks in the presence of
bailout guarantees. As Thailand, Indonesia, Malaysia, South Korea, and
Russia stumbled into crisis, culminating in the collapse of hedge-fund giant
Long-Term Capital Management (LTCM), which played key roles in precipitating
the crisis to begin with, Greenspan moved to increase liquidity to support
the distressed bond markets. At the helm of LTCM was yet another former
member of the Fed board, ex-vice chairman David Mullins. Mullins was there
to plead for help from his former colleagues. When New York Fed president
William McDonough helped coordinate a bailout of LTCM at his offices,
Greenspan defended McDonough before a congressional oversight committee.
Reflecting on all the corporate welfare being doled out to prop up bad
private-sector investments worldwide, Bill Clinton appointee Alice Rivlin,
the able former congressional budget director, observed that "the Fed was in
a sense acting as the central banker of the world". During Clinton's first
term, Greenspan had handed the president a "pro-incumbent-type economy" and
was rewarded with a seat next to the First Lady in Clinton's televised State
of the Union address and a third-term appointment as Fed chairman. Crony
capitalism was in full swing.

Short-term currency swaps are repurchase-type agreements through which
currencies are exchanged. Mexico purchased dollars in exchange for pesos and
simultaneously agreed to sell dollars against pesos three months hence. The
US earned interest on its Mexican pesos at a specified rate.

Historically, the US and Mexican economies have always been closely
integrated in a semi-colonial relationship. In 1994, the United States
supplied 69 percent of Mexico's high-value-added imports and absorbed about
85 percent of its low-cost labor-intensive exports. US investors have
provided a substantial share of foreign investment in Mexico and have
established numerous manufacturing facilities there to take advantage of low
wages and unregulated labor and environmental regimes. Also, the US has
served as a large market for illegal Mexican immigrant labor in its
underground economy and farm sector, which has grown to be a sizable
foreign-currency earner for Mexico. Mexico has long been the third-largest
trading partner of the United States, accounting for 10 percent of US
exports and about 8 percent of US imports in 1994. The maquiladora assembly
industry concentrated on the Mexican side of the US-Mexico border was hailed
by neo-liberals as a model of successful free trade, instead of the
sweatshop zone it actually was.

In 1994, under newly installed president Ernesto Zedillo, a Yale-educated
economist, Mexico entered the North American Free Trade Agreement with the
United States and Canada. NAFTA, conceived as a regional economic
counterweight to the EU, further opened Mexico to foreign investment and
bolstered investor interest on the hope that with NAFTA, Mexico's long-term
prospects for stable economic development were likely to improve, at least
for the benefit of foreign investors. NAFTA, as negotiated and signed in
December 1992 by the administrations of Mexican president Carlos Salinas de
Gortari and US president George Bush Sr, and as amended and implemented by
the Salinas and Clinton administrations in 1993, did not offer Mexico any
significant increase in access to the US market. Rather, Mexico was
blackmailed into signing NAFTA to prevent Mexican businesses from being
bankrupted wholesale by sudden waves of pending US protectionism.

Mexico was also advised by neo-liberals to adopt an exchange-rate system
intended to protect foreign investors who could exchange their peso earnings
for dollars at the Mexican central bank at an overvalued rate. In 1988, the
nominal exchange rate of the peso had been fixed temporarily in relation to
the US dollar. However, because the inflation rate in Mexico was greater
than that in the United States, a peso nominal depreciation against the
dollar was needed to keep the real exchange rate of the peso from
increasing. With the nominal exchange rate of the peso fixed, the real
exchange rate of the peso appreciated during this period. In 1989, this
fixed-exchange-rate system was replaced by a "crawling peg" system, under
which the peso-dollar exchange rate was adjusted daily to allow a slow rate
of nominal depreciation of the peso to occur over time. In 1991, the
crawling peg was replaced with a band within which the peso was allowed to
fluctuate. The ceiling of the band was adjusted daily to permit some
appreciation of the dollar (depreciation of the peso) to occur. The Mexican
government used the exchange-rate system as an anchor for an unsustainable
economic policy, ie, as a way to reduce inflation through shrinking the
economy, to force a politically destabilizing fiscal policy, and thus to
provide a comfortable climate for foreign investors, who managed to carry
home the same dollars they brought in via a short circuit, while leaving
only their peso holdings behind that the Mexican central banks had promised
to guarantee as fully convertible at an over-valued fixed exchange rate
despite predictable unsustainability.

Before 1994, Mexico's strategy of adopting sound monetary and austere fiscal
policies appeared to be having its intended effects of making foreign
capital feel secure while the Mexican economy was steadily being hollowed
out. Inflation had been steadily reduced by the inflated peso, government
social spending was down to reduce the budget deficit, and foreign capital
investment was increasing. Moreover, unlike in the years before 1982, most
foreign capital was flowing to Mexico's private sector that yielded higher
returns rather than as low-interest loans to the Mexican government to
finance budget deficits. Although Mexico was experiencing a very large
current-account deficit, both in absolute terms and in relation to the size
of its economy, neo-liberal policy makers did not consider it an immediate
problem. They pointed to Mexico's large foreign-currency reserves, its
rising exports, and its seemingly endless ability to attract and retain
foreign investment. This attitude ignored the fact that true wealth was
leaving Mexico through the turning of peso assets into dollar assets, masked
by a Mexican stock-market bubble fueled by an over-valued peso.

