The Wages of Neo-liberalism

PART 1:Core contradictions

Henry C K Liu

The US trade deficit with China ballooned in 2005 to US$202 billion, more than one-quarter of the total deficit. Rising trade imbalance between the US and China in recent years has given rise to intense pressure from the United States on China to revalue the fixed exchange rate of its currency, which had been pegged at 8.28 yuan to a dollar within a narrow band of 0.03% for a decade, from 1995-2005.

On July 21, 2005, after repeated pronouncements that no revaluation was necessary or even being considered, China announced a surprise 2% appreciation of the currency, putting it at 8.11 yuan to the US dollar. It also announced that the yuan would henceforth be pegged with the same narrow range to a basket of foreign currencies that includes the dollar, the euro, the yen and others likely to reflect China's trade relationships with the rest of the world. The components and weight of different currencies within the basket is not disclosed to the market. China appears to be following Singapore's managed-float model, keeping both weights and effective bands confidential to allow maximum flexibility within a narrow range tied to a reference peg to the dollar. Many saw it as an obvious political move to appease US pressure.

Yet US pressure on China to revalue the yuan further continues, as the trade deficit with China for January 2006 registered $17.9 billion, a 10% increase from the previous month. Total worldwide US trade deficit for the month was $68.5 billion despite a rise in US exports of aircraft and soybeans. This pressure from the US is motivated by the misguided conventional assumption that a lower exchange rate of the dollar will reduce the US trade deficit, despite clear historical data showing that past revaluations of the Japanese yen and the German mark had not reduced US trade deficits with these major trade partners in the long run.

All such revaluations did was to lower the domestic cost in local-currency terms more than raise the dollar price of Japanese and German exports. The net effect was deflation in Japan and Germany, with inflation in the US while the US trade deficit continued.

The dollar takes the form of a US Federal Reserve note, a monetary instrument issued by a central bank. The yuan takes the form of Chinese People's Currency (renminbi, or RMB) issued by the People's Bank of China (PBoC), another central bank. Both are fiat currencies issued by central banks in that they are money with no intrinsic value, not backed by gold or other species of value. Both currencies are not issued directly by their respective governments, but by their respective central banks. This means that the full faith and credit of the nation is not directly behind either of these currencies.

A holder of these fiat currencies cannot go to their government to claim a piece of the national wealth. The values of either of these currencies are determined by their purchasing powers in the respective economies as affected by the monetary policies of their respective issuers, ie, the respective central banks. The holder of a dollar is entitled to exchange it at the Fed for another dollar, no more, no less. The dollar's purchasing power within the US is affected by the Fed's monetary policy as such policy affects the inflation or deflation rates in the US economy. The same is true for the yuan. Thus the exchange rate of the two currencies reflects the domestic purchasing power differential caused by the monetary polices of their respective central banks, which are in principle politically independent.

The trade imbalance between the US and China is not caused by the exchange rate of the two currencies. It is caused mainly by a disparity in the factors of production, such as wages and rent as expressed in prices in the two trading economies. The Chinese trade imbalance with the US is primarily caused by Chinese wages and rent being too low compared with equivalent productivity in US wages and rent. The dysfunctionality in the exchange rate between the yuan and the dollar is the result, not the cause, of the trade imbalance. To correct this trade imbalance, Chinese wages and rent need to rise, not the Chinese currency. Wages and rent in the two trading economies need to converge toward parity, rather than the currencies to diverge from any particular exchange rate that has been in operation for a decade.

The yuan at 8.12 to $1 is already valued at twice the purchasing-power-parity gap of 4 between it and the dollar within their respective economies. Wage disparity between China and the US ranges from 20 to 50 times in various sectors, and an exchange rate that reflected such a wide disparity would border on the ridiculous.

A stable exchange rate is not only beneficial to trade, it is also fundamentally critical to global financial stability. Every financial crisis since the 1971 collapse of the Bretton Woods fixed-exchange-rate regime has been caused by exchange-rate instability. Exchange-rate policies cannot be substitutes for structural economic adjustments necessary for mutually beneficial trade between two economies. Nor can exchange-rate policies be substitutes for sound domestic monetary or economic policy.

When two economies at uneven stages of development trade, a trade surplus in favor of the less-developed economy is natural and just, until the less developed economy catches up with the more developed one, otherwise it would be imperialistic exploitation, not trade.

Market forces on exchange rates are derived from the relative strength of trading economies. Foreign-exchange markets express the net summary judgments of market participants on the economic health of trading economies as they are affected by government fiscal and central bank monetary policies. Markets use exchange-rate fluctuation to carry the message of aggregate judgments to the monetary and fiscal authorities of the trading economies. These authorities, usually the central bank and the Treasury, cannot ignore such market sentiments without a cost.

