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Passing the torch of financial power

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If indeed the time is upon us when Asia takes on great financial duties, then relations between (especially) China and the US must at least return to those of mutual respect.

Everyone is aware of the way the international torch of power and responsibility was passed on among the nations of the West after World War ll, the colonial operations of the UK, France, Germany, and (here considered part of the de facto West after hostilities were over) Japan could not be sustained, could not be paid for by the “smashed” nations, neither winners nor losers. 

Only the US, partly because of the protective moat of two oceans, an Arctic wilderness and a non-combatant Southern Hemisphere, emerged from combat not merely on the winning side, but virtually without loss to its non-human, non-military capital structure.

At that point, China not only had suffered great human losses, not only was it immersed in its revolution, but it had little in the way of modern industrial capital it could lose, and what it did have was also lost, just as was the case for the remainder of the war’s participants.

America was the last man standing. It is to its credit that it did not impose a Roman Peace, with itself as the unchallenged and unchallengeable HQ for all things, but neither did it fail to pick up the pieces and rearrange at least some of them in a way consistent with its national interest. 

The Royal Navy no longer ruled the seas, but the US Air Force, a superior military institution, dominated the skies. An odd exception was Russia, which traded off the Czar’s empire for Stalin’s, a deal that looked pretty good until 1990. And so, for a historically short period of time, the US had a monopoly over the stock of world power.

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But then, in the surprisingly short time span of three or four decades, China and to a lesser extent the Asian players that for one reason or another were freed from bad government and self-destructive social, political and economic habits, some imposed upon them to be sure, appeared at the table of the United Nations, the International Monetary Fund, the World Bank, one treaty organization after another, and said: “We are Tigers, hear us roar.”

So maybe the torch will be, is destined to be, must be, passed from the West to Asia? 

Any financial torch-passing that might happen must occur with the greatest possible care, caution and wisdom, because the way it happened right after World War II will not be possible now.

There are several torches that might be discussed. One profound problem is the economic and financial issues connected with establishing a new or significantly altered mix of monies that constitute world exchange reserves, and beyond that, what might be called “world money.”

At war’s end almost no nation had any money it could expect other nations would accept. But US money was OK. Using it, the US did not step into the ruins and simply rule in the Roman manner, by installing governors, consuls and pontiffs who operated by direct rule.  (Perhaps the “teaching moment” example was set by Pontius Pilate in Judea, whose decisions did not work out well in the long run tor Rome.)

Paper gold

For whatever reason, the strategy chosen was relatively benign, with benefits that flowed to both the US and the nations whose recovery it aided.  

So what strategy was decided upon? It was then and is now a more-or-less “stringless” plan of market investment, super-enlarged banking and financial infrastructure that supplied and still supplies a class of “rebuilding institutions” for management expertise and stockholder-type ownership and control.

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In the mid-1940s it was believed, especially in the US, that it was  critical to the entire recovery  operation to set up two financial entities.

The first was the International Monetary Fund, with a plan of operation that allowed it to (eventually) create “paper gold,” a form of international money that one way or another would find its way into the hands of the smashed powers, winners and losers, who had no money but who needed funding so that by way of  revived international trade (conducted in paper gold) they could bootstrap themselves back to solvency and economic health.

IMF loans of paper gold (at first dollars, later special drawing rights, or SDRs) were intended for the short-run stabilization of exchange rates and general currency-market stabilization for nations whose full recovery could be expected to occur in relatively short order.  

The second “big idea” was the World Bank. It was to be the world’s investment banker, providing long-range funding for less developed or second-tier nations. The source of the funding and the repayment terms were not worked out very carefully, but the implicit idea was that this too would be paper gold, the funds used for long-run reconstruction in cases where short-run recovery prospects were not so good.

Although it was hoped that the IMF and the World Bank would be powerful enough on their own, they have always been dependent on US dollar support. If any torch is to be passed to China, a takeover not just of these two financial players, but many other “reconstruction” bankers must occur. See below for just the FX (foreign exchange) trading value numbers.