Reality finally unmasked the faulty neo-liberal theory by late 1994.
Mexico's financial crisis was the inevitable outcome of the growing
inconsistency between its monetary and fiscal policies, its over-dependence
on export for growth, and its exchange-rate system pegged to the dollar.
Partly because of an upcoming presidential election, Mexican authorities
were reluctant to take actions in the spring and summer of 1994, such as
raising interest rates or devaluing the peso, that could have reduced this
inconsistency. This structural policy inconsistency was exacerbated by the
government's response to several economic and political events that created
investor concerns about the likelihood of a currency devaluation. In
response to investor concerns, the government issued large amounts of
short-term, dollar-indexed notes called tesobonos. By the beginning of
December 1994, Mexico had become particularly vulnerable to a financial
crisis because its foreign-exchange reserves had fallen to $12.5 billion
while it had tesobono obligations of $30 billion maturing in 1995.

A country can respond to a current-account deficit in four ways:
1. Attract more foreign capital denominated in dollars. The US does not need
to do this because of dollar hegemony, but Mexico, which could not print
dollars, thus was forced to attract more foreign capital denominated in
dollars with a Ponzi scheme of paying old capital with new capital.
2. Use foreign-exchange reserves to cover the deficit. The US can do this by
printing dollars, the reserve currency of choice, but Mexico could not print
dollars, only pesos, which put more pressure on the peso-dollar exchange
rate.
3. Allow its currency to depreciate, thus making imports more expensive and
exports cheaper. But for deeply indebted Mexico, a depreciated peso would
make servicing existing foreign loans more expensive in peso terms.
4. Tighten monetary and/or fiscal policy to reduce the demand for all goods,
including imports, shrinking the economy.

A country such as Mexico can only use (3) and (4), as most Asian countries
also found out in 1997.

It was obvious that Mexico was experiencing a large current-account deficit
financed mostly by short-term portfolio capital that was vulnerable to a
sudden reversal of investor confidence. Nevertheless, neo liberal policy
makers in both Mexico and Washington, while acknowledging that the peso was
overvalued and the existing exchange rate was unsustainable, were undecided
about the extent to which the peso was overvalued and if and when financial
markets might force Mexico to take action. Estimates of the overvaluation
ranged between 5 and 20 percent. Moreover, Fed and Treasury officials under
Alan Greenspan and Robert Rubin respectively did not foresee the magnitude
of the crisis that eventually unfolded. The IMF was oblivious to the
seriousness of the situation that was developing in Mexico and, for most of
1994, did not see a compelling case for a change in Mexico's exchange-rate
policy. In the period prior to July 1997, when the Asian financial crises
broke out first in Thailand, the IMF was praising South Korea and most other
Asian economies for its continuing growth and sound exchange-rate policies.
Even after financial contagion was in full force, the IMF kept releasing
complacent prognoses of the temporary nature of the crisis as a passing
liquidity crunch, while denying its structural causes.

The objectives of the US and IMF rescue packages for Mexico, after the
December 1994 devaluation and the subsequent loss of market confidence in
the peso, were (1) to help Mexico overcome its allegedly short-term
liquidity crisis and (2) to limit the adverse effects of Mexico's crisis
spreading to the economies of other emerging market nations and beyond. No
effort was directed at restructuring fundamental neo-liberal policy faults,
nor to admit that localized isolation is empty hope in a globalized system.

Many observers opposed any US financial rescue to Mexico. They argued that
tesobono investors should not be shielded from financial losses on
moral-hazard grounds, and that neither the danger posed by the spread of
Mexico's crisis to other nations nor the risk to US trade, employment, and
immigration was sufficient to justify such bailout.

The Bank of Mexico, the central bank, increased the interest rate from 9
percent to 18 percent on short-term, peso-denominated Mexican government
notes, called cetes, in an attempt to stem the outflow of capital. However,
despite higher interest rates, investor demand for cetes continued to lag.
Investors were demanding even higher interest rates on newly issued cetes
because of their perception that the peso would be subject to progressively
larger devaluation by rising interest rates. It was a classic vicious
circle. Options available to the Mexican government at this time included
(1) offering even higher interest rates on cetes; (2) reducing government
expenditures to reduce domestic demand, decrease imports, and relieve
pressure on the peso; or (3) devaluing the peso. All three options would
lead to increased downward pressure on the peso and the economy. The only
workable option, exchange control in the form of restrictive capital flow,
was not considered by the Harvard-Yale-trained Mexican central bankers, nor
encouraged by US advisors. It was not until 1998, when Malaysia successfully
adopted exchange control, that some born-again market-failure
fundamentalists, led by MIT economist Paul Krugman, grudging acknowledged it
as a legitimate option.

>From the perspective of the Mexican authorities, the first two choices were
unattractive in a presidential-election year because they could have led to
a significant downturn in economic activity and could have further weakened
Mexico's banking system. The third choice, devaluation, was also
unattractive, since Mexico's success in attracting substantial new foreign
investment to feed its Ponzi scheme depended on its commitment to maintain a
stable exchange rate. In addition, a stable exchange rate had been an
essential ingredient of long-standing policy agreements among government,
labor, and business, and these agreements were perceived as ensuring
economic and social stability. Also, the stable exchange rate was considered
a key to continued reductions in the inflation rate by orthodox
neo-classical economics. Ironically, typical of all Ponzi schemes, success
was fatal because it accelerated unsustainability.

Rather than adopting any of these options, the government chose, in the
spring of 1994, to increase its issuance of tesobonos. Because tesobonos
were dollar-indexed, holders could avoid losses that would otherwise result
if Mexico subsequently chose to devalue its currency. The government
promised to repay investors an amount, in pesos, sufficient to protect the
dollar value of their investment. Tesobono financing in effect dollarized
Mexican sovereign debt and transferred foreign-exchange risk from investors
to the Mexican central bank and government and to provide a short-term
liquidity solution that would exacerbate long-term structural problems.
Tesobonos proved attractive to domestic and foreign investors. However, as
sales of tesobonos rose, Mexico became vulnerable to a financial market
crisis because many tesobono purchasers were portfolio investors who were
very sensitive to changes in interest rates and related risks. Furthermore,
tesobonos had short maturities, which meant that their holders might not
roll them over if investors perceived (1) an increased risk of a government
default or (2) higher returns elsewhere. Market discipline operated like a
pool of circling hungry sharks.