For economies where the currencies are freely convertible, the cost can be massive attacks on their currencies by speculators, such as hedge funds, that would quickly drain the government's foreign-exchange reserves and cause a collapse in the economy's debt market. For economies that practice exchange and capital control, the penalty would be a drain in foreign reserves and a reduction in trade in the case of a deficit. In the case of a trade surplus, the penalty would be a drain of domestic currency capital into growing foreign-exchange reserves.

In the current global central-banking regime, fiat currencies are issued mostly directly by central banks or by banks authorized by the central bank to issue currency, such as in former British colonies like Hong Kong. Central banks are supposed to be politically independent in their key role of maintaining the stability and the value of a nation's fiat money, unaffected by constant and relentless political pressure for easy money.

The value of the fiat currency of a sovereign nation is backed only by the nation's economic health and by the issuing government's acceptance of it for payment of taxes. It enjoys monopoly status as legal tender for settlement of all debts within the country's borders. Most sovereign nations allow only their own legal tenders to circulate within their borders and require that foreign currencies be first converted into local legal tenders before being used in domestic markets. For cross-border transactions, a foreign-exchange market is necessary to inter-convert legal tenders of trading nations at economically equitable rates.

When the foreign-exchange value of the fiat currency of a country moves beyond what the government or the foreign-exchange market deems appropriate, the correction needs to come from a readjustment of the structure of its economy, not from artificial manipulation of the exchange rate of its currency. Regardless of whether the exchange rate is fixed by government or by market forces, the volatility in the gap between the economic value of a fiat currency and its exchange rate is the main cause of financial instability. Such instability has caused recurring financial crises around the world in past decades since the collapse in 1971 of the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar.

The philosophical underpinning of a central-banking regime is the assumption that a stable value for a fiat currency is necessary for the long-term health of the economy. In a globalized market economy, the domestic purchasing power of a fiat currency in large measure affects its exchange rate, not the other way around. Yet most central banks, including the US Federal Reserve, categorically defer exchange-rate policy to the Treasury or ministry of finance, because it is an issue of national economic security. Further, the raison d'etre for a central-banking regime is equally rooted in a contradicting assumption that monetary elasticity is necessary to respond to the changing financial needs of the economy to prevent cyclical bank crises and recessions or depressions.

Thus a central bank's first key function of preserving the domestic purchasing power of fiat money conflicts with its second key function of providing monetary elasticity to a slowing economy. A central bank must restrain commercial banks from creating money through excessive lending made possible by a partial reserve regulatory regime, while at the same time it must act as a lender of last resort in an approaching financial crisis or panic.

The function of a lender of last resort is to provide needed liquidity to a market in distress from already excessive debt. Without central-bank liquidity reserves, a distressed market may freeze in a circular domino effect of even creditworthy debtors being temporarily unable to meet their obligations because some less creditworthy debtors are unable to pay their debts to them. Such recurring banking crises had been regular in the US prior to the establishment of the Federal Reserve in 1913 and in recent decades in many other countries with dollar debts for which their central banks were unable to provide monetary elasticity in dollars because only the Fed can print dollars.

According to the quantity theory of money, monetary elasticity, when regularly invoked as convenient preventives against cyclical slowdowns in the economy, leads to a rise in "moral hazard", which is the encouragement to borrowers to take unwarranted financial risks with the knowledge that such risks would be protected by central-bank bailouts. Monetary elasticity is much easier to inject than to retract because deflation is more painful than inflation for debtors. Elasticity loss is eventually caused by fatigue, in the same way that rubber bands can get stretched or snapped.

The Fed under its former chairman Alan Greenspan repeatedly went on record to assert its belief in the heresy that "highly aggressive monetary ease was doubtless also a significant contributor to stability". Greenspan said in 2004 in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

By "the next expansion", Greenspan meant the next bubble, which manifested itself in housing after 2000. The "mitigating" response was a massive injection of liquidity into the US banking system.

There is a structural reason that the housing bubble has replaced the high-tech bubble. The US trade deficit finances the US capital account surplus which provides low-cost mortgages for the US housing market. Houses cannot be imported from low-wage countries like manufactured goods, although many of the contents in houses, such as furniture, hardware, windows, kitchen equipment, bath fixtures and heating and air-conditioning equipment, are manufactured overseas. Construction jobs cannot be outsourced overseas to take advantage of cross-border wage arbitrage, although many low-skill construction jobs are filled by illegal immigrants. But a housing bubble is not different from any other types of debt bubbles. It will burst if income fails to grow with asset value to sustain debt-service payments.

