G-20 Leaders will face defiant protests in London.

Some of my colleagues and other readers of the Global Markets & Foreign Policy blog have commented recently that my posts are “alarmist” in nature, or “out of the mainstream.”  Others have gone as far as saying that I’m a “radical.”   That is until I bring their attention to the fact that my posts are usually a compendium of recent news items, supported by reports from sometimes  stodgy,  staid and mainstream sources such as the Wall Street Journal, Foreign Policy (FP) magazine or the New York Times, among others. 

Case in point, last week, The Mail, a London daily, reported that British PM Gordon Brown endured a public rebuke from Brazilian President Luis “Lula” Ignacio Da Silva that it was unfair that the world’s poorest nations had to suffer the most from the greed and irresponsibility of Western bankers, and the failures of the Anglo-American, or ‘Laisse-Faire’, capitalist system.  

‘This was a crisis that was fostered and boosted by irrational behaviour of people that are white, blue-eyed, that before the crisis looked like they knew everything about economics,’ he declared. ‘Now they have demonstrated that they don’t know anything about economics.’

Gordon & Lula in London Last Week

Those aren’t my words.  And to further the point, today’s Sunday Times includes two interesting articles in particular: one titled, “Anglo-American Capitalism On Trial,” and the other questions the future role of the IMF as global finance trends shift from north to south as developing Markets are no longer content to become shackled in debt to creditor developed nations (think the G-8).  You should read them both. 

And the lead report in the ‘Washington’ section notes, among other things:

The challenges stem in part from lingering unhappiness around the world at the way the Bush administration used American power. But they have been made more intense by the sense in many capitals that the United States is no longer in any position to dictate to other nations what types of economic policies to pursue — or to impose its will more generally as it intensifies the war in Afghanistan and extracts itself from Iraq.

“There is a direct challenge under way to the paradigms that America has been trying to sell to the rest of the world,” said Eswar S. Prasad, a former China division chief at the International Monetary Fund. The American banking collapse, which precipitated the global meltdown, has led to a fundamental rethinking of the American way as a model for the rest of the world. Yet even as his presence stirs opposition to particular American policies, Mr. Obama is being welcomed by many Europeans as an embodiment of American ideals.’

IMF Board of Governors (WP)

 From the New York Times - Sunday 29 March 2009:

And then there was this also from the New York Times: (Though I usually like to mix things up a bit, it seems in its final throes as a daily newsprint, the New York Times out did itself today with exceptionally insightful analysis of the full scope of issues facing the G-20 this year.) 

“Just as Roosevelt and Churchill shared that bond, so, now, do Mr. Obama and Mr. Brown. Both men, reacting to events on Wall Street, in the City and in other financial centers, have spoken, with unaccustomed asperity, of the greed and irresponsibility of bankers, hedge-fund managers and others who, the two men have as much as said, have betrayed the system and come close to wrecking it.

Now, the conviction that the system must be rebuilt to curb future excesses forms a starting point for the reforms that will come under discussion in London. Like Mr. Brown’s, President Obama’s message to his own compatriots has focused on ways of revitalizing the system, often to the exasperation of those among their supporters who would favor more radical measures.

Even as both men have embarked on enormous increases in public-sector spending, they have maintained that solutions to the crisis lie in reawakening the markets and recapitalizing the banks, rather than having the government take them over, and in placing financial institutions under closer supervision rather than tearing at the system’s foundations. And both, when they respond to public anger at the private sector, have seemed more geared to managing that anger than stoking it.

And for the record. . .

I’m no radical; I just have a moral conscience, and a heart that bleeds.

NAFTA is a hotly debated issue from either side. But with Obama's removal of a program with Mexico, will things get worse before they get better?

Let’s peel our eyes off of today’s Dow Jones Average for just a few minutes…

March has marked a rather curious point in US-Mexican relations, causing many to raise a speculative eyebrow toward our new direction in international trade policy. Is President Obama beginning to draw a dangerously protectionist “line-in-the-sand” in an attempt to secure economic interests here at home?

Given this month’s recent events, the aggregate cost of this fledgling Obama - Mexico relationship on the country is around $3.1 billion ($2.4 billion worth of U.S. imports by Mexican President Felipe Calderon, and another $700 million in plans to increase security at our borders), excluding, of course, current costs of any Homeland Security programs lingering from the Bush administration. And while the billion dollar price tags of the stimulus package in the U.S. seem to dramatically eclipse those associated with Mexico, there are some underlying costs that our country may be incurring that may prove more damaging in the long-term renewal of our global economic prowess.

Issue:

Obama signs omnibus spending bill in which NAFTA pilot program with Mexico is effectively terminated. Mexico responds with tariffs. Washington is now in a jam to salvage Mexican trade relations as drug-fueled hostilities rage at the border.

To educate myself on the backdrop surrounding the pilot truck program, I turned to Sidney Weintraub’s Forbes.com commentary found here. (Sidney Weintraub is the William E. Simon Chair of Political Economy at the Center for Strategic and International Studies in Washington, D.C.), which I found to be a thorough explanation of both the history and implications of this portion of the NAFTA agreement, though heavily weighted on one side. According to Weintraub, the NAFTA Agreement, effective 1 January 1994, contained a provision in which Mexican trucks would bring cargo to designated commercial zones at or near the border, at which the cargo was to be unloaded and reloaded into U.S. trucks for shipment to destination within the U.S. A 2000 dispute regarding the shipment of Mexican goods, led to an arbitration panel ruling the U.S. to be in violation of the 6 year NAFTA agreement. The Mexican government determined, however, it economically disadvantageous to seek retaliation as, some 12% of total U.S. exports go to Mexico, while around 80% of Mexican exports are shipped to the U.S.