Nevertheless, Mexican authorities viewed tesobono financing as the best way
to stabilize foreign-exchange reserves over the short term and to avoid the
immediate costs implicit in the other alternatives. In fact, Mexico's
foreign-exchange reserves did stabilize at a level of about $17 billion from
the end of April through August 1994, when the presidential elections came
to a conclusion. Mexican authorities expected that investor confidence would
be restored after the August presidential election and that investment flows
would return in sufficient amounts to preclude any need for continued,
large-scale tesobono financing.

After the election, however, foreign-investment flows did not recover to the
extent expected by Mexican authorities, in part because peso interest rates
were allowed to decline in August and were maintained at that level until
December. During the autumn of 1994, it became increasingly clear that
Mexico's mix of monetary, fiscal, and exchange-rate policies needed to be
adjusted. The current-account deficit had worsened during the year, partly
as a result of the strengthening of the economy related to a moderate
pre-election loosening of fiscal policy, including a step up in development
lending, which was considered by market fundamentalists as a big no-no.
Imports had also surged as the peso became further overvalued. Mexico had
become heavily exposed to a run on its foreign-exchange reserves as a result
of substantial tesobono financing. Outstanding tesobono obligations
increased from $3.1 billion at the end of March to $29.2 billion in
December. Also, between January and November 1994, US three-month Treasury
bill yields had risen from 3.04 percent to 5.45 percent, substantially
increasing the attractiveness of US government securities. In the middle of
November 1994, Mexican authorities had to draw down foreign-currency
reserves to meet the demand for dollars.

On November 15, 1994, in response to US domestic economic conditions, the
Fed raised the federal funds rate by three-quarters of a percentage point to
5.5 percent, raising the general level of dollar interest rates and further
increasing the attractiveness of US bonds to investors. By late November and
early December, poor economic performance spilled over to political
incidents that caused apprehension among investors regarding Mexico's
political stability. These concerns were compounded on December 9, when the
new Mexican administration revealed that it expected an even higher
current-account deficit in 1995 but planned no change in its exchange-rate
policy. This decision led to a further loss in confidence by investors,
increased redemptions of Mexican securities, and a significant drop in
foreign-exchange reserves to $10 billion. Meanwhile, Mexico's outstanding
tesobono obligations reached $30 billion, all coming due in 1995. However,
Mexican government officials continued to assure investors that the peso
would not be devalued.

On December 20, Mexican authorities sought to relieve pressure on the
exchange rate by announcing a widening of the peso-dollar exchange-rate
band. The widening of the band in effect devalued the peso by about 15
percent. However, the government did not announce any new fiscal or monetary
measures to accompany the devaluation - such as raising interest rates. This
inaction was accompanied by more than $4 billion in losses in foreign
reserves on December 21 and, on December 22, Mexico was forced to float its
currency freely. The discrepancy between the stated exchange-rate policy of
the Mexican government throughout most of 1994 and its devaluation of the
peso on December 20, along with a failure to announce appropriate
accompanying economic-policy measures, contributed to a significant loss of
investor confidence in the newly elected government and growing fear that
default was imminent.

Consequently, downward pressure on the peso continued. By early January
1995, investors realized that tesobono redemptions could soon exhaust
Mexico's reserves and, in the absence of external assistance, that Mexico
might default on its dollar-indexed and dollar-denominated debt.

As 1994 began, signs were visible that Mexico was vulnerable to speculative
attacks on the peso and that its large and growing current-account deficit
and its exchange-rate policy might not be sustainable. However, neo-liberal
economists generally thought that Mexico's economy was characterized by
"sound economic fundamentals" and that, with the major economic reforms of
the past decade along Washington Consensus lines, Mexico had laid an
adequate foundation for economic growth in the long term. In reality, Mexico
was exporting real wealth and importing hot money with the help of a flawed
central-bank policy that was attracting large capital inflows and held
substantial foreign-exchange reserves derived from foreign debt. Concerns
about the viability of Mexico's exchange-rate system increased after the
assassination of presidential candidate Luis Donaldo Colosio in the latter
part of March and the subsequent drawdown of about $10 billion in
foreign-exchange reserves by the end of April. Just after the assassination,
US Treasury and Fed officials temporarily enlarged long-standing
currency-swap facilities with Mexico from $1 billion to $6 billion. These
enlarged facilities were made permanent with the establishment of the North
American Financial Group in April. The initiative to enlarge the swap
facilities permanently preceded the Colosio assassination. Mexican
foreign-exchange reserves stabilized at about $17 billion by the end of
April 1994.

At the end of June 1994, a new run on the peso was under way. Between June
21 and July 22, foreign-exchange reserves were drawn down by nearly $3
billion, to about $14 billion. In early July, Mexico asked the Fed and
Treasury to explore with the central banks of certain European countries the
establishment of a contingency, short-term swap facility. That facility
could be used in conjunction with the US-Mexican swap facility to help
Mexico cope with possible exchange-rate volatility in the period leading up
to the August election. By July, staff in the Fed had concluded that
Mexico's exchange rate probably was overvalued and that some sort of
adjustment eventually would be needed. However, US officials thought that
Mexican officials might be correct in hoping that foreign capital inflows
could resume after the August elections. In August, the US and the BIS
established the requested swap facility, but not until US officials had
secured an oral understanding with Mexico that it would adjust its
exchange-rate system if pressure on the peso continued after the election.
The temporary facility incorporated the US-Mexican $6 billion swap
arrangement established in April. At the end of July, pressure on the peso
abated, and Mexican foreign-exchange reserves increased to more than $16
billion. Significant new pressure on the peso did not develop immediately
after the August election, but at the same time, capital inflows did not
return to their former levels.

