Invited Lecture

ERC/METU International Conference on Economics
Ankara, Turkey

September 6, 2003



The Global Economy in Transition


An economy is not an abstraction. An economy is the material manifestation of a political system, which in turn is the interplay of group interests representing, among others, gender, age, religion, property, class, sector, region or nation. Individual interests are not issues of politics. Therefore, the politics of individualism is an oxymoron, and by extension, the Hayekian notion of a market of individual decisions is an ideological fantasy. Markets are phenomena of large numbers and herd instinct where unique individualism is of little consequence. The defining basis of politics is power, which takes many forms: moral, intellectual, financial, electoral and military. In an overcapacity environment, company executives lament about the loss of pricing power. The global economy is the material manifestation of the global geopolitical system, and global macroeconomics is the rationalization of that geopolitical system.

The nomenclature of economics reflects, and in turn dictates, the logic of the economic system. Terms such as money, capital, labor, debt, interest, profits, employment, market, etc., have been conceptualized to describe components of an artificial material system created by power politics. The concept of the economic man who presumably always acts in his self-interest is a gross abstraction based on the flawed assumption of market participants acting with perfect information and clear understanding of its meanings. The pervasive use of these terms over time disguises the artificial system as the product of natural laws, rather than the conceptual components of power politics. Just as monarchism was rationalized as a natural law of politics in the past, the same is true with market capitalism today.

The market is not the economy. It is only one aspect of the economy. A market economy can be viewed as an aberration of human civilization. People trade to compensate for deficiencies in their current state of development. Exploitation is slavery, not trade. Imperialism is exploitation on an international level. Neo-imperialism after the end of the Cold War takes the form of neo-liberal international trade. Free trade cannot exist without protection from systemic coercion. To participate in free trade, a trader must have something with which to trade voluntarily in a market free of systemic coercion. That tradable something comes from development, which is a process of self-betterment. International trade is not development, although it can contribute to domestic development. Domestic development must take precedence over international trade, which is a system of external transactions supposedly to augment domestic development. But neo-liberal international trade since the end of the Cold War has increasingly preempted domestic development in both the center and the periphery. Global trade has become a vehicle for exploitation of the weak to strengthen the strong. Aside from being unjust, neo-liberal global trade as it currently exists is unsustainable, because the transfer of wealth from the poor to the rich is unsustainable. Neo-liberal claims of fair benefits of liberalized trade to the poor of the world, both in the center and the peripheral, are simply not supported by facts.

This presentation will discuss the global economy in transition, focusing on the changing nature and role of money, debt, trade, markets and development.



Fiat Money as Sovereign Credit


Most monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking. This view is valid for specie money, which is a certificate that can claim on demand a prescribed amount of gold or other specie of value. Government-issued fiat money, on the other hand, is not a sovereign debt but a sovereign credit instrument. Sovereign government bonds are sovereign debt while local government bonds are institutional debt, but not sovereign debt because local governments cannot print money. When money buys bonds, the transaction represents credit canceling debt. The relationship is rather straightforward, but of fundamental importance.







If fiat money is not sovereign debt, then the entire conceptual structure of capitalism is subject to reordering, just as physics was subject to reordering when man’s worldview changed with the realization that the earth is not stationary nor is it the center of the universe. For one thing, capital formation for socially useful development will be exposed as a cruel hoax. With sovereign credit, there is no need for capital formation for socially useful development. For another, private savings are not necessary to finance development, since private savings are not required for the supply of sovereign credit. With sovereign credit, labor should be in perpetual shortage, and the price of labor should constantly rise. A vibrant economy is one in which there is labor shortage. Private savings are needed only for private investment that has no social purpose or value. Savings are deflationary without full employment, as savings reduces current consumption to provide investment to increase future supply. Say's Law of supply creating its own demand is a very special situation that is operative only under full employment. Say's Law ignores a critical time lag between supply and demand that can be fatal to a fast moving modern economy. Savings require interest payments, the compounding of which will regressively make any financial system unsustainable. The religions forbade usury for very practical reasons.







Fiat money issued by government is now legal tender in all modern national economies since the collapse of the Bretton Woods regime of fixed exchange rates linked to a gold-backed dollar in 1971. The State Theory of Money (Chartalism) holds that the general acceptance of government-issued fiat currency rests fundamentally on government's authority to tax. Government's willingness to accept the currency it issues for payment of taxes gives the issuance currency within a national economy. That currency is sovereign credit for tax liabilities, which are dischargeable by credit instruments issued by government. When issuing fiat money, the government owes no one anything except to make good a promise to accept its money for tax payment. A central banking regime operates on the notion of government-issued fiat money as sovereign credit. That is the essential difference between central banking with government-issued fiat money, which is a sovereign credit instrument, and free banking with privately issued specie money, which is a bank IOU that allows the holder to claim the gold behind it.







Thomas Jefferson prophesied: "If the American people allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive people of all property until their children will wake up homeless on the continent their fathers occupied ... The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs." It was a definitive statement against the "political independence" of central banks. This warning applies to the people of the world as well.







The Independent Treasury Act, passed in 1840, removed the federal government from involvement with the nation's banking system by establishing federal depositories for public funds instead of keeping the money in national, state, or private banks. Under the Independent Treasury Act, bank notes were to be gradually phased out for payments to and from the government; by June 30, 1843, only hard money was to be accepted. The Whigs, led by Henry Clay and Daniel Webster, opposed the Independent Treasury, but not to favor private banking. They were committed to the reestablishment of a national bank like the one President Andrew Jackson abolished in 1832. After winning a congressional majority in the election of 1840, the Whigs succeeded in repealing the Independent Treasury Act on August 13, 1841, although they were unable to gain the support of President John Tyler for their national bank proposal. The return of the Democrats to power after the election of 1844 led to the passage in 1846 of a new Independent Treasury Act, nearly identical to that of 1840. This legislation remained substantially unchanged until passage of the Federal Reserve Act in 1913, which established central banking in the US.