 I will leave it at that and confine the rest of my analysis to simpler things.

Despite its obvious importance, for reasons of space among other things, I also leave out the vital role played by military operations, including NATO and the omnipresence, immense in power, of the American military, which took up the job of all the European empires combined and then some, with bases and consequent cultural implantations greater than imperial Rome could ever attempt. 

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From these places, language, a kind of law and a cultural reality composed in part of on-base post exchanges consisting of supermarkets and shopping malls, blue jeans, Coca-Cola, Lucky Strike cigarettes and jazz/rock ’n’ roll music took over the world.

The US annual military budget is $778.23 billion. Salaries, often spent on foreign bases, are a large part of this number. The Kiel Institute, a German think-tank, says the US has provided $54.4 billion in military aid since February. In 2020 officially reported military spending abroad was $11.6 billion. Is China ready to support or replace such an international military presence?

Wine and cheese

Charles de Gaulle, no friend of Anglo-American power even though it fed him, clothed him and sheltered him at a time when a significant portion of his own people had gone over to the enemy, was especially critical of role played by the internationalization of the American dollar after the war. 

For all the emotion expressed in his attitude, he was correct in thinking that “the Americans” were able to take from the world market great quantities of French wine, cheese, and property in exchange for “mere paper.”

For the situation was then and to a degree still is that an American dollar that finds its way into international hands because of trade – perhaps because a French wine merchant made a sale to a US buyer – did not, even in the fairly long run, ever return to the US, where some Americans would have to give up some US asset or US product, in order to “retire” the wayward dollar and thereby “really pay for” that bottle of wine..

The current US external debt is $24048762 million (I wrote it out to shock you). It includes for example lots of French cheese and wine paid for with paper money that has not “come home” to be paid off. It is a “benefit” of being a reserve currency.

Is China ready to take on this role? Will the US relinquish it? This is another question I put on the table but prefer to go on to simpler things.

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The reality that international reserve-type currencies, once they “leave home,” do not quickly, or perhaps ever, go home again gives a reserve-currency nation a great power: the power to get real stuff in exchange for “mere paper.”

The trouble is that as the wandering dollars build up, especially in the case discussed in this essay, where there may be a passing of the torch, they are hammered together to form an overhanging sword of Damocles. 

If the reserve-currency nation has lost the torch, and economic entities who wish to retire their dollars, perhaps replacing them with some new reserve currency issued some emerging power, the sword may not merely drop upon the old power, but as it as it falls and bounces around, many players get cut up.

Let us discuss that more simple issue. Despite the apparent power and significance of the artificial banking, lending and financial powers granted to institutions like the IMF, World Bank, and myriad smaller “development banks,” their influence was short-lived. 

Careful what you wish for

Partly because the “Asian factor” was inadequately recognized (at least in early days, when European recovery was a political necessity and priority), private investment players and private banking, development groups, speculators, monetary visionaries, and all manner of unplanned for and unlooked-for private financial institutions quickly took over the creation and management of international money. 

Indeed, certain imaginative international banks, entirely on their own, with no connection to the American central bank, began to issue loans and create deposits denominated in US dollars (at one point called Eurodollars) all in order to satisfy the demand for a financial foundation adequate to support the burgeoning, booming, blossoming worldwide markets in which were traded all the now familiar products that fill the “market basket” of world trade. Those trade markets were critical for China.

But the trouble was, at least for the purposes of this essay, the majority of all this market action took place, and still is taking place, in terms of US-dollar-financial documents, loans, deposits, investments and controlling institutions.

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The American dollar’s omni-presence, omni-importance and omni-power must be reckoned with if any kind of torch is to be passed without setting the house afire.

China wants its currency to replace the dollar in international affairs. But China should be careful what it wishes for. Let us lay out the “simplest” special problems involved in any current torch-passing.

We won’t be looking at the entire mass of international US money. A general definition of that total is that it includes all manner of financial instruments, half of which are issued by non-US entities but which (that is, the instrument does) conditionally promise to deliver, in the long or short run, US dollars to the legitimate holder in due course of the instrument.  The entity making the promise might be private or governmental. 