The Fed and Treasury did not foresee the serious consequences that an abrupt
devaluation would have on investor confidence in Mexico. These included a
possible wholesale flight of capital that could bring Mexico to the point of
default and, in the judgment of US and IMF officials, require a major
financial assistance package. IMF officials thought that Mexico's sizable
exports meant there was not a need to adjust the foreign-exchange policy.
They did not foresee the exchange-rate crisis and, for most of 1994, did not
see a compelling case for a change in Mexico's exchange-rate policy. The IMF
completed an annual review of Mexico's foreign-exchange and economic
policies in February 1994. The review did not identify problems with
Mexico's exchange-rate policy. This pattern of IMF complacency was repeated
in Asia and Latin America throughout the rest of the decade.

Whereas the 1982 rescue package would turn out to be just the beginning of a
protracted process of managing Mexico's excessive indebtedness, including
several concerted debt-rescheduling exercises, a debt buy-back, and the 1990
debt-reduction agreement negotiated under the terms of the Brady Plan, the
1995 rescue package worked better. After the 1982 rescue package, Mexico
received support from the Fed and the Treasury on three other occasions, but
always in the form of interim financing while other workouts were concluded.
The difference between the 1982 and 1995 packages is that while the former
was followed by a decade of living in "exile" from the international capital
markets, the latter was successful in quickly restoring market access. The
difference in outcomes must be related to the size of the financial package
and its medium-term quality. In 1995 the financial rescue package was
designed to be large enough plausibly to solve Mexico's liquidity crisis; in
1982, the package was large enough to avoid a Mexican default but for the
next six years the country had to go from one rescheduling exercise to
another, with the uncertainty of whether the country would be able to meet
its obligations always lurking on the horizon. Success in the 1995 package
was not applicable to correcting Mexico's fundamental debt problem.

In 1995, after the Federal Reserve started to hike interest rates in 1994
and sharply curtailed its own purchase of Treasury bills, triggering the
Mexico peso crisis and a subsequent US slowdown, the Bank of Japan initiated
a program to buy $100 billion of US treasuries. China bought $80 billion.
Hong Kong and Singapore bought $22 billion each. South Korea, Malaysia,
Thailand, Indonesia and the Philippines bought $30 billion. The Asian
purchase totaled $260 billion from 1994-97, the entire increase in
foreign-held US dollar reserves. These recycled dollars pushed up stock
prices in the United States.

Like the rest of the world, Asia is heavily dependent on export to the
United States. Japan, by far the largest Asian economy, is paralyzed by an
export addiction for dollars that are useless in Japan. This paralysis is
made worse by an institutionally based policy dispute between the Ministry
of Finance and the Bank of Japan, its newly installed central bank, in
dealing with its economic woes. The dispute centers on the nature of the
Japanese banking system and its traditional national banking role in
supporting the export-based national economic policy. Central banking, as
espoused by BIS regulations, challenges the very root of Japanese
political-economy culture, which has never viewed reform as a license to
weaken Japanese nationalism that saved Japan from Western imperialism in the
19th century. The Japanese model, until it became captured by Japanese
militarism, provided inspiration for nationalist movements all over Asia
against Western imperialism. After 1979, central banking has been viewed
increasingly as the monetary institution of financial neo-liberalism, which
has become synonymous with economic neo-imperialism.

In the US and EU, fiscal policy was significantly diminished as a
macroeconomic policy tool in the 1990s, releasing the Fed and the ECB to
assume the role of meta-political economic manager for their societies.
Money, instead of an engine of commerce for the benefit of people, has
become an economic icon whose sanctity must be defended with human
casualties for the good of the increasingly internationalized financial
system. Unregulated global financial markets operating within the context of
international monetary anarchy allows these two key central banks to impact
economic growth adversely, first in the rest of the world, now even in their
home countries. When the Fed moved to tighten monetary policy in 1999-2000,
after a panic ease in 1997-99, it in effect suppressed global economic
growth by forcing the ECB and other central banks into a series of parallel
rate hikes designed to support the value of their currencies against the
dominant dollar. With joblessness rising and growth restrained around the
world, pressure mounted on the United States to expand its already
unsustainable current-account deficit, to the inevitable detriment of many
US households and businesses, particular in the manufacturing sector but
increasingly in the information and data-processing sectors as well. The
so-called New Economy died. The Fed, the ECB and most other central banks
have remained uniquely opaque entities. In fact, the Fed takes pride in
playing cat-and-mouse games with the market over the prospect of its
interest-rate policy and allows the financial market to operate like a
lottery, with the winner being the lucky one who correctly guessed its
interest-rate decisions. Most Asian central banks follow reactively Fed
policy and action.

Bill Gross, manager director of Pimco, the largest bond-investment fund in
the United States, may not have a monopoly on truth, but he controls vast
investment power over the credit market and makes decisions based on his
views. He wrote recently that 13 percent of the US stock market, 35 percent
of the US Treasury market, 23 percent of the US corporate bond market, and
14 percent direct ownership in US companies are now in the hands of non-US
investors. And with the trade deficit at 6 percent of GDP and the US need to
attract nearly 80 percent of all the world's ongoing savings just to keep
the dollar at current levels, "an end to the party is clearly in sight".
Gross said that former Treasury secretary Robert Rubin's policy of a strong
dollar succeeded so famously that US bonds and stocks now have lower yields
and much higher price-to-earnings ratios (P/Es) than most alternative
markets. This strong-dollar policy, implemented through the Fed under Alan
Greenspan, has painted the US into a corner from which either a falling
dollar, depreciating financial markets, or both are "nearly inevitable".

