Speculating on Quantitative Currency Wars

by Michael Hudson, President of The Institute for the Study of Long-Term Economic Trends (ISLET), a Wall Street Financial Analyst, Distinguished Research Professor of Economics at the University of Missouri, Kansas City and author of Super-Imperialism: The Economic Strategy of American Empire (1968 & 2003).

An Interview with Dr. Michael Hudson
October 21, 2010

Interviewer: iTulip’s Eric Janszen

(E): Welcome Michael Hudson to iTulip again. Thanks for joining us.

Hudson (H): Thank you, Eric.
E: So we’ve had discussions in the past about China’s response to America’s escalation of the currency wars. Yesterday they made a bold move, raising their interest rates and also imposing an export embargo on an important industrial commodity, rare earth metals.

H: Let’s talk about the latter first. I think China finally caught on to the fact that it was pricing its rare earth minerals at the uneconomic low-cost margin of extraction, not taking into account the environmental clean up costs or the replacement costs for these basically irreplaceable rare metals. They pointed out that these exports rightly should be priced at the high-cost margin, which of course is the basis of Ricardian rent theory. So they’re conforming to basic Western price theory and practice. America sells its military technology for what the market will bear. If the Pentagon would sell its new missile and bomb technology at the physical cost of production – CDs with the blueprints – then China would not have to pay the high price of buying this information from Israeli espionage agencies.

E: That’s not likely to happen, because last time I checked, the Pentagon has China on top of their list of places to worry about.

H: The thought that China would wage a war or pose any military threat to the United States is crazy. The national security approach holds that any industrial capability is potentially military, and hence is a threat. What China has reason to worry about is that there are crazy people in the Pentagon and Congress who are get ill-tempered at America’s loss of industrial power and “blame the foreigner.”

China-bashers are encouraging the Pentagon to create problems in the China Sea. And China has every reason to fear that U.S. military adventurism may take a violent turn or be accident-prone. That is what countries do when they blame foreigners for problems that they themselves caused. The Obama administration is mishandling the economy as badly as the Bush administration did, so you can expect the “blame the foreigner” reaction to take a military dimension. The xenophobic idea is that China is taking away American jobs, not that America’s pro-financial policies are responsible for de-industrializing the economy and shrinking domestic markets and employment here.

E: Isn’t there another possible explanation more consistent with the past U.S. policy of raising the spectre of the fearsome Soviet Union’s military capacity, which really was just a way to ensure that one of our greatest exports, weapons, would continue to flow?

H: That’s true. I think that just yesterday India promised a huge new fighter aircraft purchase. America has been pressuring India, saying “Look, we’re running a big trade deficit with you, so you have to balance it by buying what we can export.” Prime Minister Singh is yielding, agreeing to buy 125 fighter jets. What does India need these for?

E: We just had some pretty juicy deals with the Saudis, too. I think these deals are bigger than the entire stimulus program that Obama recently discussed.

H: Yes, this is bizarre, but what else can America export these days? Prices for these exports are so high that other countries are beginning to compete. Unfortunately, it’s an economically useless competition – overhead, not capital formation.

E: We could speculate that one of the motivations for cutting off rare earth metals is there’s a lot of difficulty in making a lot of these weapons without that stuff. So maybe China doesn’t want to participate.

H: I was in Beijing last year and they pointed out that the United States has numerous rare earth deposits. One of the biggest is owned by Molycorp – the old Molybdenum Corporation. Another mining company sold all its equipment, lock, stock and barrel to the Chinese. So the United States is not mining many rare earth metals now, because China has undersold the market so drastically – and so uneconomically. In any case, these rare earths are available in many places, only at a higher price. The military simply will bid up prices to their replacement cost, which is what Japan is paying to buy old computers, telephones and other used equipment to refine the rare earth content from them.

Suppose China charges a few thousand dollars a pound for its rare earths, instead of six or seven dollars a pound. At this price I think that the Pentagon can able to get all it needs, so higher prices are not going to stop the U.S. military threat.

E: That’s a good point. The price rise probably is going to spur a fair amount of speculation in U.S. production of rare earth metals.

H: It’s hard to speculate. I think the main company that was mining China’s rare earth deposits was a Hong Kong or Taiwanese company. The government should take control of most such monopolies and price their output at the marginal replacement cost, as textbooks describe. China was nearly giving away these metals without taking into account either their replacement costs or environmental clean-up costs. It pointed out that these were among the dirtiest metals to mine, and local opposition has arisen to protest the environmental problems they caused.

E: The second move by the Chinese was their quarter-point rate hike. This seems to be a paradoxical response to the accusation that they’re overvaluing their currency. Certainly you’d expect such a move to increase the yuan’s exchange rate.