Thus central banks are saddled with conceptual contradictions in assuming the dual role of a vigilant supervisor of the rules of prudence in the financial market while at the same time acting as a permissive cheerleader for the infraction of the same rules in the name of innovative economic expansion. Moreover, central-bank criteria for bailouts of distressed private firms are tied to their potential systemic impact. Such criteria are inherently undemocratic in that the large debtors unfailingly get preferred treatment merely because of their size. Hence the birth of a rule of finance that every borrower knows: if you owe the bank $10,000, you are beholden to the bank; but if you owe the bank $10 billion, the bank is beholden to you. It is known as the "too big to fail" syndrome.

What is even more pathetic is that in the US, the Federal Reserve is legally owned by its member banks, not the government, or the people, although some 98% of the profit made by the Fed goes to the US Treasury by law. Board members of the Fed are nominated by the member banks and appointed by the US president, and as a group they predominantly represent the special interests of the banking sector.

In China, the passage of the Central Bank Law in 1995 granted the People's Bank of China central-bank status, shifting it away from its previous role of a national bank. The difference between a national bank and a central bank is that a national bank serves the banking needs of the economy while a central bank seeks to maintain the stable value of the currency and at the same time to provide monetary elasticity to prevent banking crises, and to adopt an interest-rate policy that ensures profitability to the banking sector with the idea that the banking sector, the heart of the economy, must be protected at all cost for the good of the economy.

In the twilight zone of Chinese bank reform, no outsider knows how the process of nomination and appointment of the board members of the PBoC works. It is safe to say that the PBoC still follows the policy directives of the Chinese government, which in turn follows the policy directive of the Chinese Communist Party. To the extent that CCP policy drifts toward market fundamentalism with Chinese characteristics, PBoC will invariably also drifts toward representing the special interests of the banking sector and their big business clients at the expense of the interests of the proletariat and peasant masses, or Chinese banks cannot profitably compete in the world market. Such is the class contradiction of a "socialist market economy", no matter how the term is defined with doctrinal sophistry.

By the definition of the Bank of International Settlement (BIS), the super-national central bank for all national central banks, such an undemocratic special-interest posture is viewed as desirable "political independence" in a capitalist democratic society. Unlike the Fed, which has an arms-length relationship with the US Treasury, the PBoC manages the state treasury as its fiscal agent. In addition to regulating the inter-bank lending market, the PBoC also regulates the inter-bank bond market, the foreign-exchange market and the gold market in China.

Political independence is not a policy subject Chinese central bankers can discuss with ease as long as China still views itself as a socialist nation. They prefer more benign euphemism in the jargon of bank reform such as "conforming to international standards". There are signs that after almost three decades of headlong reform toward what Chinese officials call a socialist market economy, the adverse consequences are beginning to show.

Recent Chinese policy has shifted back in populist directions to provide affirmative financial assistance to the poor and the undeveloped rural and interior regions and to reverse blatant income disparity and economic imbalances. It can be anticipated that this policy shift will raise questions in the capitalist West about the political independence of the PBoC. Western neo-liberals will be predictably critical of the PBoC for directing money to where the country needs it most, rather then to that part of the economy where bank profit would be highest.

The birth of the Bretton Woods regime

After World War II, as the United States emerged as the only country the industrial sector of which had been left not only undamaged but actually strengthened by war, the US dollar by default became the uncontested world reserve currency for international trade.

As early as April 1942, the so-called White Plan, named after Harry Dexter White, US Treasury under secretary and a student of free-trade advocate and Harvard professor Frank W Taussig, proposed a United Nations Stabilization Fund and a Bank for Reconstruction and Development of the United and Associated Nations. The advantages of stable exchange rates that the automatic classical gold standard had provided while it lasted, from 1876 to 1914, had proved to be not so automatic after World War I. The classical gold standard was causing deflation around the world that translated into a worldwide depression, while mercantilism, the quest by nations for gold through exporting, was causing protectionist reaction in all countries.

The idea of the need for international cooperation in trade and for a new "gold exchange standard" that would make wider use of gold by supplementing it with an anchor currency that would be readily convertible into gold had been developed at a 1920 international conference in Genoa, Italy, but the participating governments failed to reach agreement because not all were ready to accept British sterling hegemony. This idea was incorporated two and a half decades later into the Bretton Woods regime with a gold-backed US dollar replacing the British pound. The challenge was to devise an operative international finance architecture out of fiat currencies anchored to a gold-backed dollar to accommodate postwar international trade.