Weintraub continues with his discussion of the pilot program currently at the center of U.S – Mexican discord. Put into effect in September 2007, a pilot program was funded with $500 million by President Bush with 26 Mexican carriers and 103 trucks to test the safety of trucks and the viability of continued operation. In 18 months and 45,000 border crossings (approximately 24 border crossings per truck each month), these trucks operated with no significant accident reported. The U.S. Department of Transportation and an independent evaluation commissioned by the department are even both cited as reporting the “safety and out-of-service” record of the Mexican long-haul trucks to be superior to that of U.S. trucks.

So when President Obama signed the $410 billion omnibus spending bill at the beginning of the month that effectively removed the safe, 18-month old, trade agreement with Mexico, in what manner did policymakers conclude that ceasing it would advantage an ailing American economy? Or did policymakers not understand the implications of yet again dishonoring the NAFTA agreement with Mexico and assume the project would not result in economic sanctions at a price 4 times greater than the programs initial cost?

If policymakers didn’t, the Teamsters sure did. The International Brotherhood of Teamsters is a 1.4 million-member labor union in both the U.S. and Canada, comprised mainly of blue collar and professional workers from both the private and public sector. Arguably one of the most influential and best known (yes, the “Jimmy Hoffa” Teamsters), the ITB has been advocating against this program for years, citing “safety” as their chief concern, not economic or job stimulation. President Hoffa, in a recent WSJ article, expressed the union’s concerns to “include but are not limited to, incomplete and inaccurate records on Mexican driver violations, an absence of any hours-of-service enforcement, and a lack of proper collection and custody procedures for drug and alcohol testing.” (See the full article, LaHood Pitches Mexico Truck Plan to Skeptical Lawmakers.) What’s been considered to be a primarily labor union-driven effort, their long-standing disapproval of the Mexican truck project gained legislative traction with Section 136 of the spending bill written as follows:

None of the funds appropriated or otherwise made available under this Act may be used, directly or indirectly, to establish, implement, continue, promote, or in any way permit a cross-border motor carrier demonstration program to allow Mexican-domiciled motor carriers to operate beyond the commercial zones along the international border between the United States and Mexico, including continuing, in whole or in part, any such program that was initiated prior to the date of the enactment of this Act.

Consequently, the Federal Motor Carrier Safety Administration announced the termination of the project, effective 11 March 2009, the docket for which can be found here.

Here are a few concerns of my own that I’d love to have addressed:

Was an 18-month old, $500 million project that, in 45,000 border crossings, produced limited (if any) significant safety issues creating such harrowing concerns that it was worth $2.4 billion given our national economic condition?

And at a time where extreme drug-related violence (not tractor-trailer crashes) has forced a $700 million increase in border control, does it make sense to remove one of the few programs that creates some semblance of cooperation in a relationship of increasing tension?

Unless during Sec. Clinton’s recent trip she had found a direct correlation between the program and the increase in drug trafficking or a threat to peace between the two countries  (and I won’t be fooled by a sudden “discovery” of “yellow cake” in these shipments, either) then I think that special interest in the United States won a decisive victory with this one.

Response.

On 16 March, while attempting to swim through a sea of questions surrounding AIG, Press Secretary Robert Gibbs was able to speak a bit to the President’s position on U.S – Mexican trade relations. During the press conference he stated:

Today, Mexico announced its intent to take retaliatory actions against a range of U.S. exports. This is in response to the termination of a cross-border, long-distance trucking demonstration project that allowed a small number of Mexican trucks to enter the United States beyond the border commercial zones, and provided reciprocal access to U.S. companies in Mexico…

…The President has tasked the Department of Transportation to work with the U.S. Trade Representative and the Department of State, along with leaders in Congress and Mexican officials, to propose legislation creating a new trucking project that will meet the legitimate concerns of Congress and our NAFTA commitments. Senator Dorgan, the sponsor of the amendment that ended the program, has written to us to express his willingness to work with the administration in good faith to address this issue…

…Obviously exports create jobs here in this country and we don’t want to find ourselves, in a time of economic slowdown, creating or erecting a barrier to that valuable trading partnership.

The full text of the press conference can be found here.

Whether a political faux pas made in an attempt to appease a strong support group from his liberal base or a poorly calculated attempt at national economic restoration, we cannot afford to risk our international trade reputation during this time of global economic calamity. Frankly, we’re internationally “overleveraged” now on all fronts, especially in our social and economic capital, and would do better to use this time to make drastic improvements to our international trade policy.

(For a very informative and entertaining bit on the importance of the issue of effective international trade policy, check out Columbia Professor Jagdish Bhagwati’s speech at the World Affairs Council of America’s 2009 National Conference found here.)