When the Civil War began in 1861, the newly installed President Abraham Lincoln, finding the Independent Treasury empty and payments in gold having to be suspended, appealed in vain to the state-chartered private banks for loans to pay for supplies needed to mobilize and equip the Union Army. At that time, there were 1,600 banks chartered by 29 different states, and altogether they were issuing 7,000 different kinds of banknotes in circulation. Lincoln immediately induced the Congress to pass the Legal Tender Act of 1862 to authorize the issuing of government notes (called greenbacks) without any reserve or specie basis, on a par with bank notes backed by specie, promising to pay "on demand" the amount shown on the face of the note with another note of same value. The greenbacks were supposed to be gradually withdrawn through payment of taxes, as specified in the Funding Act of 1866, to allow the government to redeem these greenback notes in an orderly way without interest. Still, during the gloomiest period of the war when Union victory was in serious doubt, the greenback had a market price of only 39 cents in gold. The fall in value was related to the survival prospect of the Union, not to loss of specie basis, which was non-existent. After the war, the Supreme Court in a series of cases declared the Legal Tender Act constitutional and Congress decreed that greenbacks then outstanding would remain a permanent part of the nation's currency. Indisputably, these greenback notes helped Lincoln save the Union. Lincoln wrote: "We finally accomplished it and gave to the people of this Republic the greatest blessing they ever had - their own paper to pay their own debts." The importance of this lesson was never taught to the world's governments by neo-liberal monetarists.







Government levies taxes not to finance its operations, but to give value to its fiat money as credit instruments. If it chooses to, government can finance its operation entirely through user fees, as some fiscal conservatives suggest. Government needs never be indebted to the public. It creates a government debt component to anchor the debt market, not because it needs money. Technically, government never borrows. It issues tax credit in the form of fiat money. So when President Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing a political slogan, with no clear understanding of the true nature of money and credit. Fiat money is all that government makes, freely and without constraint, as Federal Reserve governor Ben S. Bernanke recently warned in a speech on deflation. And only government can make fiat money as sovereign credit.







Sovereign debt is a pretend game to make private debts tradable. The relationship between assets and liabilities is expressed as credit or debt, with the designation determined by the flow of obligation. A flow from asset to liability is known as credit, the reverse is known as debt. A creditor is one who reduces his liability to increase his assets, which include the right of collection on the liabilities of his debtors.







The state, representing the people, owns all assets of a nation not assigned to the private sector. Thus the state's assets is the national wealth less that portion of private sector wealth after tax liabilities, and all other claims on the private sector by sovereign rights. Privatization generally reduces state assets. As long as a state exists, its credit is limited only by the national wealth. If sovereign credit is used to increase national wealth, then sovereign credit is limitless as long as the growth of national wealth keeps pace with the growth of sovereign credit. Even if the private sector has been assigned all of a nation's tangible assets, the state, by virtual of its existence, can still claim that portion of private sector assets allowed by the constitutional regime. Such claims include the state's power of taxation, nationalization, confiscation, condemnation by eminent domain and the power to grant and revoke monopolies, and above all, the power to issue legal tender by fiat - in other words, the inherent rights of sovereignty.







When the state issues money as legal tender, it issues a monetary instrument backed by its sovereign rights, which includes taxation. The state never owes debts except specifically so denoted voluntarily. When a state borrows in order to avoid levying or raising taxes, it is a political expedience, not a financial necessity. When a state borrows, through the selling of government bonds denominated in its own currency, it is withdrawing previously-issued sovereign credit from the financial system. When a state borrows foreign currency, it forfeits its sovereign credit privilege and reduces itself to an ordinary debtor because the state cannot issue foreign currency.







Government bonds can act as absorber of credit from the private sector. Government bonds in the US, through dollar hegemony, enjoy the highest credit rating, topping a credit risk pyramid in the international debt market. Dollar hegemony is a geopolitical phenomenon in which the US dollar, a fiat currency, assumes the status of primary reserve currency of the international finance architecture. Yet, architecture is an art of aesthetics in the moral goodness sense, of which the current international finance architecture is visibly deficient. Thus dollar hegemony is objectionable not only because the dollar usurps a role it does not deserve, but also because its effect on the world community is devoid of moral goodness.







Money issued by government fiat is a sovereign monopoly while debt is not. Anyone with acceptable credit rating can borrow or lend, but only government can issue money as legal tender. When government issues fiat money, it issues certificates of its credit good for discharging tax liabilities imposed by government on its citizens. Privately issued money can exist only with the grace and permission of the sovereign, and is different from government-issued money in that privately issued money is an IOU from the issuer, with the issuer owing the holder the content of the money’s backing. But government issued fiat money is not an IOU from the government because the money is backed by a potential IOU from the holder in the form of tax liabilities. Money issued by government by fiat as legal tender is good by law for settling all debts, private and public. Anyone refusing to accept dollars in the US is in violation of US law. Instruments used for settling debts are credit instruments. Buying up government bonds with government-issued fiat money is one of the ways government releases more credit into the economy. By logic, the money supply in an economy is not government debt because, if increasing the money supply means increasing the national debt, then monetary easing would contract credit from the economy. Empirical evidence suggests otherwise: monetary ease increases the supply of credit. Thus if money creation by government increases credit, money issued by government is a credit instrument, quod erat demonstrandum.















Credit and Money Creation











Hyman Minsky rightly said that whenever credit is issued, money is created. The issuing of credit creates debt on the part of the counterparty; but debt is not money; credit is. If anything, debt is negative money, a form of financial antimatter. Physicists understand the relationship between matter and antimatter. Einstein theorized that matter results from concentration of energy and Paul Dirac conceptualized the creation of antimatter through the creation of matter out of energy. The collision of matter and antimatter produces annihilation that returns matter and antimatter to pure energy. The same is true with credit and debt, which are related but opposite. They are created in separate forms out of financial energy to produce matter (credit) and antimatter (debt). The collision of credit and debt will produce an annihilation and return the resultant union to pure financial energy un-harnessed for human benefit.







Monetary debt is repayable with money. Government does not become a debtor by issuing fiat money, which, in the US, takes the form of a Federal Reserve note, not an ordinary bank note. The word "bank" does not appear on US dollars. Zero maturity money (ZMM) in the dollar economy, which grew from $550 billion in 1971 when President Nixon took the dollar off a gold standard, to $6.333 trillion as of June 2003, is not a federal debt. It amounts to over 60% of US GDP, roughly equals to the national debt of $6.67 trillion at the same point in time.