On August 14, 1941, some fours months before the Japanese attack on Pearl Harbor, the United States, not yet at war, issued jointly with a Britain - already at war with Germany - the Atlantic Charter, which set out a postwar world vision as an unspoken condition for a pending US alliance with Britain. Among other provisions, the Atlantic Charter emphasized British commitment to postwar international cooperation, including support for US efforts to form a United Nations based on the principle of self-determination for former colonies. Six months later, in February 1942, barely two months after the Pearl Harbor attack, under the Lend-Lease Agreement, Britain agreed to a postwar multilateral payments system in exchange for US commitment to help Britain financially during and after the war.

Four months after the declaration of the Atlantic Charter, on Sunday, December 14, 1941, one week after the Pearl Harbor attack, while the US was mobilizing for all-out war, treasury secretary Henry Morgenthau was busy figuring out how to finance the war. He asked White to prepare a monetary-stabilization plan that would include all the Allies, while Britain was also busy with its own plan. One crucial difference between the US plan by White and the British plan by John Maynard Keynes was that the Stabilization Fund (SF) proposed by the US was to be based on a mixed bag of national currencies, while the Clearing Union (CU) proposed by Britain was to operate with a new international currency to be known as the bancor. The CU also had less strict rules than did the SF for its use by countries with balance-of-payments deficits.

The US was concerned about its own potential financial liability about the rights of creditor countries with balance-of-payments surpluses, which at that time meant only the United States. The US team voiced serious reservations about the British/Keynes plan, which had liberal liquidity provisions and ready access to liquidity for countries with temporary trade deficits. Britain anticipated huge wartime deficits as revenue from many parts of the British Empire was suddenly interrupted.

In addition, the White plan contemplated the forbiddance of exchange-rate intervention, an important feature for the United States, whereas the Keynes plan did not put much emphasis on limits on exchange-rate intervention and even advocated the use of capital controls for the weaker economies, of which Britain expected to become one in the course of the war. Britain imposed exchange control soon after the war began and kept it for four decades until the new Conservative government abolished exchange control in 1979.

The pre-1979 controls on direct investment restricted sterling-financed foreign investment except where it had a positive effect on the balance of payments. With respect to portfolio investment, the controls stipulated that purchase by United Kingdom residents of foreign exchange to invest overseas could be made only from the sale of existing foreign securities or from foreign-currency borrowing. A third element of the controls restricted the holding by UK residents of foreign-currency deposits as well as sterling lending to overseas residents.

The 1944-45 international conference at Bretton Woods, New Hampshire, was attended by representatives of 44 governments who agreed on "a framework for economic cooperation partly designed to avoid a repetition of the disastrous economic policies that had contributed to the Great Depression of the 1930s" and which led to a further eclipse of a British Empire already weakened by World War I.

British resistance, with US support, to a geopolitical challenge to its crumbling empire from rising powers such as Japan and Germany in the 1930s eventually led to World War II, which was a geopolitical contest between competing powers that morphed into an ideological contest between democracy and fascism, an image created by Anglo-US propaganda as a high-principle pretext to marshal domestic political support for war.

While constantly vowing in private that Britain did not go to war merely to give the empire away, prime minister Winston Churchill cleverly referred in public to the Allies as "the democracies", to appease historical US anti-colonial ideology. Churchill neutralized the isolationist elite in the United States by appealing to the anti-communist right in US politics with conservative rhetoric in his spirited speeches. Taking advantage of a common language, Churchill's ringing speeches sounded inspiring to the US public just as Adolf Hitler's firebrand speeches inspired the Austrians.

Churchill's protective posture toward fascist Spain illustrates his ambivalence toward fascism. On June 19, 1945, at the San Francisco Conference, the United Nations, a reincarnation of the Allied Powers, voted unanimously to exclude Francisco Franco's fascist Spain. Then, at the Potsdam Conference later that summer, Soviet leader Josef Stalin proposed a worldwide total boycott of fascist Spain, and that the Allies break diplomatic relations with Madrid and aid the "democratic opposition" within Spain.

US president Harry Truman was in favor, which was the only time he and Stalin ever agreed on anything, but Churchill opposed the idea, pointing out that Britain had strong trade links with Spain that a postwar Britain could not afford to break and that "interference in the internal affairs of other states was contrary to the United Nations Charter". Churchill was counting on the Spanish fascists to keep the communists from gaining back Spain, lost in the Civil War through Third Reich help to Franco.

The Soviet Union, while wanting to appear to be associated with plans being fashioned at Bretton Woods out of a desire to be perceived as a participating world power, showed little enthusiasm for monetary cooperation with US capitalism. Soviet economists were not interested in capitalist world trade and they lacked sufficient theoretical sophistication to understand the subtleties between the contested proposals in capitalist economies. The USSR agreed to send a technical observer delegation to the Bretton Woods conference without the commissar of finance.