And as we prepare for the G-20 Summit in April, I start to question the appropriateness of this program’s termination within the omnibus bill (given both the President’s length of time in the White House and our current economic situation). And when I did, I found myself concluding this blog entry on words from the most unlikely of sources: Sen. McCain. During a 6 March Congressional Record hearing Sen. McCain stated a rather poignant view in the following:

When we signed a free-trade agreement with Mexico – I believe it was 14 years ago – part of the deal was that Mexican trucks, provided they met all the safety standards and all the requirements, would be able to come into the United States, with reciprocal access to each other’s markets. Thanks to the influence of the unions and others, there is an amendment in this bill that basically kills that. Now, you can take either side of that issue. Maybe there are a lot of Americans saying – even though these Mexican trucks are inspected, even though they meet the safety standards, even though we promised tin the North American Free Trade Agreement that they would have access to our markets – maybe we shouldn’t do that. But should we be doing it in an appropriations bill, in a bill this thick, in a statement of managers this thick? Should we be making policy changes in here?

…The President of Mexico, President Calderon, has staked everything on taking on the drug cartels, and the corruption he is fighting is at the highest levels of Government. So what have we done in this appropriations bill? We have just sent a signal to the Mexicans that we are not going to keep our agreements with them. We are not going to stand by our solemn pledges to them. And, by the way, we are going to do it in an obscure provision in one of these either 1,122 pages or 1,844 pages.

And I admit, as a former Obama staffer, I rarely agree with the Arizona Senator, but on this issue, McCain holds some serious validity. The issue with Mexico cannot become an issue of fairness, in which if our economic stake in Mexico is less than to theirs in the U.S., then we abandon the agreement, even in the face of a sensitive history. It is, however an issue of making good on our current relationships, strengthening them, and finding creative solutions to tackling problems that are currently shared by both countries.

So go out and “Buy American”, help restore our economy, but let’s not make it our only option in the process. Because whether it’s AIG today, or Sec. Geithner tomorrow, there will be far bigger issues in national economic recovery if, for any reason, we freeze up our current global trade relations.

And if you don’t believe me, see what the WTO has to say on growing protectionist measures and the effect on national stimulus, here.

U.S.-Mexico Cross-border Illegal Drug & Weapons Trade Fueling Violence

In a major foreign policy shift, U.S. Secretary of State, Hillary Clinton admitted publicly that an “insatiable demand” by Americans for illegal drugs in the U.S., along with easy – and cheap –  access to powerful hand guns and assault rifles are fueling the drug cartel violence at the U.S. – Mexican border. “Our inability to prevent weapons from being illegally smuggled across the border [to Mexico, from the U.S.] to arm these criminals causes the deaths of police officers, soldiers and civilians,” noted Clinton. That violence threatens to spill over across the border into the U.S.  Seeking to ease a cross-border relationship strained by the illegal drug trade and cross-border  drug trafficking, Secretary Clinton made the clearest acknowledgment yet from the U.S. government of the role American demand for illegal drugs, and the supply of illegal weapons to the drug cartels play in the illicit cross-border narcotics Market.

In addition to the burgeoning demand & supply of illegal drugs Market, Secretary Clinton noted about the flow of American guns and money into Mexico that criminals are out-gunning Mexican law enforcement. Clinton, referring to guns and military-style equipment like night vision goggles and body armor that the cartels are smuggling into Mexico from the United States, “Clearly, what we have been doing has not worked and it is unfair for our incapacity … to be creating a situation where people are holding the Mexican government and people responsible,” she said. “That’s not right.”

Mexian President Felipe Calderon has complained for two years that the U.S. isn’t carrying its weight in the cross-border drug war, despite the fact that American drug users and illegal weapons smugglers fuel the problem. “We need to stop the flow of guns and weapons towards Mexico,” President Calderon told U.S. reporters last month. “Let me express to you that we’ve seized in this last two years more than 25,000 weapons and guns, and more than 90 percent of them came from United States, and I’m talking from missiles launchers to machine guns and grenades.”

Secretary Clinton announced the Administration’s plan to boost cooperation to improve security on both sides at a news conference with Mexican Foreign Relations Secretary, Sra. Patricia Espinosa. “The criminals and kingpins spreading violence are trying to corrode the foundations of law, order, friendship and trust between” our two countries. She added, “They will fail,” and that the U.S. ”…will stand shoulder to shoulder with you,” she said after lengthy talks with Espinosa. Earlier, the Obama Administration pledged to send more money, technology and manpower to secure the border in the U.S. Southwest in order help Mexico battle the drug cartels.  The White House announced it also sought an additional $80 Mn to help Mexico buy U.S. made military ‘Blackhawk helicopters.’

On Wednesday, U.S. Attorney General Eric Holder promised to enforce a long-ignored ban on importing assault weapons, many of which are re-sold illegally and smuggled into Mexico to re-supply the cartels. Calderon applauded the Obama Administration’s announcements saying it was the first time in many years that the American government was showing a stronger commitment to a mutual problem.

The Illegal Drug Trade

An "insatiable demand" for illicit drugs in the U.S.

 Circa the late 1980’s, Mexican drug cartels became the dominant distribution channel for the illegal drug trade in the U.S.  These organizations usurped control from Colombian drug cartels after the U.S. – Columbian “War on Drugs” started to curtail the cartels in Columbia.  In fact, according to the Drug Enforcement Administration (DEA), Colombian cartels have been limited to predominantly a Caribbean smuggling route into South Florida. Mexican cartels, on-the-other-hand, have access to an expansive 2,000 mile border along several Southwestern states; as well as a vast network of Mexican and Central American – both legal, as well as undocumented – immigrants residing in major metropolitan areas such as L.A., Dallas and Chicago, and later, throughout a number of large and small communities in all corners of the U.S.  Based on law enforcement and the accounts of social staticians, most immigrants are hard-working, law-abiding residents and make a contributed to the American economy.  However, a few bad apples inevitably turn to the illicit drug trade because of the demand and the perception of “easy profits.”