A holder of fiat money is a holder of sovereign credit. The holder of fiat money is not a creditor to the state, as many monetary economists claim. Fiat money only entitles its holder a replacement of the same money from government, nothing more. The holder of fiat money is acting as a state agent, with the full faith and credit of the state behind the instrument, which is also good for paying taxes. Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit. It is a certificate of state financial power inherent in sovereignty.















Bank Reserves as a Money Creation Tool











In the US, government issues fiat money in the form of cash or bank reserves (high power money) through the Federal Reserve System. Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or as deposits at a Federal Reserve Bank. Reserve requirements represent a cost to the banking system. Bank reserves are used in the day-to-day implementation of monetary policy by the Federal Reserve. As of February 2002, the reserve requirement has been 10% on transaction deposits, and zero reserves for time deposits. The monetary base is the sum of high-powered money and an adjustment factor that measures changes in reserve requirement ratios. This adjustment factor is calculated so that it responds to changes in deposit levels in addition to changes in reserve requirements.







The Monetary Control Act (MCA) of 1980 authorizes the Fed's Board of Governors to impose a reserve requirement of from 8% to 14% on transaction deposits (checking and other accounts from which transfers can be made to third parties) and of up to 9% on non-personal time deposits (those not held by an individual or sole proprietorship). The Fed may also impose a reserve requirement of any size on the amount depository institutions in the United States owe, on a net basis, to their foreign affiliates or to other foreign banks. Under the MCA, the Fed may not impose reserve requirements against personal time deposits except in extraordinary circumstances, after consultation with Congress, and by the affirmative vote of at least five of the seven members of the Board of Governors.







In order to lighten the reserve requirements on small banks, the MCA provided that the requirement in 1980 would be only 3% for the first $25 million of a bank's transaction accounts, and that the $25-million figure would be adjusted annually by a factor equal to 80% of the percentage change in total transaction accounts in the United States. An adjustment late in 2001 put the amount at $41.3 million. Similarly, the Garn-St. Germain Act of 1982 provided for a 0% reserve requirement for the first $2 million of a bank’s deposits. This level, too, rises each year as deposits grow, but it is not adjusted for declines in deposits. For 2002, the level is $5.7 million. These data testify to a continuing expansion of the money supply.







Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $80. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money. In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500. Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.







In practice, the connection between reserve requirements and money creation is not quite as direct. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels. Furthermore, the Federal Reserve operates in a way that permits banks to acquire the reserves they need to meet their requirements from the money market at the prevailing price (above the Federal Funds rate) for borrowed reserves. This is significant in two ways. First, it permits bank reserves to come from bank borrowing rather than bank deposits; and secondly, it reduces the importance of sovereign credit in money creation. Consequently, reserve requirements currently play a relatively limited role in money creation in the United States. This is the main reason why the US is increasingly a private-debt-driven economy and not a sovereign-credit-driven economy. With government deficits (tax revenue shortfalls) financed by government debt (bonds) rather than sovereign credit (money), with tax cuts reducing the demand for sovereign credit, and with privatization of public facilities and services, the public sector has come to dependent increasingly on private credit. As the Fed Funds rate approaches zero, private money creation becomes increasingly free from Fed control. This has led to the co-optation of the state by private special interests and a corruption of democracy by the moneyed classes.







Reserve requirements, open market operations (the Fed’s buying and selling of government securities) and the discount rate (the interest rate that Federal Reserve Banks charge depository institutions for short-term loans) are the three main tools of monetary policy used by the Fed. The first two focus on banks reserves while the discount rate deals with bank liquidity. There is a continual flow of reserves among banks, representing the ever-changing supply and demand for these reserves at individual banks. When the Fed engages in open market operations, it adds to or subtracts from the supply of reserves. Open market operations are the Federal Reserve's most flexible means of carrying out monetary policy. Through open market operations, the Federal Reserve buys and sells US Government securities in the secondary market in order to adjust the level of reserves in the banking system. Open market operations enable the Federal Reserve to influence short-term interest rates and reach other monetary policy targets.







The effectiveness of the Fed's actions results from the reasonably predictable demand for reserves set by reserve requirements. The Fed changes reserve requirements for monetary policy purposes only infrequently. Reserve requirements impose a cost on the banks in foregone interest on the amount by which required reserves exceed the reserves that banks would voluntarily hold in order to conduct business, and the Fed has been hesitant to make changes that would increase that cost. Between 1980 and 1987, reserve requirements underwent a series of changes mandated by the MCA. Requirements on banks that were members of the Federal Reserve System were lowered, while those on nonmember depository institutions were raised gradually from zero to the final levels applied to the member banks.







There have been only a handful of policy-related reserve requirement changes since the passage of MCA in 1980. In March 1983, the Fed eliminated the reserve requirement on non-personal time deposits with maturities of 30 months or more, and in September 1983, it reduced that minimum maturity to 18 months. Then, in December 1990, the Fed cut the requirement on non-personal time deposits and on net Eurocurrency liabilities from 3% to 0%. In April 1992, it cut the requirement on transaction deposits from 12% to 10%. In announcing its December 1990 move, the Fed noted that the cut would reduce banks' costs, "providing added incentive to lend to creditworthy borrowers." Similarly, in announcing its April 1992 cut in reserve requirements, the Fed observed that the reduction would put banks "in a better position to extend credit." Current reserve requirements are low by historical standards. From 1937 to 1958, for example, the reserve requirement on demand deposits was always at least 20% for banks in New York and Chicago, which were "central reserve cities" -- a term now obsolete. The central bank of Brazil cut bank reserve requirements on demand deposits from 60% to 40% on August 8, 2003, still a ruinously tight monetary policy.







Before the passage of the MCA in 1980, only banks that were members of the Federal Reserve System had to meet the Fed's reserve requirements. State-chartered banks that were not Federal Reserve members had to meet their state's reserve requirements, which typically were lower. As a result, many banks dropped their Federal Reserve membership, and member bank transaction deposits fell from nearly 85% of total US transaction deposits in the late 1950s to 65% two decades later, weakening the Fed's ability to influence the money supply. The MCA sought to solve this problem by authorizing the Fed to set reserve requirements for all depository institutions, regardless of Fed membership status.