Britain, concerned with preserving its special economic relationship with members of the Commonwealth, reorganized from a collapsed empire, also said it would not send cabinet-level officials to the conference. Both Britain and the Soviet Union asserted that participation in the conference in no way foreclosed their option to reject eventual membership in the proposed International Monetary Fund.

The Bretton Woods conference, predominantly a US-run show, produced an international financial regime that set the value of the US dollar at one-35th of an ounce of gold, with all other currencies of other participating nations set at fixed exchange rates to the dollar that were not expected to fluctuate beyond a narrow range of 1% from unruly market forces. Foreign-exchange control between borders was strictly enforced. Official exchange rates were determined by economic fundamentals and were expected to change only fundamentally, but not temporarily because of speculative forces, because trade was supposed to increase wealth for all trading nations proportionately and was not expected to alter their relative wealth.

Cross-border flows of funds were not considered by then-prevalent trade-economics theories as either necessary for trade or desirable for domestic development. All members of the United Nations were eligible to join, provided they were committed both to eliminating controls over foreign-exchange transactions and to establishing fixed exchange rates, to be altered only with the consent of the Fund.

Trade, though not unimportant, was considered to have only a supplementary function in a nation's economy, the main economic functions being in domestic economic development. A weak domestic economy could not possibly be expected to solve its problems through trade alone. National economic development was the goal of every nation, with trade being conducted only for auxiliary purposes. This was just common sense, for no nation would tolerate or could afford a sustained trade deficit. Trade among nations either had to be balanced or trade would soon stop until temporary trade deficits were eliminated. If every national economy were to seek growth only through exports, the aggregate effect for the world economy would be negative.

While World War II was a global conflict between the Allies and the Axis powers, a parallel undercurrent financial war was waged between the two leading allies. British historian Robert Skidelsky in his three-volume biography of John Maynard Keynes writes of the relationship between Keynes, who represented Britain, and White, who represented the US at Bretton Woods, as a "battle between the two ... one of the grand political duels of the Second World War, though it was largely buried in financial minutiae".

He sees the differences as the result of US malevolence: "Harry Dexter White of the US Treasury wanted to cripple Britain in order to clear the ground for a postwar American-Soviet alliance." Later, in the Joseph McCarthy era, White was accused unfairly of having been a communist, on flimsy circumstantial evidence, notwithstanding that in the 1920s, every thinking individual on the US cultural scene was to some degree sympathetic to communism. Critics on the right in the United States at the time saw Bretton Woods as an attempt to "set up a super-national Brains Trust which is to think for the world and plan for the world, and to tell the governments of the world what to do", wrote Skidelsky.

After the Dunkirk evacuation, when the badly mauled British military retrieved its expeditionary force of 300,000 by the skin of their teeth with the use of civilian small boats, the British had to make a choice: either to lose the military war to Germany as France did, or to lose the financial war to the United States. Churchill chose losing to the US, based on the time-honored strategic theory of keeping distant allies to oppose nearby enemies.

Churchill was out-and-out pro-US, with his American mother and close connection to the US moneyed elite. This policy was not unanimously supported by all in Britain, the Duke of Windsor being a prominent example. But Churchill's choice turned out to be the only sensible option, with Canada dominated by the US and Singapore, Malaysia, British Borneo, India and Australia threatened by a hostile Japan, an ally of Germany.

Moving US General Douglas MacArthur from embarrassing defeat by the Japanese in the Philippines to Australia cemented British-US interests in Asia and saved the United States from an unthinkable disgrace of having a top general surrender to what was commonly considered by US sentiment as an inferior race. Since 1941, Britain had been holding up a stiff-upper-lip facade, pretending to remain a world power in its de facto role of a US client state, a mere water boy on a powerful team. It did get some benefits from the Cold War, which was in no small way engineered by Churchill, exploiting the insecurity and paranoia of Truman to keep a crippled Britain a minor player in the power game of global geopolitics.

Bretton Woods called for a Bank for Reconstruction (now known as the World Bank) to finance investment in the postwar era, and an International Stabilization Fund to repair the flaws in the inter-war gold standard. This was to make explicit and to enforce the rules of behavior expected of trading nations, to manage exchange rates, to assist in resolving temporary balance-of-payments problems (the key operative word is "temporary", ie, not persistent), to encourage tariff reduction and free trade, and to control destabilizing movements of "hot money" across national borders, as in Mexico in 1995 and in Asia in 1997.

Keynes saw payments imbalance as a problem for both surplus and deficit countries, both of which needed to be encouraged to change their domestic policies, not rely on changing exchange rates to paper over unsustainable imbalances. White, representing the US, which anticipated huge trade surpluses, saw a balance-of-payments deficit as the problem that the countries running the deficit need to correct by changing their domestic policies.