The number of Mexican and Central American nationals (e.g., El Salvadorans, Guatemalans & Nicaraguans) living in the U.S. occurred as a result of an influx of migrant laborers in search of higher-paying jobs and a better life for themselves and their families.  However, the increased presence also brought with it a large number of drug traffickers.  Some drug statistics estimate that twenty-three metric tons of cocaine is smuggled into the U.S. annually, two-thirds of which enter across the U.S./Mexican border. The DEA estimates that 80% of the methamphetamine in the U.S. is either manufactured in Mexico or is manufactured in the U.S. by Mexican and Central American drug traffickers operating under the direction of Mexican-based drug cartels. These illicit drug sales in the U.S. have resulted in a boom of revenues for Mexico, and to a lesser extent other Central American nations. In fact, after petroleum revenues, the second largest revenue source for Mexico comes from “foreign remittances” — immigrants sending money back home from the U.S., with a portion of those proceeds coming from illegal drug proceeds.

The Illegal Gun Trade 

Display of illegal weapons seized from Mexico-based drug cartels.

 

 

 

 

 

 

 

 

 

 

 

 

In addition to the Mexican drug cartels that engage in torture and killings (at times involving beheadings), armed criminal gangs are notorious kidnappers — prompting some to call Mexico the “kidnapping capital of the world.” This has resulted in a boom for armored car manufacturers and security companies, given that most wealthy people living in the country own armored vehicles, and many employ executive protection teams to provide security for themselves, their families and their homes. Additionally, heavily armed criminal gangs regularly commit armed robberies, muggings and express kidnappings.

The one constant in these violent crimes is guns. Mexico’s robust gun culture stretches back to revolutions, counterrevolutions and revolutionary bandits such as Pancho Villa. Because of this culture, guns are common in Mexico — despite strict gun-control laws and licensing procedures. This demand for guns has created an illicit market that not only is intimately related to the U.S. market for illegal narcotics but also, in many ways, mirrors the dynamics of that market. Drugs flow north and guns flow south — resulting in handsome profits for those willing to run the risks.

Mexican Laws

Similar to the U.S. Constitution, the 1917 Mexican Constitution guarantees Mexico’s inhabitants the right to have “arms of any kind in their possession for their protection and legitimate defense.” However, the constitution includes many caveats on private citizens’ ownership of guns, prohibiting those “expressly forbidden by law” and those “the nation may reserve for the exclusive use of the army, navy or national guard.” Furthermore, Mexican law calls for long prison terms for violators.

Mexico, then, has some of the world’s strictest gun-control laws — making guns difficult to obtain legally. Average citizens who want to purchase guns for self-defense or recreational purposes must first get approval from the government. Then, because there are no private-sector gun stores in the country, they must buy weapons through the Defense Department’s Arms and Ammunition Marketing Division (UCAM). In accordance with Mexican law, the UCAM carefully limits the calibers of guns it sells. For example, it does not sell handguns larger than a .380 or .38 Special. Also, under Mexican law, popular handguns such as .357 magnum revolvers and 9 mm pistols are exclusively reserved for the armed forces.

Regardless of these efforts, the illicit arms market has been thriving for decades — not only because firearm laws are not evenly enforced but also because criminals have found a way to circumvent efforts to stem the flow of guns. Moreover, not all illegal guns are in the hands of cartel members and street criminals. A healthy percentage of them are purchased by affluent Mexicans who are not satisfied with the selection of calibers available through the UCAM. Sources say it is not at all unusual to find Mexicans who own prohibited .357 magnum revolvers or .45 caliber pistols for self-defense against kidnappers and armed robbers. In addition to ballistic considerations, Latin machismo is also a factor — some Mexican men want to own and carry powerful, large-caliber pistols.

The Mechanics of the Gun Trade. . . ß (Read more, click here)

Mohamed El-Erian, Co-CEO of PIMCO

Foreign Policy magazine interviews Mohamed El-Erian, Co-CEO & Co-Chief Invesment Officer of PIMCO — an international invesment firm.  It is an interview from March 2008, but remains both relevant and insightful in my view.  Mr. El-Erian is the former investment manager of the Harvard endowment and one of the world’s most regarded investment managers & economic analyst.  His commentary is widely followed on Wall Street.  He shares his insights on the realignment  and eventual recovery of the new global economy and why we still aren’t prepared to manage systemic risks of market as well as policy missteps in re-making the global regulatory framework.

Mohamed El-Erian is co-chief executive and co-chief investment officer at PIMCO and author of the book When Markets Collide: Investment Strategies for the Age of Global Economic Change  (McGraw-Hill, 2008).

Foreign Policy: Is the credit crisis under control?

Mohamed El-Erian (ME): Not yet. We are getting closer to a time when the endogenous financial part of the crisis will be behind us because of two factors: One is a recognition by the financial institutions of losses, and second, a previously unthinkable policy reaction looking to reliquefy the financial system and cut off the fat tail.

FP: You wrote in the Financial Times in March that U.S. policymakers ought to study the experience of emerging economies. Can you explain a little bit what you mean by this?

ME: I think the United States finds itself in the unusual position of being a manager for a crisis that originated within the U.S. The U.S. normally has witnessed crisis management in other countries, but this time the crisis has erupted at home. Crisis management involves a certain mind-set. And that mind-set is one of making sure that you act early, making sure that you act in a coordinated fashion domestically and internationally, and be willing to live with the fact that there is no perfect policy response—that once you get to crisis-management world, every policy response entails collateral damage, and the issue is how you minimize that.