The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has opposed it because of the revenue loss that would result to the US Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would be an additional expense to the Fed. Furthermore, partial reserve banking enables banks to earn profit from leveraging of funds. It would be greedy of banks to want to earn interest from their reserve requirement.







Federal Reserve deposits that banks keep with the Federal Reserve System are used to process, in a systematic, centralized fashion, the millions of checks written each day by customers of one bank that are deposited by customers of another bank. Using these deposits, the Fed acts as a central clearing house for checks, being able to simultaneously debit the account of one bank and credit the account of another. Bank reserves are definitely not government debts. They are sovereign credit assigned to banks on deposits with the Fed. The amount of bank reserve credit over and above that which the Federal Reserve System requires a bank to keep (excess reserves) is what banks use to make loans to create broad money. This is the key to the Fed's ability to control the money supply - the higher the reserve requirement, the tighter the money supply and therefore the slower the economic growth. Using open market operations, the Fed can add to, or subtract from, the excess reserves held by banks without changing the reserve requirements. Banks make loans in relation to the amount of reserves they hold, by adding to their customers' checking account balances. This is of some importance, because checking account balances are a major part of the economy's money supply. In essence, controlling excess reserves is the Fed's main method of "printing" money without physically printing money.







For decades, the Fed published data on the money supply, and for many years, the Fed set targets for money supply growth. Analysts have long monitored the growth of the money supply because of the effects that money supply growth is believed to have on real economic activity and on the price level. Over time, the Fed has tried to achieve its macroeconomic goals of price stability, sustainable economic growth, and high employment in part by influencing the size of the money supply. In the past two decades, developments have broken down the relationship between money supply growth and the performance of the U.S. economy. In July 2000, the Fed announced that it was no longer setting target ranges for money supply growth, and emphasis on the money supply as a guide to monetary policy has waned.







For July 2003, M1 was $1.278 trillion, M2 was $6.093 trillion and M3 was $8.934 trillion. While as much as two-thirds of U.S. currency in circulation may be held outside the United States, all currency held by the public is included in the money supply because it can be spent on goods and services in the U.S. economy. The Federal Reserve began reporting monthly data on the level of currency in circulation, demand deposits, and time deposits in the 1940s, and it introduced the aggregates M1, M2, and M3 in 1971. The original money supply measures totaled bank accounts by type of institution. The original M1, for example, consisted of currency plus demand deposits in commercial banks. Over time, however, new bank laws and financial innovations blurred the distinctions between commercial banks and thrift institutions, and the classification scheme for the money supply measures shifted to one based on liquidity and on a distinction between the accounts of retail and wholesale depositors.







The Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act, required the Fed to set one-year target ranges for money supply growth twice a year and to report the targets to Congress. During the heyday of the monetary aggregates, in the early 1980s, analysts paid a great deal of attention to the Fed's weekly money supply reports, and especially to the reports on M1. If, for example, the Fed released a higher-than-expected M1 figure, the markets surmised that the Fed would soon try to curb money supply growth to bring it back to its target, possibly increasing short-term interest rates in the process.







Following the introduction of NOW accounts nationally in 1981, however, the relationship between M1 growth and measures of economic activity, such as Gross Domestic Product, broke down. Depositors moved funds from savings accounts -- which are included in M2 but not in M1 -- into NOW accounts, which are part of M1. As a result, M1 growth exceeded the Fed's target range in 1982, even though the economy experienced its worst recession in decades. The Fed de-emphasized M1 as a guide for monetary policy in late 1982, and it stopped announcing growth ranges for M1 in 1987.







By the early 1990s, the relationship between M2 growth and the performance of the economy also had weakened. Interest rates were at the lowest levels in more than three decades, prompting some savers to move funds out of the savings and time deposits that are part of M2 into stock and bond mutual funds, which are not included in any of the money supply measures. Thus, in July 1993, when the economy had been growing for more than two years, Fed Chairman Alan Greenspan remarked in Congressional testimony that "if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction." Chairman Greenspan added, "The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."







A variety of factors continue to complicate the relationship between money supply growth and US macroeconomic performance. The size of the M1 aggregate has been held down in recent years by "sweeps" - the practice that banks have adopted of shifting funds by computer out of checking accounts that are subject to reserve requirements into savings accounts that are not subject to reserve requirements. In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy. However, M2, adjusted for changes in the price level, remains a component of the Index of Leading Economic Indicators, which some market analysts use to forecast economic recessions and recoveries.















The Ineffective Discount Rate











The highest historical point for the discount rate occurred on May 5, 1981 at 14%. Reserve Banks lent $45.5 billion to depository institutions at 3% discount rate on September 12, 2001, the day after the 9:11 attacks, the record for a single day. On November 6, 2002, the discount rate was set at 0.75% and the Fed Funds rate target was set a 1.25%, with a customary 50 basis point spread. On January 9, 2003, Regulation A (Extensions of Credit by Reserve Banks) was amended to restructure Federal Reserve credit programs that resulted in a new method of establishing the discount rate. The rule does not entail a change in monetary policy stance. The Federal Open Market Committee's target for the Federal Funds rate will not change as a result of the adoption of these programs, and the level of market interest rates more generally will be unaffected. The rule replaces adjustment credit, which was previously extended at a below-market rate, with a new type of discount window credit called primary credit that will be broadly similar to credit programs offered by many other major central banks. Primary credit will be available for very short terms as a backup source of liquidity to depository institutions that are in generally sound financial condition in the judgment of the lending Federal Reserve Bank. The Board expects that most depository institutions will qualify for primary credit.