The other half of the problematic mass of non-US-located world money are holders of financial documents who expect to receive, at some close or distant time, “real” US money (able to be exchanged for “real”) US assets, property goods or what have you. 

Of course, these two kinds of instrument overlap. Even if we had data to describe them, there would be much double-counting. Even just half of their combined total amounts to many trillions of dollars. The value (but who could buy it?) of just the private world market for FX is $2,409 quadrillion US dollars. It is available 24/7. Daily trading in the FX market is 6.6 trillion US dollars. Is China ready to take it over?

But once again, after noting the big issue, we will move on to something simpler: the total of international FX reserves held by the world’s central banks as reported by the IMF and World Bank. 

When a central bank such as the Bank of England has in its possession the money of some other nation, for example China, then the US dollar value of that renminbi/yuan counts as part of the world’s FX reserves. Such funds may or may not “run around the world” for long periods of time, rarely returning to the “mother ship” if they have the “lucky” status of being a “reserve currency.”

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The IMF reports the total amount of world for exchange reserves in terms of US dollars is $12.8 trillion; the amount that is in American dollars is $7.08 trillion; the amount that is in renminbi is only $314 billion; the amount that is in Japanese yen is $672 billion; the amount that is in euros is $2.4 trillion; the amount in pounds sterling is $560 billion.  

Australian dollars have a surprisingly large amount of $218 billion and Canadian dollars even though reported in American dollar terms are $270 billion; Swiss francs are only $23 billion. Lesser players make up the rest.

These official totals are but a small part of the challenge China would face were it to replace the United States’ overall role as a financial and quasi-financial world presence, as I have established above. The official numbers are themselves misleading. It is notoriously true that Swiss francs, long used in markets (like that for tax evasion) where facts are kept secret, have a greater real role than is suggested by the numbers above.

But consider China’s challenge were it to contemplate just multiplying its presence on the books of international central banks by 22.5 times (7080/314 = 22.5) while somehow reducing the US dollar position to zero.

I don’t know if the ratio of 22.5 is the correct metric, but among other things: Is China ready to open its financial, property, investment, equity and debt markets by a double-digit multiple to accommodate the inflow and outflow of renminbi implied by these numbers? Remember the other “internationalizing” factors mentioned above, from military issues to the world of private finance.

This is a deep and highly political question, so let us simplify one more time, and just look at the question of how 7.08 trillion US dollars, made redundant by China’s having replaced them, just in official FX balances, be absorbed? In other words, who will eat, and will someone choke from eating surplus dollars if the American relative presence in the world’s financial markets is diminished?

If the dollar is no longer a reserve currency, somebody must eat the dollars that “come home” to be “retired.” The country that takes over could simply take on the dollars, replace them with its own currency, and hold the dollars idle. The danger is, those stored dollars will have quickly lost purchasing power, since the market for them has gone away. 

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The player(s) who hold surplus dollars could take the to US markets to buy US goods, services and assets, taking them all out of US hands, making America poorer in the sense they no longer could enjoy the goods sold, or take profits from the assets transferred.  Americans who were active and “rich” buyers in foreign markets for overseas goods services and assets will leave foreign sellers of such things with much diminished markets. Those French cheese makers will have to eat their own cheese or find other buyers.

The player nation that produces the new reserve currency discovers it must open completely its banker books, financial market records and set up internationally transparent legal systems within which other trading nations may, with assurance that everything is fair and in accordance with due process and rule of law, trust the outcome of dispute settlement mechanisms. 

If the workings out of destiny, or by way of its own conniving, China finds it has grasped the torch, it will of necessity adopt many features of Western finance capitalism. It will need peaceful guidance or mentoring or accept it must imitate the nation that invented the idea of a paper reserve currency, the US.

A toxic relationship won’t help. Even if that is rectified, it won’t be easy.

Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.

Source: Asia Times

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