Why pander to the financial markets?

In an article in the Melbourne Age today (February 11) entitled Taxpayer trillions fuel a monster mess, columnist David Hirst writing on the massive injection that the US Congress has approved quotes President Obama who said

“Only the stimulus package to be approved this week, the $US700 billion Troubled Asset Relief Program passed four months ago and $US168 billion in tax cuts and rebates approved in 2008 have been voted on by lawmakers. The remaining $US8 trillion in commitments are lending programs and guarantees, almost all under the authority of the Fed and the FDIC. The recipients’ names have not been disclosed.”

His issue is that the secrecy of the arrangements is troublesome given their magnitude. With that I agree.

But he then goes on to say:

Most Americans and almost every Australian I know see the Federal Reserve as like our Reserve Bank or the central banks of the world. But it is not. Few know how the Federal Reserve functions. It is in an enviable position for those who own the bank, the richest people on earth.

This is how the Fed scheme works: The US issues Treasury bonds. It then sells them to the Fed, which buys the bonds from thin air, with money created by a computer stroke – a bookkeeping entry. The money from nowhere then goes to the US Government and the Fed holds the bonds. Then the US Government pays interest on the bonds that the US itself issued.

That is as good as it gets, for the interest is money in the bank for the private owners of the Fed. They might well be the bankers whom the Fed is granting untold and untellable sums to – the lucky few who are running the scheme.

In fact, it is easy to find out about the structure of the Fed and its system of regional banks. First, who owns the Federal Reserve? The official FAQ tells us that:

The Federal Reserve System is not “owned” by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.

As the nation’s central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as “independent within the government.”

The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation’s central banking system, are organized much like private corporations–possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

Second, how is the Federal Reserve funded? Again, the official FAQ tells us that:

The Federal Reserve’s income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other sources of income are the interest on foreign currency investments held by the System; fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations; and interest on loans to depository institutions (the rate on which is the so-called discount rate). After paying its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.

So it is not quite the situation that Hirst depicts.

The major problem with the US bail out is that most of the incentives are aimed at attracting new financial capital. Huge public transfers are now going to persons with financial capital. They are the main beneficiaries of the new Obama administration, despite the salary cap announced last week.

Underpinning this policy slant is the aberrant notion that the nation will be unable to resume growth unless new (outside) financial capital is forthcoming. A sovereign government is never hostage to the dictates of financial capital. A nation that adopts its own floating rate currency (such as Australia) can always afford to put unemployed domestic resources to work. Its government may issue liabilities denominated in its own currency (for interest-rate maintenance reasons), and will service any debt it issues in its own currency. Whether its debt is held internally or externally, it faces no insolvency risk.

Further, the floating currency gives domestic policy an additional degree of freedom. This does not mean that the nation will necessarily ignore its trade balance or movements of its exchange rate, but it does mean that it can put domestic employment and growth at the top of its policy agenda.

Thee first thing any sovereign government should do to improve the security of its most disadvantaged citizens it so introduce a comprehensive job creation strategy.

The recent history of Argentina is worth reflecting on in this regard. Argentina successfully defaulted on significant international debt obligations in 2002. Initially, FDI dried up completely when the default was announced. However, the Argentine government could not service the debt as its foreign currency reserves were gone and realised, to their credit, that borrowing from the International Monetary Fund (IMF) would have required an austerity package that would have precipipated revolution. As it was riots broke out as citizens struggled to feed their children.

Despite stringent criticism from the World’s financial power brokers (including the International Monetary Fund), the Argentine government refused to back down and in 2005 completed a deal whereby around 75 per cent of the defaulted bonds were swapped for others of much lower value with longer maturities.

The crisis was engendered by faulty (neo-liberal policy) in the 1990s. Between 1991 and 2002, Argentina essentially adopted a currency board by pegging the Argentine peso to the US dollar for reasons that beg belief. This faulty policy decision ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board. However, as soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.

At the time of the 2001 crisis, the government realised it had to adopt a domestically-oriented growth strategy. One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.

Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.

The data is instructive. The resumption of growth has been strong and persistent (8.8 per cent in 2003, 9.0 per cent in 2004, 9.2 per cent in 2005, 8.5 per cent in 2006 and 8.7 per cent in 2007). Real wages have also risen modestly over the same period.

Official data shows that poverty rates (measured either as extreme poverty defined as not being able to eat properly and a more general poverty line defined by the minimum income needed for basic needs) have fallen dramatically since the abandonment of the neo-liberal fixed exchange rate system.

Period Extreme poverty (%) Below Poverty line (%)
May 2001 11.6 35.9
Oct 2001 13.6 38.3
May 2002 24.8 53.0
Oct 2002 27.5 57.5
May 2003 26.3 54.7
Second half 2003 20.5 47.8
First half 2004 17.0 44.3
Second half 2004 15.0 40.2
First half 2005 13.6 38.5
Second half 2005 12.2 33.8
First half 2006 11.2 31.4
Second half 2006 8.7 26.4
Second half 2007 5.9 20.6
First half 2008 5.1 17.8

Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed. And then as growth resumes, renewed FDI floods in.

One commentator wrote a few years ago that that the Argentinian Government appears to have perpetuated the perfect crime. The Government offered the world financial markets a ‘take-it-or-leave-it’ settlment which was favourable to the local economy. At the time, the rhetoric claimed that countries that treat foreign creditors so badly would surely stagnate and suffer a FDI boycott. This is the standard neo-liberal line that is used to coerce debtor nations into compliance with the needs of ‘first-world’ capital largely defined through the aegis of the IMF. But the Argentinian case shows this paradigm to be toothless because the Government defied the major players including the IMF and the Argentine economy went on to boom despite it.

It is clear that many foreign firms are expanding in Argentina in addition to strong investment from Argentine interests. The country’s biggest real estate developer explained (in 2005) the quandary facing the neo-liberals as such: “there has never been a better time to invest in Argentina … [as for foreign banks, after shunning Argentina for a while] … now the banks are coming to us … It’s been tough. We will have restrictions … But in terms of access to capital, what defines access? Greed. When opportunities look profitable, access to capital will be easy.”

This is a lesson all countries should learn. International capitalism, ultimately does not really take ‘political’ decisions – it just pursues return.

The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies – such as the introduction of a Job Guarantee – which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.

Argentina’s defiance has lessons for Australia. Many critics of the Job Guarantee argue that the international financial markets would wreak havoc on the Australian economy if it was introduced here. This is clearly just a neo-liberal myth. My view is that the international investment community would soon realise that rather than being a threat to their activities, the introduction of a Job Guarantee would provide them with an even better investment climate in which to chase return. It is time that we abandoned the neo-liberal myths and instead realise that in capitalism ‘greed comes before prejudice’.

We should immediately announce an $8.3 billion package to introduce a Job Guarantee before we do anything else.

As an unrelated postcript: My home state has been devastated and many lives lost. Very sad.

This Post Has 2 Comments

  1. In the past couple of years I’ve become interested in economics, and the “global financial crisis” has provided ample opportunity for study. Thank you for an interesting and informative blog. I do have a question. Shouldn’t the part of this entry which reads, “a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies with an IMF austerity program being needed” read *without* an IMF austerity program? Forgive me if the answer is obvious– I’m learning.

    Thank you again for taking the time to create this blog– I just discovered it today and I keep reading entry after entry.


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