Reserve Banks will extend primary credit at a rate above the federal funds rate, which should eliminate the incentive for institutions to borrow simply to exploit the positive spread of money market rates over the discount rate. The Board anticipates that the primary credit rate will be set initially at 100 basis points above the FOMC's target federal funds rate. The Board's final rule also establishes a secondary credit program that will be available in appropriate circumstances to depository institutions that do not qualify for primary credit. The Board anticipates that Reserve Banks will initially establish a secondary credit rate at a level 50 basis points above the primary credit rate. The rate change on January 9, 2003, did not reflect a change in the stance of monetary policy. Prior to 2003, the discount rate's importance as a tool of monetary policy was limited, because banks did little adjustment borrowing at the discount window. On January 9, 2003, the discount rate was raised to 2.25%, while the Fed Funds rate remained at 1.25%. The average discount rate for August 2003 was 2%, 100 basis points above Fed Funds rate at 1%. The effectiveness of the revised discount window lending program as a tool of monetary policy remains to be seen.















The Rise of Non-bank Money Creation











With the advent of unregulated financial markets, the relative role of banks as mediator of credit has been reduced and the portion of bank lending in the aggregated amount of debt in the global financial system has been shrinking. Money now is routinely created not just through banking lending, but in the money markets, through commercial papers, the issuers of which look to bank credit lines only as a back-up facility. According to Federal Reserve data, at the end of 2002, $1.37 trillion of commercial paper was outstanding in US money markets. These commercial paper are traded constantly and the money proceeds from these trades are deposits in banks, which in turn lend the money out. Pacific Investment Management Co. (PIMCO) bond fund manager Bill Gross recently criticized General Electric of using off-balance-sheet activities to manipulate its reported earnings. He also suggested that the company's heavy dependence on the short-term commercial paper market was becoming precariously risky. Questions about Special Purpose Entities (SPEs) and other means of moving risk off corporate balance sheets are being raised in regulatory and investment quarters, with few answers. Commercial banks use SPEs to securitize their own assets, and to sponsor asset-backed commercial-paper conduits, which purchase and securitize assets from third parties. New accounting rules for these activities since the surfacing of fraudulent scandals in the energy and communication sectors will cost both banks and their corporate borrowers. At stake for the business community is the ability to make illiquid assets liquid by packaging them into securities, creating money by sidestepping banks loans - the most significant innovation in the capital markets in the past two decades.







Since Fannie Mae and Freddie Mac began securitization in the mortgage market as part of their mandate to foster home ownership in America decades ago, securitization has expanded into a variety of markets, including credit-card debt, auto and home-equity loans, commercial mortgages, and trade receivables. The practice allows originators to sell assets from their balance sheets and devote their capital to generating new business. The benefit of securitization is that it has enabled the extension of credit to far more individuals and businesses. The danger about securitization is that financial-reporting practices have not kept up with the financial innovation. Because the programs are executed in SPEs off-balance-sheet, investors and regulators know next to nothing about the risks involved in the activities.







Securitization enables banks and corporations to finance assets through the capital markets, but it does not eliminate the risks associated with those assets. In fact, in most cases, banks and other asset-sellers have retained the majority of the risk of assets transferred off-balance-sheet. The process works when the economy is expanding and credit losses are small in relation to growth, as was the case through most of the last decade. In an economic downturn, problem securitization can act as an explosive force to cause a systemic crisis.







Risk cannot be extinguished by mere transfer or redistribution. In the asset securitization process, companies create a hierarchy of securities, or tranches, with escalating degrees of credit risk associated with a pool of assets. The asset-backed deal tranches typically range from AAA credit rating down to BB. With the federal government issuing less sovereign debt during the Clinton years, and hardly any corporation still holding a AAA credit rating, highly rated, asset-backed paper is an easier sell with institutional investors, making securitization a low cost route to capital for companies. But in most cases, the originator of the asset — whether it is a manufacturing company financing trade receivables or a specialty finance lender securitizing loans — retains a residual interest in the performance of the assets. This interest obligates the issuer to cover losses in the asset pool up to a certain percentage. If losses exceed that percentage, other low-rated, subordinate tranches of the issuance begin to absorb them. The identities of the holders of those subordinate tranches remain unknown, among them hedge funds seeking high return for high risk. The banks also agree to provide liquidity support if cash flow from the conduit is insufficient to pay off the paper as it matures. If enough loans in a conduit go bad, the sponsor bank could be liable and its failure can cause systemic problems. This substantial systemic risk is not transparent to the market, or to regulators until it hits the fan.







The repurchase agreement, or repo market is another venue of non-bank money creation. The $2.5 trillion-a-day repo market is the place where bond firms and investors drum up cash to buy securities, and where corporations and money market funds park billions of dollars daily to produce returns on short-term idle funds. A repo is a loan, often for as short as a day, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. The interest rate is usually close to the federal funds rate, which banks charge each other for overnight loans.







Created to raise funds to pay for the flood of securities sold by the US government to finance growing budget deficits in the 1970's, the repo market has grown into the largest financial market in the world, surpassing stocks, bonds, and even foreign-exchange. The repo market grew as it came to be used to raise money for other investments. The derivatives markets also require a thriving financing market, and repos are an easy way to raise funds to pay for new securities. Repos are used to raise money to pay for corporate bonds and are increasingly used to finance equities.







Repos chalked up average trading volume of about $2.5 trillion a day in 1999 in the US, up from $2 trillion a year earlier. Conventional perception not withstanding, the repo market is no longer as risk free as presumed because the proceeds are mostly channeled towards risk speculation.







It is difficult to obtain exact statistics about the volume of repo market activity involving financial assets other than US government securities, which are not all tracked by the Fed or cleared or settled in any one system. However, repo activity involving financial assets other than US government obligations are increasing due to dealers' and investors' desire to achieve the least expensive and most efficient funding sources for their inventories. In recent years, market participants have turned to money market instruments, mortgage and asset-backed securities, corporate bonds and foreign sovereign bonds as collateral for repo agreements. Many market participants expect the lending of equity securities to become a growing segment of the repo market, in light of recent US legislative and regulatory changes.







The Government Securities Clearing Corporation (GSCC), a registered clearing corporation that helps facilitate orderly settlement in the US government securities markets, tracks repo trades settled through its system by product type. An estimated $69.5 trillion in repo agreements was submitted and compared by GSCC participants in 1997, representing an average daily total of $277.8 billion in transactions collateralized by US Treasury and agency securities. The bulk of the total involved transactions using treasury notes as collateral, which accounted for $52.0 trillion or 74.8% of the total. Transactions collateralized by Treasury bonds accounted for $9.3 trillion of the total, while repo agreements involving Treasury bills accounted for an additional $7.1 trillion of the total. Repo agreements collateralized by Treasury bonds and bills accounted for 13.4% and 10.2% of the total, respectively.