John Maynard Keynes, father of Keynesianism, which became the theoretical fuel for US president Franklin Roosevelt's New Deal, and by 1941 an adviser to the British Treasury, came to Washington that July, some six months before the Pearl Harbor attack, to discuss with US officials the conditions for US wartime financial aid to Britain. The State Department gave him a draft agreement for defense aid that would include a provision for postwar arrangements in which there would be no discrimination by the United States or the United Kingdom against imports from any other country. This provision upset Keynes, because it meant abolishing the British imperial preference system that had been negotiated in Ottawa with the members of the Commonwealth in 1932.

Keynes, who had been working and writing on monetary and exchange-rate problems since World War I and who had come to prominence after that war with his criticisms of the reparations provisions of the Treaty of Versailles, was inclined, however, to look with favor on the benefits of stabilizing exchange rates. Keynes believed that it was possible and desirable to have a high degree of exchange-rate stability without the rigidity of classical gold standard.

Thus US and UK officials had a common starting point. Keynes, however, worried that the US might return to the pre-New Deal deflationary policies of the 1930s, and so favored a plan that would give the UK freedom to pursue domestic full-employment policies without having to be concerned about the impact on the resultant UK balance of payments.

The policy struggle between Keynes and White was geopolitical in a world of finance capitalism where national wealth determined national power more than the reverse, as in the age of imperialistic mercantilism. The subtle economics difference between the two plans represented a huge gulf geopolitically. The Keynes plan fit the need of a financially drained British Empire upon which the sun was about to set while the White plan fit the needs of a financially well-heeled US about to inherit the Earth.

British imperial conservatives believe that the US during World War II provided aid to Britain on measly terms guaranteed to destroy Britain as a super power. Skidelsky writes of financial war as the "intensity and often bitterness of the struggle between Britain and America for postwar position which went on under the facade of the Grand Alliance. When the European war started, Britain, not Germany, was seen by most American leaders as America's chief rival." He writes of how "Churchill fought to preserve Britain and its Empire against Nazi Germany. Keynes fought to preserve Britain as a Great Power against the United States. The war against Germany was won; but, in helping to win it, Britain lost both Empire and greatness."

He writes of how it was a tragedy that Hitler's being "in charge of a great nation ... threw Britain into the arms of America as a suppliant, and therefore subordinate: a subordination masked by the illusion of a 'special relationship'". Skidelsky saw that the British government's "underlying belief that the New World had to be yoked ... to the Old" led to "the deference Britain paid to America's wishes ... and its failure to exploit crucial elements in its bargaining position - like fighting a more limited war, or even making a separate peace with Germany."

Declassified documents on wartime Allied summits provide substantial evidence to support Skidelsky's observations. Until his untimely death, Roosevelt was on a collision course with Churchill on the "good" war's objective vis-a-vis British colonialism. It was not until Truman replaced Roosevelt as president that US policy accepted British insistence on the preservation of the British Empire as a war aim, in the name of anti-global-communism. This policy change greatly limited US options in developing a viable postwar foreign policy toward new emerging nations of the Third World, and this limitation eventually led to the Vietnam War by indiscriminately equating Third War nationalism with communism.

The idea that the United States should help Britain fight to defeat a tyranny, not to preserve an empire, was an embarrassing self-deception. The US only declared war on Germany after Japan attacked Pearl Harbor, Hawaii. German tyranny had by then been going on for a number of years. Kristallnacht, "the Night of Broken Glass", took place on November 9-10, 1938, a year before Britain and France declared war on Germany on September 3, 1939, and three years before the US entered the war. During Kristallnacht more than 7,500 Jewish shops were destroyed and 400 synagogues were burned to the ground all over Germany.

Ninety-one Jews were killed and an estimated 20,000 were sent to concentration camps, which until that time had been mainly for non-Jewish political prisoners. Prominent Americans were actively against US involvement in Europe and many were actively pro-Germany until after the Pearl Harbor attack.

World War II was a conflict of geopolitical interests among great powers. The "struggle against tyranny" image was an afterthought moral icing on the geopolitical cake. The "good war" was especially good for the US economy.

After World War II, Britain was still saddled with many of the costs of empire while losing most of the benefits. Colonial natives soon converged on the British Isles to take advantage of liberal social programs originally designed for native Britons - free health care and generous unemployment benefits. Even wealthy Third World elites would send their children to Britain for fancy orthodontic work and their pregnant mistresses to give birth in London hospitals, all for free, plus a British passport for the newborn, not to mention generous welfare payments for the unwed mother.

Aside from the pride of being on the "winning" side, Britain got pitifully few tangible benefits from the war. London and other industrial cities had suffered severe damage from Luftwaffe air raids and the country had in reality been an occupied territory by US forces after 1942.