The net foreign debt in the US economy is now 22 percent of GDP. Assuming an
economic recovery, the US economy is on a trajectory toward a debt burden of
40 percent of GDP within five years, roughly the debt-to-GDP ratio of
Argentina in 2000. What keeps the US afloat is dollar hegemony. The US
cannot forever borrow in order to buy more from the rest of the world than
it sells. The interest burden will eventually be so heavy that foreign
investors will be unwilling or unable to keep financing this rising debt.
When that happens, the dollar will drop and dollar interest rates will spike
upward. The United States will then be forced to run a trade surplus with a
drastic devaluation of the dollar and/or a draconian deflation in real
incomes in order to reduce demand for imports and make US goods cheap enough
to run a surplus in world markets. Yet this will directly shrink world
trade, making it difficult for the US to reduce its cumulated debt.

The costs of balancing trade through deflation would be near fatal.
According to one calculation (Godley 1995), bringing a current-account
deficit of 2 percent GDP into balance would require a 10 percent drop in GDP
and a jump of 5 percent in the unemployment rate. With today's trade deficit
of 4 percent and rising, the required contraction in GDP would be 20 percent
or greater and an unemployment rate of an additional 10 percent to the
current 7 percent. Attempting to regain balance through currency devaluation
could be catastrophic. Goldman-Sachs recently estimated that it would take a
more than 40 percent drop in the dollar just to halve the US current-account
deficit. Getting to a trade balance will be even more difficult because US
manufacturing capacity may well have shrunk below the level needed to
eliminate the trade deficit through expanding exports. Given relentless
import competition, investors are reluctant to make long-term capital
available to small and medium manufacturing firms, and some large ones as
well. The grim outlook for manufacturing also reduces the incentive for
young people to invest in becoming skilled manufacturing workers.

The low savings rate in the United States also contributes to the
current-account problem but it is now a function of a deficiency in private
rather than public savings. This is a much harder problem to solve. In fact,
the US does not seem to know how to raise its private savings rate without
putting a damper on its relentless push on expanding consumer finance. Under
current conditions, increasing the savings rate would reduce consumer
demand, upon which the US economy and the world depend.

Japan's economic problem is rooted in the geopolitical shift resulting from
the end of the Cold War. The Japanese economy has outgrown its postwar role
as an export engine. With the end of the Cold War, Japan no longer enjoys
geopolitically induced special trade concessions from the United States. The
continuing trade surplus with the US is now contingent on its being recycled
into dollar assets. Not only will the continued expansion of export to the
US not be sustainable at a rate that will help the doomed Japanese domestic
economy, but even effective stimulation of domestic consumption cannot solve
the Japanese dilemma because the domestic economy is too small to sustain
the enormous and growing overcapacity of its export engine. The Japanese
economy cannot be revived by domestic restructuring unless it is prepared to
shrink drastically to the size of the United Kingdom. No monetary or fiscal
measures can overcome this structural problem, which is the legacy of
policies of General Douglas MacArthur's occupation after World War II. The
Japanese problem is not a purely economic problem. It is a political-economy
problem. What Japan needs is to restructure its international economic
relationships away from its unnatural partner, the United States, toward its
natural partner, China, and to shift from an export economy to a
regional-developmental economy.

The anchor of US policy in Asia is the United States' "special relationship"
to Japan. The intensity and bitterness of the historical conflict between
Japan and the US for their separate interests in Asia have not been
eliminated by the post-World War II facade of "special relationship" or by
the Mutual Defense Treaty. Before World War II, Japan, not China, was seen
by most US leaders as America's chief rival in Asia. They squeezed Japan's
access to vital raw materials, particularly oil, and so obstructed Japan's
plan of becoming a great regional power through its conquest of a fragmented
China weakened by a century of Western imperialism. While the targets of
Japanese expansion in World War II were primarily the colonies of the
British and French empires, the sole exception being the Philippines, the
objective made it necessary for Japan to disable the US Pacific Fleet. The
Pacific theater against Japan in World War II was won mainly by US efforts,
unlike the European theater, where Britain and the Soviet Union also played
major roles. It was the Japanese attack on Pearl Harbor that forced Adolf
Hitler to declare war on a formally neutral United States, thus saving
Britain from imminent defeat. It was one of the two strategic errors Germany
made, the other being the invasion of the Soviet Union. Without a two-front
war that eventually destroyed the German 6th Army on Russian soil in
February 1943 and the relentless Soviet counteroffensive afterward that tied
up half of German military assets, it would be doubtful whether the US
landing in Normandy in 1944 would have been as successful as it was.

Britain, in winning a Pyrrhic victory against Germany with US and Soviet
help, lost both empire and greatness. Together with Britain, supposedly the
winner, Japan and Germany, the vanquished, were thrown by World War II into
the arms of the United States as suppliants, in a subordination masked by
the euphemism of "special relationships". Postwar Germany, divided into
socialist East and capitalist West, benefited economically from the Cold War
by the need of the US to subsidize West Germany to keep it safely in the
Western camp. Outside of imposed anti-Sovietism and anti-communism, West
Germany enjoyed enviable autonomy from US policy domination. Japan enjoyed
much less autonomy than West Germany, a fact many Japanese resented as US
racism. Further, Germany had a real historical phobia against a powerful
Russia pushing westward, while Japan had less real reason to fear China, or
an Soviet Union that was fundamentally Europe-oriented. Japan had already
defeated Russia once.