The direct dependence of the derivatives markets on the repo market is worth noting. According to Fed Chairman Greenspan, by far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. At year-end 1998, US commercial banks, the leading players in global derivatives markets, reported outstanding derivatives contracts with a notional value of $33 trillion, a measure that has been growing at a compound annual rate of around 20 percent since 1990. Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange or over-the-counter (OTC) derivatives. An OTC instrument is traded not on organized exchanges (like futures contracts), but by dealers (typically banks) trading directly with one another or with their counterparties (hedge funds) using electronic means. Most of the funds come from the exploded repo market. The average amount outstanding in the repurchase agreement (repo) market was $2.53 trillion in 1998.







These developments overshadows the role of sovereign credit in the global economy, pushing the financing of socially necessary development towards reliance on private funding. It distorts the balance between the public and private sectors even within the US where dollar hegemony ensures an ample supply of sovereign credit. Thus the denial of sovereign credit is a necessary condition for dollar hegemony. The result is a shortage of credit for the public sector, which is forced to compete for funds with private development. Socially desirable development is simply not funded unless it offers a competitive return to private capital, leaving the world’s poor not being able to afford safe drinking water.















Sovereign Debt Not Needed for Economic Development











Government bonds are debts, because the selling of bonds soaks up money (sovereign credit) from circulation. Money is sovereign credit because it soaks up sovereign or private debt when used to buy bonds (debt) and inject credit into the financial system. Sovereign debt is never needed to finance domestic development, which can be financed with sovereign credit. Government issues sovereign credit so that a private debt market can work without specie money. Sovereign credit is the benchmark of all credit ratings. Swapping of bonds is a common practice in finance, particularly in structured finance where a bond can be stripped in many different ways to meet the varying requirements of different buyers. The technical term is unbundling. These unbundled bonds all have one thing in common with sovereign debts, i.e. they entitle the holder at maturity to receive payment in money directly or indirectly from the Treasury, retiring the debt with sovereign credit. When that happens, the retired bond disappears from the debt market. Repo contracts from the Fed are short-term borrowings from the central bank using government bonds as collateral. The Fed gives the repo borrowers money with an agreement for the borrower to repossess the bonds by paying off the short-term loan with money. The process generally can be rolled over with only an interest rate risk. Private repo contract between counterparties do not involve the Fed, but are subject to interest rates target set by the Fed. Repos do not cancel any collateralized bonds, they only monetize the bonds for the duration of the repo agreement. The monetized amounts then become bank deposits, which generate broad money through partial reserves.







Government bonds when traded or use as loan collaterals between private or public entities beside the issuer can generate broad money creation, but not high power money creation. At the initial issuance of the government bond, the money supply is reduced by the discounted amount of the bonds, because money is withdrawn from the market. But if the Treasury deposits the proceeds from the bonds in banks, then the deposits will generate broad money through bank lending. Trading of debt does not turn debt into credit because the owner of a debt is the creditor, and the holder of a government bond is a creditor to the government. At maturity, the debt is payable in fiat money. But the holder of fiat money is only an agent of the government and not a creditor to the government, because the holder of fiat money is only entitled to replacement by government of the same money. Changing money for itself is not a financial transaction. Changing bonds into money at maturity is a financial transaction between government and bond holders, in which government-issued sovereign credit is exchanged for sovereign debt.







A debt instrument, even a government debt instrument, can be used as a credit instrument by the creditor. In that case, the transaction is an assignment. The original buyer of the bond has paid money (a government credit in his possession) for the government bond (a government debt). The bond holder can trade away the government debt to another party by transferring or assigning the right to receive money from the government (government credit) at maturity of the bond. Nevertheless, the debt is cancelled only at bond maturity, not sooner, regardless how many times it is traded and with whom.







Although government-issued money is not a government debt, a government credit instrument can be used by market participants in the private sector either to issue credit or to assume debt. The payer of money for services not yet received is a creditor. The receiver of money for services not yet delivered is a debtor. Government, when issuing money, expects no goods and services other than the future payment of taxes in the form of money. Thus government-issued money is a credit instrument for taxes not yet received. When government buys good and services with money, it is spending its tax credit. The transaction does not make money a government debt.







Fiat money is government credit and fiat money in the hands of a private entity makes the holder an agent of the government, the ultimate creditor. Holders of fiat money acts as an agent for government credit. The money holder earned the right to be a government credit agent by providing goods and service in exchange for the money, or becoming indebted to a bank who acts as an agent of government credit. Money paid for tax liability is government credit cancelled. Money spent for goods and services is assignment of government credit to the money receiving party.







Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the distorted reflection in the mirror as a perfect representation.







Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.







In the language of economics, credit and debt are opposites but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods, whose consumption increases when their prices go up, and creates what US Federal Reserve Board Chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.















The Foreign Capital Hoax











The Chartalist theory of money claims that government, by virtual of its power to levy taxes payable with government-designated legal tender, does not need external financing. Accordingly, sovereign credit should enable the government to act as employer of last resort to maintain full employment even in a regulated market economy. The logic of Chartalism reasons that an excessively low tax rate will result in a low demand for currency and that a chronic government budget surplus is economically counterproductive and unsustainable because it drains credit from the economy. The colonial administration in British Africa learned that land taxes were instrumental in inducing the carefree natives into using its currency and engaging in financial productivity.