FP: The U.S. Federal Reserve has been extremely active. What’s your assessment of the way Fed Chairman Ben Bernanke and the Treasury have handled this crisis?

ME: I think that they’ve done well in terms of effort, given the situation they’ve found themselves in. In particular—and this is a much broader comment about the international financial system—they have had to handle new problems with old instruments. The problems that have emerged are largely reflections of some major structural changes in the global financial system. Yet, the tools that are available to policymakers as well as a lot of Wall Street firms haven’t evolved as quickly as the system has evolved. So, you get a lot of effort but less-than-perfect outcomes.

FP: They’re using outdated equipment.

ME: As is typical of any innovation, the world changes much more quickly than the infrastructure does. I have a whole book coming out on this issue in June that basically demonstrates that whatever you look at—an individual firm, countries, or the multilateral system—innovations have enabled activities that cannot as yet be sustained by the infrastructure we have. I’m speaking in terms of the marketplace—the proliferation of structured finance that has lowered entries to all markets and resulted in massive financial alchemy that is not well understood. I’m talking about the realignment of the global economy and the limited potency of traditional policy responses.

FP: You’ve been critical in the past of the International Monetary Fund (IMF) as an organization that hasn’t adapted well to this new world.

ME: Yeah, I think the IMF in particular got caught offsides in this. First, its income model is dependent on the IMF being a large lender. But with the realignment from West to East of growth and wealth, very few countries now borrow from the IMF. They don’t need to. So, the first thing that has suffered is the IMF’s ability to raise income to cover its expenses. The second thing that’s suffered is that the IMF is a macroeconomy powerhouse, and increasingly it is financial markets that are impacting the macroeconomy, so the IMF has got caught still having to retool and enhance its understanding of the linkage from the financial system to the real economy. The third issue is that the IMF has a large representation and legitimacy deficit. It is still reflective of the world of yesterday and doesn’t take sufficiently into account this major realignment that has taken place.

FP: But we have yet to see the United States and Europe show willingness to change the system. Why should they want to?

ME: Because it’s in their interest to have organizations that have legitimacy and that are representative of the world we live in rather than representative of a feudal system.

FP: If people don’t take your advice and nothing changes, what happens then?

ME: We will have a series of increasingly acute market accidents and policy mistakes. That process will lead to a significant decline in global growth. It will lead to increasing poverty around the world and will lead to protectionism. So, the challenge that every level has is to recognize that the alternative is much worse. Retooling is uncomfortable, but not retooling is incredibly costly. This is not business as usual, and we will not go back to business as usual.

If I had told you a year ago to believe the following four hypotheses, tell me what you would have thought. I know I would have told myself, “Mohamed, you’ve gone a little bit crazy.” Suppose I would have told you the next systemic crisis is going to take place in the most sophisticated financial system in the world—that’s hypothesis No. 1. Hypothesis No. 2: There will be collateral damage. There will be bank runs and bank failures, but they will occur in the first- and second-most sophisticated financial systems in the world: the United States and Britain, and not in the traditionally vulnerable emerging economies. Hypothesis No. 3 is that there will be lots of people resigning and losing their jobs, but guess what? It’s not going to be central bank governors in emerging economies; it’s not going to be ministers of finance or even prime ministers. It’s going to be the CEOs of some of the most respected and well-established financial organizations in the world. And issue No. 4: Emerging economies will not be seriously contaminated. In fact, they’re going to be viewed as a force for stability, including by buying assets in industrial countries. If I had made these four predictions publicly, a lot of people would have thought that I’m a little bit crazy. But in fact every single one of those is fact today. It’s just an illustration of how quickly things are changing.

Reaction to Decline and Devaluation of the Greenback in the Global Market

By Andrew Datson (WSJ) 

BEIJING — China called for the creation of a new currency to eventually replace the dollar as the world’s standard, proposing a sweeping overhaul of global finance that reflects developing nations’ growing unhappiness with the U.S. role in the world economy.

The unusual proposal, made by central bank governor Zhou Xiaochuan in an essay released Monday in Beijing, is part of China’s increasingly assertive approach to shaping the global response to the financial crisis.

Mr. Zhou’s proposal comes amid preparations for a summit of the world’s industrial and developing nations, the Group of 20, in London next week. At past such meetings, developed nations have criticized China’s economic and currency policies.

This time, China is on the offensive, backed by other emerging economies such as Russia in making clear they want a global economic order less dominated by the U.S. and other wealthy nations.

However, the technical and political hurdles to implementing China’s recommendation are enormous, so even if backed by other nations, the proposal is unlikely to change the dollar’s role in the short term. Central banks around the world hold more U.S. dollars and dollar securities than they do assets denominated in any other individual foreign currency. Such reserves can be used to stabilize the value of the central banks’ domestic currencies.

Monday’s proposal follows a similar one Russia made this month during preparations for the G20 meeting. Like China, Russia recommended that the International Monetary Fund might issue the currency, and emphasized the need to update “the obsolescent unipolar world economic order.”