The other disadvantage was that unlike Japan and Germany, Britain actually still had a performing democracy at the end of the war, though hardly a working one. This prevented the British communists from any real prospect of coming to power and thus did not rate serious US attention. Unlike Germany and Japan, on which much US aid was driven by the US fixation on anti-communism, Britain had an anti-communist Labour government, the worst of all possible combinations in terms of the postwar US geopolitical agenda. While the US hated and feared communists, it had even less respect for the social democrats in the Labour Party.

The US was set to teach European social democrats a lesson, and the British Empire was taken over by the United States in the name of communist-containment, with the pretense that British Labour was not trustworthy on the ideological struggle. Then there was the brain drain to the US, and the overvalued pound sterling devastated British trade. For five decades after World War II, British ingenuity expressed itself in pop culture rather than in independent national revival strategy.

Immigrants from the Commonwealth did not catch on until years later that they could get free rides on the welfare programs in Britain originally designed to serve only UK residents with money collected before the war from distant parts of the empire. But the programs put in place by the Labour government stayed operative long after the administration of prime minister Clement Atlee, until the Conservative Margaret Thatcher came to power. Not only Third World residents but US residents did the same thing.

Fulbright exchange students selected Britain mostly for its medical benefits for all residents regardless of citizenship. The returned US students taught their friends how to vacation in the United Kingdom for free dental work and childbirths. Socialism cannot work unless all who draw from the system also pay into the system. The residual effects of a collapsed empire were used by Thatcher to prove that social welfare did not work.

The collapse of the Bretton Woods regime

US president Richard Nixon's 1971 declaration "we are all Keynesians now" had the effect of rendering modern Keynesians monetarists, ending four decades of polarity in economics between Keynesianism and monetarism. The reason modern Keynesianism cannot avoid monetarism is the collapse of Bretton Woods in 1971, which exacerbated the monetary implications of fiscal policy. Any government today trying to repeat US president John Kennedy's 1960 New Economy of tax cuts and fiscal spending will face a market assault on its currency. That is, any government except the US, because of dollar hegemony.

Nixon's declaration served to cover up the impact of his historic abandonment of the Bretton Woods regime of gold standard/fixed exchange rates on August 15, 1971, a date that marked the end of US dominance of world finance derived from the strength of its monetary system, and put the US on a slippery slope of currency manipulation through dollar hegemony. To compensate for removing the dollar from its gold throne, Nixon imposed ineffective wage/price controls to arrest domestic inflation, which was really an institutional measure rather than a Keynesian one. The net result was that while wages were kept from rising legitimately, prices rose in the black or gray market that came into existence because of price-induced shortages.

Paul Volcker, Nixon's Treasury under secretary for monetary policy and international affairs, at first reassured foreign central bankers and finance ministers that the United States was merely looking for a "breathing space" to reconstruct an orderly monetary system. Later, Volcker admitted that the breakdown of Bretton Woods was a failure of US leadership and self-discipline to rein in US financial excesses.

With the collapse of the Bretton Woods regime, for the first time in the post-World War II economic order, inflation became exportable because of cross-border flows of funds, and the way to fight inflation was to force down wages in the exporting economies. A government willing to dilute the value of its currency by inflation could gain windfalls at the expense of its trading partners by temporary currency-exchange-rate and pricing advantages. With unregulated global foreign-exchange markets in the 1990s, the US was eventually able to maintain a strong dollar without merit, through the residual historical geopolitical arrangement of denominating oil (black gold) in dollars.

With dollar hegemony, this temporary advantage became permanent for the United States. It was able to devalue its currency domestically while keeping it strong in relation to other currencies. The boom in the US economy was being financed by deflation in the economies of its trading partners.

At Bretton Woods, Harry Dexter White used the gold-backed dollar to appropriate a century of British financial hegemony and to use the gold-backed US dollar as a disciplinary device to punish dishonest fiat currencies of countries that ran recurring deficits. It is ironic that by the 1990s, the dollar had become the dishonest fiat currency used by globalized currency markets to punish honest fiat currencies of countries that had accumulated surpluses.

Milton Friedman applauded the fall of the Bretton Woods regime in 1991, since he and other conservative monetarists of the Chicago School saw floating exchange rates as an excellent "laissez-faire" free-market solution, notwithstanding that events have since shown that currency markets, manipulated by hedge funds that created recurring financial crises around the globe, are anything but "free".

Friedman, father of modern monetarism, saw the development of foreign-exchange markets as forcing the US Federal Reserve to focus on the one thing it allegedly could control: the domestic money supply. Friedman was fixated on the truism of the theory and not particularly concerned with the practical effects on the economy from the violent volatility in interest rates that a steady money supply would generate.