Thus, according to Chartalist theory, an economy can finance its domestic developmental needs, to achieve full employment and maximize balanced growth with prosperity without any need for sovereign debt or foreign loans or investment, and without the penalty of hyperinflation. But Chartalist theory is operative only in closed domestic monetary regimes. Countries participating in neo-liberal international “free trade” under the aegis of unregulated global financial and currency markets, cannot operate on Chartalist principles because of the foreign-exchange dilemma. Any government printing its own currency to finance legitimate domestic needs beyond the size of its foreign-exchange reserves will soon find its currency under attack in the foreign-exchange markets, regardless of whether the currency is pegged at a fixed exchanged rate to another currency, or is free-floating. Thus all non-dollar economies are forced to attract foreign capital in dollar to meet domestic needs. But countries must accumulate dollars before they can attract foreign capital. Even then, with capital control, foreign capital will only invest in the export sector where dollar revenue can be earned. But the dollars that accumulate from trade surpluses can only be invested in dollar assets in the United States, depriving local economies of needed capital. The only protection from such attacks on domestic currency is to suspend full convertibility, which then will keep foreign investment away. Thus dollar hegemony starves the non-dollar economies of needed capital by depriving their governments of the power to issue sovereign credit domestically.







Precisely to prevent such currency attacks, tight control on the international flow of capital was instituted by the Bretton Woods system of fixed exchange rates pegged to a gold-backed dollar at $35 per ounce after World War II. Drawing lessons from the prewar 1930s Depression, economics thinking prevalent immediately after WWII had deemed international capital flow undesirable and unnecessary. Trade, a relatively small aspect of most national economies, was to be mediated through fixed exchange rates pegged to a gold-backed dollar. The fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the participating economies. The impact of exchange rates were limited to the finance of international trade, and was not expect to dictate domestic monetary policy, which was crucial to domestic development and regarded as the province of national autonomy.







Under principles of Chartalism, foreign capital serves no useful domestic purpose outside of an imperialistic agenda. Thus dollar hegemony essentially taxes away the ability of the trading partners of the United States to finance their own domestic development in their own currencies, and forces them to seek foreign loans and investment denominated in dollars, which the US, and only the US, can print at will.







The Mundell-Fleming thesis, for which Robert Mundell won the 1999 Nobel Prize, states that in international finance, a government has the choice between (1) stable exchange rates, (2) international capital mobility and (3) domestic policy autonomy (full employment/low interest rates, counter-cyclical fiscal spending, etc). With unregulated global financial markets, a government can have only two of the three options.







Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis. For more than a decade since the end of the Cold War, the US has kept the fiat dollar significantly above its real economic value, attracted capital account surpluses and exercised unilateral policy autonomy within a globalized financial system dictated by dollar hegemony. The reasons for this are complex but the single most important reason is that all major commodities, most notably oil, are denominated in dollars, mostly as an extension of superpower geopolitics. This fact is the anchor for dollar hegemony. Thus dollar hegemony makes possible US finance hegemony, which makes possible US exceptionism and unilateralism.















The Foreign Exchange Carnage











Finance capitalism has operated on fiat money issued by governments worldwide ever since Nixon abandoned in 1971 the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar. Beginning in the early 1960's, with the growth of Eurocurrency markets where banks in one European country could take deposits and make loans in currencies of other countries, the tight controls of international flow of capital set up by the Bretton Woods system of fixed exchange rates after World War II were effectively bypassed. When the fixed exchange rate system set by Bretton Woods finally broke down by 1973, with a gold-backed US dollar that became fatally wounded in 1971 by decades of US fiscal irresponsibility, the developed countries abandoned capital controls officially. In the late 80's, many developing countries followed suit.







Growing from $190 billion at the beginning of the 1990s, daily turnover of foreign exchange grew almost one hundred fold to $1.5 trillion in unregulated foreign exchange markets. Only 5% of theses transaction is related to trade and others trade-associated transactions. The other 95% are financial transactions to facilitate international flow of funds, much of which involve speculative plays as traders bet on exchange rate fluctuations and interest rate differentials between currencies. This kind of financial speculation plays havoc with national budgets, macroeconomic planning and rational allocation of resources. Governments, businesses and individuals have become increasingly frustrated with the whimsical and often irrational activities in global financial markets that have such influence over national economies and are seeking some means to curb damaging and unproductive speculative activities.







By 1996, some $350 billion of private capital flowed into emerging markets, a seven-fold increase in 6 years. The bulk of this inflow went through global commercial banks. After July 1997, the bulk of the outflow left in the form of sudden withdrawal also through commercial banks. For the two decades before the Asian Financial Crises that began in 1997, technical imbalances between interest rates set by different central banks for funds in different currencies distorted capital flow around the world from economic fundamentals. The resultant inflow of capital into Asia through inter-linked financial markets around the globe outstripped the region's viable absorption rate. Financial institutions took advantage of low cost funds denominated in currencies of select countries, namely Japan, Germany and the United States, to make loans at higher interest rates denominated in local Asian currencies. These institutions sought to strategically profit from recurring technical imbalances in global finance by assuming currency risks, rather than from traditional direct investment returns. Economists call this activity international arbitrage on the principle of open interest parity. In banking parlance, this type of activity is known as "carry trade".







This abusive speculation was by no means limited to emerging economies. Corporation in developed economies routinely engaged in global financial and stock manipulative speculation at the expense of sound investment/production strategies. The public announcement of plans to open new factories in emerging markets in Asia and Latin America predictably lifted share value in home markets, regardless of such factories being risky loss-makers, for the loss would be more than offset by the increase market capitalization resulting from the publicity of a presence in an emerging market.







Corporate borrowers in Asia, attracted by low rates in some foreign currency loans, have also assumed currency risks, at times even bypassing local banks to borrow directly overseas in global debt markets. Borrowers, anticipating asset inflation brought on by runaway growth, also succumbed to the irresistible temptation of borrowing short-term to finance long-term projects, thus adding to the risk they assumed. Simultaneously, many Asian banks have taken local currency deposits at low saving rates (in Hong Kong at times at negative interest rates - depositors pay the bank to keep their money in local currency) to invest overseas in risky foreign currency instruments yielding higher returns, engaging in carry trade. Local banks in turn replenished the depleted local capital pool with low-cost foreign currency loans from international banks, taking on both economic and currency risks.