H: That’s right. I can understand why they would raise the rate in order to slow the rise in bank credit and housing prices. I would rather use a tax approach to this. Joseph Stiglitz had a good report today [October 19, 2010] in The Guardian on why tax policy rather than financial policy should be used. China will have to impose capital controls to prevent interest-rate arbitrage from flowing into its currency out of the dollar

E: Exactly.
H: And what Prof. Stiglitz said on Democracy Now is even sharper [1]:
“[Fed] lending is actually below what it was in 2007. In a globalized economy, the money is looking for the best place to go. And where is it finding it? In the emerging markets.

“So, the irony is that money that was intended to rekindle the American economy is causing havoc all over the world. Those elsewhere in the world say, what the United States is trying to do is the twenty-first century version of “beggar thy neighbor” policies that were part of the Great Depression: you strengthen yourself by hurting the others. You can’t do protectionism in the old version of raising tariffs, but what you can do is lower your exchange rate, and that’s what low interest rates are trying to do, weaken the dollar. The flood of liquidity abroad is trying to push the exchange rates abroad. And they say—they’re saying, ‘We can’t allow that.’”

So the important question is how China can respond except by imposing capital controls? And how can Brazil or other countries avoid such controls in the face of the Federal Reserve’s “quantitative easing” that actually is financial aggression?

E: The interest-rate rise appears to be a doubling down on China’s assertion that they’re not underpricing their currency.

H: What is pushing up the renminbi’s exchange rate is largely capital flight out of the dollar, not trade. I don’t think they’d raise their interest rate just for public relations or psychological purposes. I think their main concern is to hold down price rises for real estate and slow the stock market. Any economy in this position would probably raise its interest rate. But given the international effects, I don’t see how China is going to withstand yet more demand for its currency as speculators and other foreigners try to buy yuan-denominated assets.

There’s going to be a lot more renminbi flowing into the Central Bank – which already got $2.6 trillion in reserves. What can China do with these reserves, when the United States is taking a nationalistic position by saying, “We’re not going to let you buy U.S. companies. You have to let us buy your companies but we’re not going to let you buy Unocal or refineries or anything that we consider important.” Canada now is under nationalist and even overtly racist pressure not to let the Chinese buy their Potash mining company in Saskatchewan.

E: Almost every government that has allowed property prices to rise so steadily (Japan in the 1980s, the U.S. in the early 2000s) seems to think that they can end these distortions with merely marginal measures such as rate hikes. Alan Greenspan said throughout the dotcom bubble, “Raise the rates, raise the rates.” But it takes quite a bit to finally drive speculators out of the market. This usually happens quite suddenly. That’s the lesson that was learned in 1999-2000, and again in 2006. Do you think that the Chinese will experience a similar kind of effect?

H: I think everything happens by a phase change, not in smooth marginal movements. You go from one phase to another. Things may be marginal within each phase, but there is something like turning an on/off switch from one phase to the next. That’s as true for China as it has been for any other economy. I’m sure they must realize this, but I’m not sure just what they have in mind, except maybe an attempt to show up the U.S. in preparation for the G20 meeting in Seoul next month.

E: I think that’s right. There’s obviously a lot of pushing and shoving verbally before the IMF meeting two weekends ago, and then we’ve got the G20 coming up in November. A lot of this is probably a combination of posturing and sending messages to bolster the positions of the various players.

H: My experience is that China’s position in the current situation is defensive, not offensive. It’s trying to figure out a way to defend its stability. It’s saying: “We’re not going to destabilize our economy in order for you (Europe and the U.S.) to take measures that you claim will stabilize your economy, but actually is making your economy worse and worse.” In other words, “we’re not going to give in to your fantasies, we’re going to live in the real world.”

E: So in a way, what Chinese policy makers are doing is explaining back to the Bernanke set, “You don’t really have an inflation problem. It doesn’t make any sense with $25 silver and $1300 gold. What the United States really has is a debt-deflation problem. That’s a political problem, and you guys have got to deal with it without flooding us with your money.”

H: That’s exactly correct. The U.S. economy is all loaned up. So when the Federal Reserve provides more liquidity to the banks, they are not going to lend to real estate that already has one-third of homes in negative equity. Obviously, the only thing banks are going to do is to try to work their way out of debt is by lending abroad—by speculating in the carry trade, just as Japan’s banks did.

E: Sure. And countries from Brazil to China – any economy on the receiving end of all this liquidity – will have to defend themselves against this “quantitative easing.”

H: That’s right.

E: What is the end game here? On one side of the equation we have rising commodity prices, and on the other side we have falling bond yields. I think if you went to the average portfolio manager five years ago and told him, “Five years from now silver will be five times the price it is today and the yield on ten-year Treasury bonds will be around 4.5%,”they’d probably have thought you were crazy.