After the Japanese surrender, MacArthur at first aimed at restructuring
Japanese politics and economics to prevent a return to militarism. For that
purpose, MacArthur's occupation regime purged from Japanese politics all
wartime leaders, instituted land reform, and began breaking down large
corporate conglomerates (zaibatsu or keiretsu), in favor of populist if not
socialist forces. This strategy would begin to change in the early months of
1948 with what would be labeled in diplomatic history as "The Reverse
Course".

As fears of Soviet expansion grew in Washington, concerns also grew that
MacArthur's reform program was making Japan geopolitically unreliable,
ideologically unstable, economically weak, and geopolitically vulnerable to
subversive infiltration or, in the longer run, perhaps even military
invasion with Fifth Column help. As China liberated itself by establishing a
socialist state in 1949, MacArthur was ordered to turn US occupation policy
abruptly into a strategy of keeping Japan from turning toward socialist
paths. Since Japan was viewed as a "strong point" by key US grand
strategists George Kennan, George Marshall, and Dean Acheson, a more
politically regressive and economically conservative program was put into
place. It was a program designed to stabilize the Japanese political economy
and to set the stage for revived limited Japanese military strength in the
future that would assist US efforts in countering international communism in
Japan and the rest of East Asia.

To support this controlled military power, a US trade subsidy/preference
regime for Japan was instituted. MacArthur, who had all but set himself up
as the new emperor of Japan and who had built a postwar popularity within US
domestic politics, criticizing the State Department for shortcomings ranging
from Eurocentrism to excessive meddling in the Pacific to lack of political
will to use nuclear weapons on China, would argue not only against reversing
the anti-zaibatsu program, but also against strengthening the Japanese
military from whom he had suffered well-publicized defeat with deep personal
embarrassment. Ironically, it was left to the Supreme Military
Commander/Occupier to argue that economic growth and a stable political
order were the most important weapons in the struggle for containment of the
communist threat for Japan, not the creation of military might.

Nobody doubted the general's argument about the importance of economic
strength and political stability, but many at the US Defense Department and
some even at the State Department subsequently insisted that they wanted a
major portion of the fruits of US supplied economic revival to be channeled
into Japanese military strengthening. In their minds, Japan should accept a
significant share of the burden of defending itself and containing communism
in the region. This position would win the debate in Washington and would be
presented to Japanese authorities in 1950-51 by president Harry Truman's
special envoy, John Foster Dulles. In the 1950s, the administrations of
Truman and Dwight D Eisenhower both believed that open tolerance of Japanese
resistance to US imports, systematic undervaluation of the yen, and total
reliance on US military protection were necessary to strengthen Japan
domestically and legitimize it internationally as a solid anti-communist
ally. After persistent persuasion by premier Yoshida Shigeru, US leaders
also decided that pushing the Japanese government too soon and too hard to
build up its military significantly merely to reduce the US defense burden
could lead to a popular backlash in Japan that might threaten the budding
alliance and, by association, the maintenance of US military bases in Japan.

Japan, a recent and very bitter enemy, was clearly not sharing much of the
cost burden of the anti-communist alliance early in the Cold War. In fact,
it worked to benefit economically from it. The kernel of this dilemma is
still alive in the developing relationship of new US-Japan relationship
under the current administration of President George W Bush. While the Bush
Team claims a continuation of the strong-dollar policy, there is much open
talk of coordinated government intervention against a yen devaluation beyond
120 to the dollar. Concerned about the acceptance of the US-Japan alliance
in domestic US politics, US leaders decided they must maintain US dominance
of the political alliance in exchange for generous US aid, trade, and
military protection policies Washington had already granted to Tokyo. As the
sole economic power that had directly profited from World War II, the United
States had the resources and the confidence to buy Japanese support with
economic carrots. In particular, Yoshida would be pushed to accept
Washington's pro-Kuomintang (KMT, or Nationalist) and tough anti-communist
China policies. US elites worried that if Yoshida diverged too strongly from
the anti-communist strategies being advocated by the United States, Congress
and the public would demand a fundamental reconsideration of the already
controversial one-way economic relationship. The same argument was presented
to other national leaders around the world as a reason for them to shun
independent national-policy lines toward the communist world. The
geopolitical foundation of the Marshall Plan was obvious, but the US
domestic-politics argument was the classic mantra.

Yet the cost for Japan of compliance with US geopolitical leadership demands
was very high because the United States had adopted such a tough policy
toward China, with which Japan would have preferred to have closer economic
and diplomatic ties than intransigent US policy would allow. This problem
exists even today, albeit under different geopolitical conditions. The
Truman administration's need to guarantee domestic consensus for its
domestically controversial early-Cold War grand strategy often compelled it
to abandon its privately preferred economic and diplomatic strategies toward
China. In 1949-50, the US refused to abandon KMT leader Chiang Kai-shek and
recognize the new People's Republic of China (PRC), despite Truman's
personal disdain for Chiang and KMT corruption and Madam Chiang's deft
manipulation of the Republican right wing and the anti-communist Christian
fundamentalists in US domestic politics.

At the outbreak of the Korean War, the Truman administration reversed
earlier statements of neutrality regarding the Chinese Civil War and sent
the 7th Fleet to protect KMT-controlled Taiwan from potential forceful
unification with the communist mainland. This locked the United States into
an exclusive diplomatic relationship with Chiang's regime until 1973, and
the 7th Fleet continues to be active in the Taiwan Strait today. The Taiwan
issue remains the main obstacle to normal US-China relations. After the
late-1950 escalation of the Korean War, a desperate Truman administration
applied a total embargo on China, and policies more hostile than those
applied to the Soviet Union (this imbalance in the Coordinating Committee
for Multilateral Export Controls - CoCom - regime would come to be known as
the "China Differential").