Chinese officials are frustrated at their financial dependence on the U.S., with Premier Wen Jiabao this month publicly expressing “worries” over China’s significant holdings of U.S. government bonds. The size of those holdings means the value of the national rainy-day fund is mainly driven by factors China has little control over, such as fluctuations in the value of the dollar and changes in U.S. economic policies. While Chinese banks have weathered the global downturn and continue to lend, the collapse in demand for the nation’s exports has shuttered factories and left millions jobless.

In his paper, published in Chinese and English on the central bank’s Web site, Mr. Zhou argued for reducing the dominance of a few individual currencies, such as the dollar, euro and yen, in international trade and finance. Most nations concentrate their assets in those reserve currencies, which exaggerates the size of flows and makes financial systems overall more volatile, Mr. Zhou said.

Moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better, he argued, because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates. It could also be the basis for a more equitable way of financing the IMF, Mr. Zhou added. China is among several nations under pressure to pony up extra cash to help the IMF.

Reuters

Zhou Xiaochuan, governor of the People’s Bank of China.

John Lipsky, the IMF’s deputy managing director, said the Chinese proposal should be treated seriously. “It reflects officials’ concerns about improving the stability of the financial system,” he said. “It’s interesting because of China’s unique position, and because the governor put it in a measured and considered way.”

China’s proposal is likely to have significant implications, said Eswar Prasad, a professor of trade policy at Cornell University and former IMF official. “Nobody believes that this is the perfect solution, but by putting this on the table the Chinese have redefined the debate,” he said. “It represents a very strong pushback by China on a number of fronts where they feel themselves being pushed around by the advanced countries,” such as currency policy and funding for the IMF.

A spokeswoman for the U.S. Treasury Department declined to comment on Mr. Zhou’s views. In recent weeks, senior Obama administration officials have sought to reassure Beijing that the current U.S. spending spree is a short-term effort to restart the stalled American economy, not evidence of long-term U.S. profligacy.

“The re-establishment of a new and widely accepted reserve currency with a stable valuation benchmark may take a long time,” Mr. Zhou said. In remarks earlier Monday, one of his deputies, Hu Xiaolian, also said the dollar’s dominant position in international trade and investment is unlikely to change soon. Ms. Hu is in charge of reserve management as the head of China’s State Administration of Foreign Exchange.

Mr. Zhou’s comments — coming on the heels of Mr. Wen’s musing about the safety of China’s dollar holdings — appear to be a warning to the U.S. that it can’t expect China to finance its spending indefinitely.

The central banker’s proposal reflects both China’s desire to hold its $1.95 trillion in reserves in something other than U.S. dollars and the fact that Beijing has few alternatives. With more U.S. dollars continuing to pour into China from trade and investment, Beijing has no realistic option other than storing them in U.S. debt.

Mr. Zhou argued, without mentioning the dollar by name, that the loss of the dollar’s de facto reserve status would benefit the U.S. by avoiding future crises. Because other nations continued to park their money in U.S. dollars, the argument goes, the Federal Reserve was able to pursue an irresponsible policy in recent years, keeping interest rates too low for too long and thereby helping to inflate a bubble in the housing market.

“The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Mr. Zhou said. The increasing number and intensity of financial crises suggests “the costs of such a system to the world may have exceeded its benefits.”

The People's Republic of China Central Bank in Beijing

Mr. Zhou isn’t the first to make that argument. “The dollar reserve system is part of the problem,” Joseph Stiglitz, the Columbia University economist, said in a speech in Shanghai last week, because it meant so much of the world’s cash was funneled into the U.S. “We need a global reserve system,” he said in the speech.

Mr. Zhou’s idea is to expand the use of “special drawing rights,” or SDRs — a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.

These days, the SDR is mainly used in the IMF’s accounting for its transactions with member nations. Mr. Zhou suggested countries could increase their contributions to the IMF in exchange for greater access to a pool of reserves in SDRs.

Holding more international reserves in SDRs would increase the role and powers of the IMF. That indicates China and other developing nations aren’t hostile to international financial institutions — they just want to have more say in running them. China has resisted the U.S. push to make an immediate loan to the IMF because that wouldn’t give China a bigger vote. Ms. Hu said Monday that China, which encourages the IMF to explore other fund-raising options, would consider buying into a bond issue.

The IMF has been working on a proposal to issue bonds, probably only to central banks. Bond purchases are one way for the organization to raise money and meet its goal of at least doubling its lending war chest to $500 billion from $250 billion. Japan has loaned the IMF $100 billion and the European Union has pledged another $100 billion.

—Terence Poon in Beijing, James T. Areddy in Shanghai, and Bob Davis and Michael M. Phillips in Washington contributed to this article.

Prof. Ferguson explains the role of money in the development of human progress in his new book, The Ascent of Money.

 

The Ascent of Money

By Niall Ferguson (Penguin Press, 2008)

For both the financial history enthusiast and the newcomer to the global financial markets alike, Prof. Niall Ferguson offers an excellent survey of the development of money in his latest of financially themed books. Ferguson, regarded as one of Britain’s most noted historians, is provocative as he weaves together a world of complex relationships and issues in a very palpable yet rich explanation of the evolution of money and its role in society. Smartly written, Ferguson’s book is rather poignant considering current world events and is written in such detail to paint a very informative accounting of events and world issues that have resulted in money becoming what he argues is the “essential backstory behind all history”.

Ferguson’s book has also been turned into a two-hour documentary, written and presented by Ferguson himself, that will air as a four-hour presentation by PBS later in 2009. For the more information regarding the broadcast, click here to view its webpage.

The US government is taking a clear stance against bonuses paid out by companies receiving bailout funds.