Borrowing low and lending high is the basic business of banks and there is nothing wrong with it if the activities occur within a well-regulated market in a bank's domicile community. With the advent of deregulated global banking, however, the unregulated internationalization of finance has created perilous systemic stress. Banks began to act as international loan brokers, profiting from interest rate spreads between local and foreign funds, often booking the risk premium added to over-valued currency interest rates as legitimate loan profits. These banks also began to maximizing their profits by maximizing loan volume, abrogating their traditional economic function as responsible financial pillars of local economies to ensure the productive allocation of capital. In time, local banks de-coupled their business self-interest from the economic impacts of their loans on the local economies, because they hedged the risk in such loans by passing it to overseas hedge funds which became the real loan originators to whom the banks themselves lend the funds. Western and Japanese international banks in turn provided funds to the local broker banks in Asia whose credit ratings were considered acceptable because the borrowers' exposures were hedged by instruments designed to transfer risk to other international institutions. In effect, the widespread transfer of business risks into currency risks forced the governments of the affected currencies to become lenders of last resort. This is the real economic effect of Hong Kong's, Argentina’s and other currency peg regimes to the US dollar.







To increase returns, banks also creatively skirt regulation through structured finance devices such as collateralized mortgage obligations (CMO) which releases pressure on capital requirements. CMOs are essentially new junior debts secured by old senior debts that takes advantage of the theory of large numbers and hierarchy of risk. Similarly, corporations issue convertible bonds that do not appear on the corporation's balance sheets, but expose the borrower to instant repayment requirements should its share value drop below the specified amount. So in an era of allegedly increased transparency, layers of opaqueness are introduced through structured finance. The unbundling of risk acts as a disguise of risk.







Hedging does not eliminate risk, it merely passes risk along to other parties. In fact, complex hedging schemes, with the effect of reducing the risk exposure of individual lenders and inflating the credit worthiness of the hedged individual borrowers, when widely practiced, actually increase systemic risk exposure, initially of regional financial systems and ultimately of the global system. Yet the soundness of financial institutions continue to be assessed singularly without regard to counterparty credit worthiness and the breakdown of insularity within national borders, while financial markets have become intricately linked globally. A poor credit rating seldom means the denial of credit. It only means a higher interest rate which actually attracts more eager lenders who rationalize that the high risk has been compensated for by the increased lending rate. Junk bond rates are calculated from historical industry-wide default frequencies. Through extensive hedging, private financial risks have been largely socialized globally, while profits from systemic efficiencies remain in private hands.







The ingenious layering of protection against risk, while providing comfort to individual players, buys such comfort at the expense of the security of the total global system. At some point, the strained circular chain breaks at the weakest link and panic sets in. That break occurred in Thailand on July 2, 1997. When the Asian financial crises began in Thailand, it had not been triggered by hyperinflation or a sudden drop in corporate earnings. It was triggered by a collapse of an over-valued Thai currency pegged to the US dollar, the defense of which drained the Thai central bank of its foreign exchange reserves. In hindsight, it is indisputable that the conditions that led to the Asian financial crises were: unregulated global foreign exchange markets; the widespread international arbitrage on the principle of open interest parity (carry trade); short term debts to finance long-term projects; hard currency loans for project with only local currency revenue; overvalued currencies unable to adjust to changing market values because of fixed pegs and, above all, instant massive movement of funds that was susceptible to herd panic, known as contagion.







Under these conditions, when a threat of currency devaluation caused by a dwindling of reserves appeared, the entire financial house of cards collapsed, causing havoc in connected economies in a chain reaction, called contagion. Collapse of one currency then quickly grew into regional economic crises within weeks, then turned global, eventually hitting Russia, Brazil, Argentina and Turkey.







Because of this circular system of global hedging, the economic crises in Asia inevitably spread worldwide. The regional crises, each with unique local characteristics, are merely early symptoms of a ticking global time bomb constructed out of the complex calculus of inter-linked financial markets in which countless individual credit risks are legally masked as sound transactions through sophisticated hedging. Derivatives, financial instruments which derive their value from other underlying financial instruments or benchmarks such as stock indices or exchange rates, are the cards in the fragile house of cards built by a financial specialty known as "structured finance".















The Growth of Structured Finance (Derivatives)











By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. International finance in recent years has been saturated with disastrous and scandalous abuses that clearly and repeatedly epitomize the deficiencies of the unregulated global inter-linking of financial markets. Speculators have been blamed for precipitating the run on Asian currencies that started the financial crises. Yet speculation and risk management are two sides of the same coin. At the opposite end of a prudent hedge, a speculator is required. In a structurally flawed system, even perfectly honorable businessmen or institutions individually true to high ethical and financial standards, can unwittingly participate in systemic games of dubious value. Data on the now 6-year-old Asian financial crises show that currency hedging individually by sophisticated businesses and alert government bodies, domestic and foreign, as protective measures against foreign exchange exposures in both debts and revenues, have been mostly responsible for the sudden currency turmoil in the region. In international finance, a game of musical chair in financial risk is in full force in which the players are handcuffed together through inter-linking hedges. This game can cause serious systemic rupture when the music stops.







Specifically, the increased risk associated with a financial environment which profits from instability characterized by abrupt and unpredictable change and flux, has created a demand for financial instruments to protect against that risk. These instruments, generally called derivatives, can be defined simply as aggregated or "bundled" contractually created rights and obligations, the effect of which is to create a transfer or exchange of specified cash flows between counterparties of coupled needs at defined future points in time.







The size of the invisible money pool created by financial derivatives is now many times (no one knows how many) the amount of M3. One firm alone (LTCM) commanded open positions of US$1.2 trillion financed by 100-fold leverage. That is almost the entire daily transactional value of the world's foreign exchange markets. Another hedge fund (Tiger Management) can suffer an asset evaporation (loss) in the amount of US$20 billion in 6 hours by a 10% appreciation of a single currency (yen) against the dollar. At year-end 1998, US commercial banks, the leading players in global derivatives markets, reported outstanding derivatives contracts with a notional value of $33 trillion, a measure that has been growing at a compound annual rate of around 20 percent since 1990. Of the $33 trillion outstanding at year-end, only $4 trillion were exchange-traded derivatives; the remainder were off-exchange, or over-the-counter (OTC) derivatives. On a loan equivalent basis, a reasonably good measure of such credit exposures, US banks' counterparty exposures on such contracts are estimated to have totaled about $325 billion