Many of the US diplomatic and trade policies around the world, particularly
in Asia, were often viewed by top presidential advisors as ineffective or
even counterproductive on geopolitical grounds, but politically unavoidable
on domestic grounds, particularly after the outbreak and escalation of the
Korean War from June-November 1950.

To understand the sacrifice Tokyo had to make in order to grant the United
States a firm leadership role on the budding US-Japan alliance's China
policy, it is critical to note just how important the Chinese economy had
been to Japan in modern history. It was the search for a preferred
integrated economic relationship with China that fueled Japanese aggression
on the mainland in the 1930s. Japanese leadership was actually obsessed
first and foremost with the threat from the Soviet Union and the lessons of
World War I about the need for an autarkic economy to provide staying power
in war. The quest for Japanese autarky on the Asian mainland helped drive
Japan deeper and deeper into a quagmire in China and, eventually, into war
with the United States over oil supply. In the 1920s and for most of the
1930s, China (including Manchuria) was by far Japan's biggest export market
and import provider in the region. Japanese exploitation of Chinese
resources financed the Japanese military machine for World War II. In 1949,
Yoshida and other members of the Japanese elite saw real economic and
political benefits in establishing relations with the new communist regime
in Beijing. Postwar Japan wanted to appear sympathetic to the new Asian
post-colonial nationalist movements, a theme of the wartime Co-prosperity
Ring.

The problem was not that PRC-Japan trade was viewed as against US or
Japanese national interests, but that it was unacceptable to US domestic
politics. In February and March 1949, six months before the founding of the
People's Republic, the US National Security Council produced NSC 41, a
report on China trade policy. The document reflected a cautious faith in the
possibility of Chinese Titoism and the usefulness of US trade with areas
held by the Chinese Communist Party as a way to reduce the CCP's dependence
on Moscow. The sections on Sino-Japan trade were, in a sense, more
practical, emphasizing the goal of reducing the US burden of rebuilding
Japan as well as gaining some degree of political leverage over China
through trade dependence with Japan. The State Department was hardly
indifferent to the concerns raised by opponents to Sino-Japanese trade, so
NSC 41 and other directives advised MacArthur to encourage trade on a quid
pro quo basis and to try to find alternative markets and raw-material
sources elsewhere in Asia to reduce Japanese dependence on China for
critical materials. The need for such alternative markets for Japan was one
of the arguments Washington used on Japan to secure its support for keeping
Southeast Asia out of communist hands early in the Cold War. This
constituted another "Reverse Course", in which the United States went from a
critic to a supporter of European imperialism in British Malaya and
Indochina.

Despite US restrictions, Japanese trade with mainland China grew tenfold
from 1947-50. The Korean War and the US-led embargoes against China halted
this trend. Another problem facing the United States in its calculation
about US-China and US-Japan trade was that, for economic and political
reasons, Britain was unwilling to apply the strict export-control measures
toward China that Washington demanded, fearing the damage such measures
would do to British Hong Kong. In November 1949, top US officials recognized
that if Western Europe traded relatively normally with China while the
United States and Japan embargoed it, this would only serve to increase the
expense of the US relationship with Japan without any real costs being
raised to the Chinese economy. Although the Truman administration would
continue to try to prevent China from getting strategically important
materials (1A and 1B items on the CoCom list), it seemed resigned to allow
PRC trade with the US and Japan on a "cash basis". The logical standard was
that the same criteria should be applied to China that were being applied to
the Soviet Union and Eastern Europe. In the first half of 1950, the picture
became more mixed as relations with Beijing worsened after the January
seizure of US consular property and the February signing of the Sino-Soviet
defense treaty. The United States wanted to find a balance between, on the
one hand, reducing the burden on the Japanese economy (and, indirectly, on
the United States) by allowing trade between Japan and the PRC, and, on the
other, reducing Japanese dependence on China, which could provide China with
political leverage over Tokyo and threaten US dominance.

The Truman administration pushed this argument particularly hard on other
non-communist partners in East Asia, which had been reluctant to open up
their economies to their former Japanese occupiers. The administration
argued that increasing their trade with Japan was a necessary role for these
allies since Japan's natural market in China had fallen to the communists.
The Korean War would radically alter this picture, with the US leveling the
"China Differential" in CoCom. It was clear that domestic politics, rather
than the "high politics" of strategy, was driving US trade policy toward
China, as was true with the US attitude toward Chinese accession to the
World Trade Organization five decades later. This all but destroyed
Sino-Japanese trade, as some 400 items were put on the list of prohibited
products. Over the next several years, important elites, including president
Eisenhower himself, recognized the illogic of the China Differential and a
strict Japanese embargo on China. But significant relaxation of China-Japan
trade restrictions would remain in place until well after the end of the
Korean War.

Throughout 1951, John Foster Dulles, Truman's envoy to Japan for
negotiations on the Japanese Peace Treaty, would apply the same logic with
Yoshida Shigeru. Dulles made various arguments why Japan should reject
Beijing as a diplomatic partner, continue recognizing Chiang Kai-shek's
regime on Taiwan as the sole legitimate government of all of China, and sign
a peace treaty with Chiang's Republic of China rather than the PRC. Dulles
also sought Yoshida's general compliance with US limits on trade contacts
with the PRC.

Like most Japanese elites since MacArthur, Yoshida was anti-communist. But
as a practical matter, Japan wanted diplomatic ties with Beijing and much
more extensive trade relations than Dulles's preferred scenario would allow.
Yoshida bluntly put it: "I don't care whether China is red or green. China
is a natural market, and it has become necessary for Japan to think about
markets."