Question: What happens when an 80% shareholder of a company decides that the $165 million in bonuses contracted to employees prior to the purchase of shares are an abuse of the over $170 billion given in taxpayer bailout?

Answer: American International Group CEO, Edward Liddy, asks bonus recipients who received $100,000 or more to return at least half of the money back.

This recent chapter in the travails of the current U.S. economic crisis has become quite the controversy as it has exposed the underbelly of the federal bailout; how far can the government go in nationalizing companies before it inhibits stability and growth? A clear position from the government on the issue has begun to surface with the case of AIG, expressed quite poignantly by Massachusetts Representative and Chairman of the Financial Services Committee, Barney Frank, in a statement on CNN’s American Morning:

“The notion that we want to retain these people, that we want to pay the people who messed it up in the first place, so they don’t leave is just backwards to me… we [the government] own this company in effect, and we’re not asking that these bonuses be rescinded because we have lent money to the company, I believe we are saying as the owners of the company we do not think that we are paying bonuses or should have paid bonuses to people who made mistakes or are incompetent.”

For the complete 18 March interview with Barney Frank on American Morning, click here:

From the top, down we’re hearing the government express a relative degree of solidarity against what is being viewed by many as the misuse of bailout funds, including those vehemently against the most recent bailout’s amount of oversight. Representative Scott Garrett (R – NJ), a member of the Capital Markets Subcommittee, pointed questions toward those unhappy with AIG’s course of action, asking “What did you expect, and why weren’t you asking more questions before?” And given the sheer magnitude of monies spent by the federal government in national financial bailout, both sides of the debate are experiencing greater resistance as the government’s reach increases with the bailout’s price tag.

But just how far can the government go?

Rep. Barney Frank makes a very poignant distinction of note, later in the American Morning interview, when he mentions what is legislative vs. legal. In the case of AIG, Washington is first seeking legal action against AIG as everything from taxes on bonuses as high as 91% and lawsuits are on the table to subvert the use of funds as bonuses. New York Attorney General Andrew Cuomo even threatened the insurance company with subpoenas unless records of bonus information were revealed, using the 1921 Martin Act to gain convictions in investment related cases without proving criminal intent. (See NY’s Cuomo wins praise for pursuing AIG on bailout) And with 80% share of the company, the U.S. government is the majority shareholder and thereby has the legal voting rights on compensation packages, especially when dealing with the performance or underperformance of employees.

However, the true test of the AIG bonus fallout will be the impact of Liddy’s decision on corporate management by those companies also currently receiving federal aid. Many banks receiving funds from the original $350 billion bailout have begun to reconsider retaining these funds, citing the federal governments zealous and pliable exercise of legislative power. A 10 March New York Times article entitled “Some Banks, Feeling Chained, Want to Return Bailout Money”, found here, provides a good bit of insight into the conditions many of these institutions are wrestling with as they come to terms with the growing implications attached to this financial “lifesaver” being tossed by the federal government.

And if a clause giving shareholders (i.e. Uncle Sam) the right to vote on executive compensation packages wasn’t enough to make many of these executives nervous, House Representatives took charge on Thursday passing a bill to tax 90% of bonuses paid out since 1 January to AIG or any other company currently receiving more than $5 billion in federal aid. The Senate on the other hand has proposed a 35% tax on AIG bonuses and a 35% tax on the company; a bit milder of an alternative seeking to return a portion of taxpayer dollars toward other stimulus efforts.

From Main St. to Wall St. the argument continues on with each passing day. How will fairness and equality be delivered during this time of financial crisis. And as new theories and arguments about the best course of action will continue to develop, I’ll leave one in closing: Morton’s Fork.

Under the rule of Henry VII lived Lord Chancellor John Morton, who, in 1487, developed a policy of tax collection based in a two pronged argument: if a subject lived luxuriously he obviously had sufficient income to spare for the king, and if the subject lived frugally, he must have substantial savings from which he could afford to pay sufficient tax to the king. Dubbed Morton’s Fork, either choice of lifestyle for subjects under Henry VII’s rule painted an unfavorable conclusion, as no matter how one chose to live, he was still subject to an increased level of taxation.

As the federal government seeks economic stability and fairness, and Morton’s Fork is applied to companies decisions to choose bailout money or not, let’s hope that the windfall of increased government scrutiny over the use of funds doesn’t eclipse the bailout’s original intent: economic stimulus.

The FOMC today announced plans to buy $300B in treasuries and up to $750B in mortgage-backed securities, effectively agreeing to print a trillion dollars.

Well, we knew the money had to come from somewhere. When the federal government wants money, there are four places they can get it:

1) Take from other parts of the budget (Social security and military spending are the two big ticket items.)

Quite simply not going to happen. Both of the above are sacrosanct.

2) Increase taxes

Seems unlikely. This year’s budget included tax cuts for the middle class. The increased taxes for the rich seem unlikely to even make up the difference, since entrepreneurs are unlikely to be active in this economic climate, bonuses are way down, and big earners still have a variety of ways to shield their income. Raising taxes on an economy you’re trying to stimulate also sounds a lot like one step forward, one step back.

3) Borrowing money by selling treasuries

We’ve been doing this. But nobody in the world has the liquidity right now to support our enormous stimulus apparatus.

Printing money causes inflation, which nobody likes. Inflation can be looked at as a tax on savings, which doesn’t sound good. It’s also a tax on debt securities, which is even worse. Our foreign and domestic creditors, who have already funded quite a bit of our enormous bailout, are going to be understandably upset.