H: There’s no way that you can project past trends to see where the intersection point is today, because we’re in a quandary. The U.S. economy has reached a wall of indebtedness. It can’t take on more debt. A choice has to be made: Either write down the debts to the ability to pay, or flood the market with enough credit to keep the debt bubble growing. That’s ultimately going to make it even harder for the economy as a whole to work its way out of debt. So I don’t see what can happen, except more breaks in the chain of payments.

We’re now living under what James Galbraith calls the Predatory State,” a government taken over by the financial interests. They say, “We want all the debt to be paid, regardless of the effect on the economy as a whole. And we also want all of our financial gambles and CDOs to be made whole, even if it shrinks the economy. We don’t care if you have to scale back pensions and Social Security, or reduce wages by 20% and lower living standards. We want to get paid.” And they’re telling politicians, “Don’t forget that we’re the guys who are paying for your Congressional and Senate campaigns. We expect you to do what we tell you to do, or else we’ll back someone else.”

So basically, the financial sector is saying to the economy, “Drop dead!”

E: Isn’t it even worse? Paul Krugman wrote in his New York Times op-ed yesterday [October 18, 2010] comparing U.S. deflation to that of Japan. This is one of the favorite arguments for advocates of printing more money and increasing federal deficits further. They claim that we’re making the same mistake that Japan did, by not being “aggressive enough” with fiscal stimulus.

H: On another plane we’re doing the opposite of what brought on Japan’s bubble crisis. The Basel II agreement in 1988 ruled that banks needed much higher capital reserves to bring them up to the new European standard. As a result of their weak position after World War II, Japanese banks had been operating for half a century on much lower capital. All of the sudden, the Basel Agreement forced these banks to stop lending and rebuild their capital base. In conjunction with high interest rates (which the Americans insisted upon) and upward revaluation of the yen, this killed Japan’s economy. So Japan’s giving in to American financial demands destroyed it.

By contrast today, instead of lowering bank liquidity the U.S. Federal Reserve is pushing liquidity into the financial system. This enables banks to increase their loans, on the theory that America can borrow its way out of debt – which is crazy, of course. So Bernanke and Krugman are drawing a false parallel.

E: I agree completely. The US was never slow on the gas pedal as the Bank of Japan was. We never did fall into a liquidity trap that some members of the Feds are claiming we are in today. The way I see it is that these arguments for continuing to borrow – to use your phrase, to move debt from private to public accounts by the Fed’s cash-for-trash swaps and bailouts.
Comparing our opportunity to Japan’s, isn’t our sovereign credit risk much higher than Japan’s in terms of per capita GDP growth, structural balance-of-payments deficit, history of default and history of inflation?

H: The financial credit risk is really a political question of national policy. In the last few weeks China has negotiated currency swaps with Russia, Turkey and Brazil. The aim is to prevent losses on these swaps. There’s a mutual guarantee that a central bank of a currency that loses value will reimburse the central bank that’s holding its currency so that the latter will not suffer a loss as denominated in its own currency.

I suspect that all the United States would have to do (at least in the short run) would be to make the same deal so that foreign countries would not take a loss on their dollar holdings. Instead, America is saying bluntly: “In order for us to solve our economic problem at no cost to ourselves, you must take a loss. We are going to solve our problem at your expense. If you don’t like it, you had better arm yourselves (preferably by buying our own weapons exports) because we’re going to do things our way. What are you going to do about it?”

E: Yes.

H: Imagine what effect this is creating abroad! Other countries have gone along with U.S. policy so far, because there was some mutual gain, at least in the U.S. market for foreign countries’ exports. But now that U.S. consumers have little left to spend on goods and services (because they have to spend so much on debt service and housing), America has little to offer any more. So foreign countries are moving away. I was told two weeks before Turkey made the currency-swap agreement with China that they decided that America is going to be on the losing side, and they wanted to go with the winners – that is, with the growing economies, not those that are sinking into debt deflation.

The United States is playing as if other countries are still going to automatically obey it. The only ground for believing this is that other countries are looking at the United States as a “madman.” It certainly looks as if people like Ben Bernanke are even nuttier than Alan Greenspan. They’re disappointed with Obama, whom they see more as a continuation of Dick Cheney than of George Bush. He’s turned over the shop to the Rubinomics gang of financial predators.

E: You’re in Germany. What’s the general feeling there about US economic policies?

H: There is resentment against Angela Merkel and her government for following American policy and not realizing that the world has changed from what it used to be. There is still high unemployment here, almost 20%. The economy is not doing well, and German exports – like other European exports – are being hurt by the euro’s rise while the U.S. Fed continues to pursue low interest rates to increase the capitalization rate of its real estate and corporate income – which has the side effect of lowering its exchange rate. So Europe is bearing the brunt of American financial aggression. There is a feeling that Merkel is turning as much into Obama’s poodle as Blair was Bush’s poodle. And her French friend Sarkozy is not popular here either.