In his effort to persuade Japanese leaders, Dulles' trump card was not a
geostrategic argument but a domestic political one. He emphasized that if
Japan did not comply with US general Cold War strategy, the military
protection of Japan by US forces would become more controversial
domestically, as would economic aid and Japan's preferential trade and
financial arrangements. It was this domestic political argument, above all
others, that convinced the reluctant Japanese that questioning the US
leadership role in the Cold War in Asia could carry devastating results for
the maverick nation's security and economic interests. Dulles would return
to this tried-and-true bargaining tactic again as president Eisenhower's
Secretary of State in order to prevent Japan from establishing politically
significant trade offices in China. The result of Japan's acquiescence to US
demands, the December 1951 Yoshida Letter and subsequent bilateral Peace
Treaty negotiations with Taipei in 1952, locked Japan into a pro-Taiwan,
anti-Beijing diplomatic posture for the next 21 years. With Japanese
acquiescence to America's harsh economic sanctions regime against China, the
small-scale but promising trade between Japan and the PRC allowed by the US
in 1949-50 practically disappeared.
Politicians are probably held in as low esteem in Japan today as in the
United States. For an Asian culture, that is a serious development.
Unfortunately, the bureaucracy, which basically sets policy for Japan, is
also not trusted because of the present anemic state of the economy and US
media scapegoating. After a whole decade of slow growth, the streets of
Tokyo still do not look like those of a poor economy, because the Japanese
government has been effectively insulating the Japanese public from the real
pain. The US had a cozy relationship with the Liberal Democratic Party but
had a contentious relationship over trade. Today, young people in Japan are
more openly nationalistic than the subdued older generation. It will be
increasingly more difficult for the United States to work with Japan as time
passes.

For many years, Japan has counted on its economic strength to provide its
regional and global influence. There was one magic moment when the yen was
79 to a US dollar and the Japanese economy on a currency basis was larger
than the US economy and Herman Khan was predicting the Japanese Century. The
psychological shock in shifting from a position of a rising economic
powerhouse to a situation where the world is criticizing Japan's economy has
sapped Japan's self-confidence. Market capitalization of Japanese equity
fell from 50 percent of global value to just 10 percent, even as the US lost
60 percent of its peak market capitalization. The economic difficulties
Japan is experiencing are not a banking problem, as US neo-liberal
economists keep saying. The central bank, though newly created, has become
part of the problem. But the central problem involves a much broader system
of a dual economy of successful transnational companies built on
subsidiaries and networks of other small companies that are operating along
unique Japanese relationships.

The Finance Ministry, trying to help consumers by dropping the discount rate
to 0 percent, failed to help consumers but decimated the insurance industry
because it offered a guaranteed rate of return on its pension plans that are
now much higher than current returns on investment. The industry could not
find any place to put the money to provide the return it had guaranteed.
Large insurance companies went broke and the people counting on them for
their pensions no longer had pensions. As a result, people started not
renewing their policies.

Japan is becoming an older society faster than any society in the world. But
it has a large savings base, about $10 trillion, which amounts to about a
per capita amount of $80,000, enough to cover per capita debt in the United
States at its height. But 60 percent of that money is held by people over 65
who are not robust consumers. How does one motivate such an economy? The
world has never seen a country with a population this old.

The world consensus is pushing Japan into a quick solution so as to avoid an
even more traumatic Asian financial crisis. The concern in Tokyo is that, if
Japan did "fix" the economy in a hurry, it might cause more trouble than
would a gradual approach. The US has told Japan to lead. The first solution
Japan came up with when the Asian economy started to collapse was a $100
billion security fund to help Asian economies, which the US rejected.
Economic growth has been flat since the real-estate and stock bubble burst
in 1990, except for 1996, when real GDP growth was 3.6 percent due to a
large fiscal stimulus and low interest rates. Japan remains a massive net
exporter of goods to the rest of the world as its economy sinks. It has
emerged as a model for other Asian economies to avoid, rather than copy.

Japan, as an Asian culture, places importance on the national economy and
operates as if individuals and companies can only prosper if the national
economy prospers. The US economy operates as a "natural" calculus of
individual survival. To Americans and American corporations, a national
economic boom has no meaning unless the individual unit first benefits. As
markets globalize, this creates problems for management in both cultural
regimes. For Japan, bailouts are normal, while in the US bailouts, though
they occur, are exercised with apologies. When in trouble, the US economy
historically sacrifices quickly the weak and the small, while the Japanese
economy punishes the strong and big gradually.

When the long-overdue US recession hits, Americans will see their faith in
market free enterprise shaken as the Japanese have been losing their faith
in their command economy, despite the fact that the government has been
reasonably effective in insulating the Japanese public from economic pain.
The Campaign 2000 rhetoric in the United States was already slightly
populist and the recession has yet to begin. The recent Bush tax plan was
couched in heavy populist rhetoric. The problem is that around the world
there are visible signs of exhaustion. Asia and Latin America are completely
worn out after six years of tumult. The US boom was fed mostly by global
deflation, and there have not been free lunches even in the US. Even those
who are still doing well have to work 14-hour days and most families need to
be two-income households to make do. The press has stop running stories
about people with $60,000 annual incomes living in their cars in Silicon
Valley because it is no longer news. At this rate, unemployment may even
come as a relief and a guiltless way to get off the treadmill.

There was a moment in the late 1960s, before the Vietnam War blew away all
of America's surpluses, that people with good incomes were beginning to take
three-day weekends on a regular year-around basis and eight-week vacations.
>From Los Angeles to Dallas to Scarsdale, fathers were home by 5:30pm
barbecuing for the whole family and mothers had time for their children, and
the GDP was a mere $200 billion. Economists thought then that if the GDP
reached $1 trillion, all economic problems would be solved. Instead, the GDP
is now more than $10 trillion, and there is financial crisis everywhere -
from health care to social security to education, even defense. There
appears to be a problem with what growth really is.