But the fact of the matter is, all of the other options are exhausted. If we’re going with a Keynesian solution, which the Obama administration as well as the plurality of academia seem committed to, then the cash has to come from somewhere. Overall, I think today’s news is frustrating, but inevitable.

At least the leprauchans won.

In a strange piece of spin, the New York Times says today that the financial crisis will wind up being good for China. It’s an unconvincing position to say the least. It’s true that, unlike the West, China has no trouble with currency exchange or stock markets, which are state regulated, or bank failure, because all of the banks are state owned. Or, to put it another way, the worst case scenario in the West is already the status quo in China.

The Chinese trade surplus is down almost 90%,  but apparently that’s ok, because the Chinese government is allowing their semi-private companies to shop more easily for foreign acquisitions. Foreign acquisitions at a time like this are a dubious proposition, and could just as easily wind up being deadweight losers as undervalued investments. Unemployment is down, wages are down, clothes are piling up in the factories, white collar workers are unemployed and may wind up a source of significan unrest. The Times says that this is “causing personal pain but reviving China’s advantage in labor costs.” I’m sure the laborers are pleased about that.

But! Unemployed laborers can now be part of a vocational retraining program to prepare China’s workers to better participate in the global economy. Call me a cynic, but that sort of language makes me think of the PRC’s last vocational training program.

Overall, it looks grim to me. China’s export dependence means that recovery will not happen there until it happens in the West. Their centralized economy is less agile at dealing with hardship, and the potential for social unrest is high. But on the bright side, maybe pressure from the unemployed will be able to achieve some liberalizing reform that was impossible during the good times.  Like Hu Jintao said, “Challenge and opportunity always come together — under certain conditions, one could be transformed into the other.”

AIG Executives have been given huge bonuses with taxpayer money, and everyone is furious. AIG claims that they have contractual obligations which predate the largest private sector bailout in history. Politicians say these obligations are secondary to satisfying taxpayers who are keeping them above water. Pundits, smelling blood in the water, have come out in force to grind their axes with issues ranging from from the outrage of international capital mobility to defenses of laissez-faire capitalism unfettered by government intervention. Everyone has taken this as an opportunity to hop up on the soap box.

Sen. Charles Grassley (R-IA) says:

“I would suggest the first thing that would make me feel a little better toward them [AIG executives] is if they follow the Japanese example and come before the American people and take that deep bow and say, ‘I am sorry,’ and then either do one of two things: resign or go commit suicide, and in the case of the Japanese, they usually commit suicide.”

Here’s the story behind the noise, as I see it.

What Did AIG Do Wrong?

Over the last several years, they sold lots and lots of Credit Default Swaps, without putting up any collateral. They weren’t required to put up collateral because they were Triple A rated by Moody’s and S&P. They were Triple A rated because they are an enormous, old company with a sound business model: selling insurance. They weren’t re-rated when they started CDS’s because the CDS’s appeared to be a small part of their overall business. They appeared to be a small part of the balance sheet because accounting standards were differently applied than they were to other sorts of insurance. It also seems likely that the ratings agencies were complicit. Accounting standards were uneven due to the same piece of legislation, the Commodity Futures Modernization Act, which allowed the Enron fiasco to happen.

Who’s to blame here? AIG, the ratings agencies, regulators, independent accountants and risk managers, not to mention the actual buyers of these massive quantities of CDS’s all seem to have more or less culpability. Essentially everyone. AIG was just the first to crack.

So Why Did The Feds Bail Them Out?

In early September AIG finally got downgraded by the ratings agencies, and it became immediately clear that they did not have the funds to back up their obligations. Now, the preposterous CDS system collapsing due to AIG’s default would itself have been terrible, but AIG is also a normal insurer, responsible for a variety of commercial and industrial insurance and reinsurance which are vital for the continued functioning of the global economy. The bailout gave the U.S. government 80% control over the company, rendered the stock virtually worthless, and charged a punitive interest rate of 8.5% plus LIBOR (About 10% total right now.) That is an inescapable debt if ever one existed. It was never intended to keep the company afloat indefinitely, merely manage the continuity of its obligations while it was dissolved in an orderly fashion.

So How Can We Let Them Steal Our Money Like That?

Continuity of obligations is a key concept here. Just like AIG is obliged to pay you if you get in a car accident or your supertanker sinks, they are likewise obliged to pay the bonuses they agreed to last year. Because, for reasons that are unclear, proper bankruptcy proceedings have not been initiated, and having not officially entered into receivership, their obligations are still valid, both internal and external.

And that’s the question I haven’t seen any of the grandstanding politicians have even pretended to try to answer. Why hasn’t this been handled as a dissolution? Why is AIG still allowed to behave as though it’s a going concern? There was a legal, systematic way to go about fixing this, and it was not pursued. That’s a shame, because if Obama and Geithner personally reach in now and grab the checks out of the hands of the executives, it will damage the sanctity of legal structure in a way that will take a long time to repair. It will also, in its own way, reflect an idea of executive privilege comparable to the Bush Presidency, the abolition of which was one of Obama’s campaign promises.

It is not the role of the executive branch to ride roughshod over private sector contracts, taking money from the wicked and giving it to the virtuous. So as much as I hate to see the greedy, stupid executives of AIG profit off of the misery they helped to create, at present I don’t see any better alternative. Suggestions?