E: Regarding the currency swap agreements between China and other countries to avoid the downside of holding dollars and doing trade in them, is this a gradualist approach?

H: It’s an either/or approach. Foreign central banks know that holding dollars is like buying an asset that is going down in price. Nobody wants to do that, because they will have to show a loss on their books, which are kept in their own currency. Most central bankers expect China’s currency to rise, just like the yen rose after 1985. They naturally would rather hold a rising currency asset than a depreciating one.

E: Speaking of which, one of the major changes in the global market over this year is that central banks have become net buyers of gold. Earlier this week the central bank of South Korea announced that they’re beginning to diversify out of dollars. Do you see this as part of the process that I call decommissioning the dollar as a reserve currency?

H: Certainly. The United States, Germany and France hold half of their foreign reserves in gold. Korea has only 0.2% of its international reserves in gold. So it’s saying, in effect: “Wait a minute. There’s some hypocrisy going on here. You’re telling us to hold dollars, but you’re holding gold. We’ve decided to do as you do, not as you say.” The corollary is to spell this out: “We don’t know what the future global monetary system is going to be. But it looks like the United States is expecting a gold-based system. Otherwise, let the U.S. Treasury sell off its gold stock.”

Korea’s may have been discussed its gold purchase with other countries. Its act says, in effect: “We’re hosting the G20 meetings next month. Why doesn’t America hold down the price of gold by putting its money where it’s mouth is, and announce that it’s going to sell the gold in Fort Knox?” Other countries might well say, “By the way, can you give us back the gold we’re holding in the New York Federal Reserve? Now that we don’t have to worry about World War II any more, we’d like to hold our own gold.” There is a growing feeling that the U.S. Government is acting on behalf of financial thieves, and that this theft is causing unemployment in Europe and other countries.

E: So this leads to my final question: Clearly the world needs a new global monetary system. This has been obvious for a while. My sense is that for most governments around the world, the final straw has been the financial crisis that we’ve imposed on everybody. So the question is, in the past such agreements were reached with at least one dominant power (that would be us) holding most of the cards and dictating the arrangements. This time around, that’s not really an option any more. But it’s not clear just where the leadership is. So is there any precedent for a multilateral agreement among countries for a new international currency regime?

H: I think this mischaracterizes the issue. There never was a multilateral currency system. There was the US dictating to the rest of the world, as you point out. It used an internationalist rhetoric for nationalistic financial and trade purposes. That’s what my Super Imperialism was all about.

E: Yes, that’s what I mean. That is what we always had before.

H: The United States said to other countries: “We’ll never join a multinational system in which other countries can set our policy. We insist on veto power – or the power to simply ignore your recommendations. And for your part, you must do what we say, or we’ll do to you what we did to Iraq or Afghanistan. So get out of our way!”
I think that other countries have given up hope of a multi-lateral system in which the United States will cooperate. So they’re creating a parallel system, namely as the BRIC countries have done. They’re saying, “We’re going to avoid using the dollar altogether.” And the dollar’s own financial managers are turning it into nearly a pariah currency. This is what I wrote about in the Financial Times yesterday: the U.S. refusal to cooperate with other countries, above all its double standard insisting that other countries must turn their foreign-exchange surpluses over to the U.S. Treasury to promote U.S. financial markets at their expense – and the demand that any country running a trade surplus with America spend the money on U.S. arms – is so abhorrent that other countries are proceeding to create an alternative global financial system of settling trade and balance-of-payments transactions without the United States.

So what will emerge is a new multi-lateral financial system after all. But there will be two financial systems: one centered on the BRIC countries with strong trade balances and currency values, another system centered on the U.S. dollar. Europe is likely to be left out, and may become an economic backwater, because so much of its politics are run by U.S. aficionados. So I see a dual world monetary system and a dual world trade system operating under a different set of trade and financial rules.

U.S. diplomats no doubt will call this socialism. Other countries can reply, “What we’re doing is just what the French Physiocrats, Adam Smith, John Stuart Mill and the other major classical free-marketers wanted: no free lunch. If we’re socialists, what are you guys? We’re too polite to use the word, but it was used in World War II.”

E: On that note we’ll wrap it up. We appreciate your thoughts on this. It’s certainly going to be an interesting meeting coming up next month among the G20, and we’ll see what comes out of it.

H: Have a glance at the article I wrote in the Financial Times [October 19, 2010].

E: Will do.

H: I think that spelled out a lot of the logic of what I’ve just been talking about.

E: Very good. Thank you very much Michael. Appreciate your time.

H: It’s always good to talk to you.

[1] Nobel Laureate Joseph Stiglitz: “Foreclosure Moratorium, Government Stimulus Needed to Revive US Economy,”

Democracy Now, Oct. 21, 2010.