Volcker, as Fed chairman, influenced by a Friedman, who had been buoyed by a general wave of conservatism into guru status among ideologue monetarists, adopted in 1980 a "new operating method" for the Fed as a therapeutic thunderbolt on Wall Street, which seemed to have lost faith in the Fed's political will to control inflation.

The new operating method, by concentrating on monetary aggregates, ie, money supply, and letting it dictate interest-rate swings within a range from 13-19%, to be authorized by the Federal Open Market Committee (FOMC), was an exercise in "creative uncertainty" to disrupt the financial market's complacency about interest-rate stability or gradualism, which was widely perceived as the key Fed policy objective. There had been a traditional expectation that even if the Fed were to raise rates, it would do so at a gradual pace to avoid causing the market to become volatile. The expectation of interest-rate gradualism was again justified by the Fed's most recent "measured paced" approach to interest-rate hikes in the final year of Greenspan's watch.

Volcker's failed monetary experiment in 1980 forced the Fed back on its old path: focusing on interest rates and not money supply, and ironically to vow again to focus on the long term. To avoid total economic collapse, the Fed had no choice but to maintain interest-rate gradualism over aggregate money stability that came with the unbearable price of interest-rate volatility.

For the long term, money supply was the correct barometer, while interest-rate policy was the appropriate tool for the short term. Since interest-rate volatility is unavoidable, the compromise is to make the change in rates gradual to reduce the volatility. But gradualism prolongs a short-term solution into a long-term cure, thus neutralizing the effectiveness of interest-rate policy as a short-term tool. That is the real conundrum of interest-rate policy, not the inverse yield curve as Greenspan suggests.

The surviving Bretton Woods twins

Two related super-national institutions were organized by the US-sponsored Bretton Woods conference: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), more commonly known as the World Bank. Both institutions have been dominated by the US since their inception, as the United Nations has been. Together, these two super-national agencies helped build the US global financial empire through world trade conducted under the auspices of the World Trade Organization, the rules of which are set by the strong, well-developed economies to the disadvantage of the weak, developing economies.

The IMF world view is expressed by its official statement of its function:

During that decade [1930s], as economic activity in the major industrial countries weakened, countries attempted to defend their economies by increasing restrictions on imports; but this just worsened the downward spiral in world trade, output, and employment. To conserve dwindling reserves of gold and foreign exchange, some countries curtailed their citizens' freedom to buy abroad, some devalued their currencies, and some introduced complicated restrictions on their citizens' freedom to hold foreign exchange. These fixes, however, also proved self-defeating, and no country was able to maintain its competitive edge for long. Such "beggar-thy-neighbor" policies devastated the international economy; world trade declined sharply, as did employment and living standards in many countries.

This of course is a free-trade view favored by the dominant economies, such as prewar Britain and the postwar US.

Among the official purposes of the IMF are: to promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation; to assist in the establishment of a multilateral system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions that hamper the growth of world trade; to give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

Only 29 of the 43 conference participants signed the IMF's Articles of Agreement in 1945 because many governments saw Bretton Woods as a US-British condominium, with Britain ceding many of its prewar financial hegemonic privileges to the US in exchange for being allowed to stay in the game. Thus when the US forced Japan and Germany to accept the Plaza Accord of 1985 to revalue the yen and the mark respectively, it amounted to forcing a "competitive exchange depreciation" of the dollar, in violation of IMF principle.

The overvaluation of the dollar in the 1980s was the result of Federal Reserve policy under Volcker, not of policies of the central banks of Germany or Japan. Similarly, pressure on China in recent years to revalue the yuan amounted to a comparable violation of the same IMF principles. The fall in the purchasing power of the dollar was the result of Fed policy under Alan Greenspan, and the unwarranted strength of the dollar exchange rate reflects the effects of dollar hegemony constructed by Robert Rubin, US treasury secretary under president Bill Clinton.

Unlike the IMF, whose function was to promote international trade with a currency-stabilizing fund, the official function of the World Bank was to promote long-term economic development, including financing of infrastructure projects, such as road-building and improving water supply. The so-called Bretton Woods twins, the IMF and the World Bank, because of critical noises made by Joseph Stiglitz, a former World Bank chief economist who had been forced out by US treasury secretary Lawrence Summers, appeared to be at odds in their policy focus. But this was mere sibling rivalry.

In late 1995, in the face of threats from the US Congress to cut US contributions to the bank, the World Bank embarked on a high-profile advertising campaign to underline its importance to the economies of donor countries. The World Bank announced that it "doesn't just lend money; it helps developing countries become tomorrow's markets". The US was getting back from the World Bank more than what it put in, so the argument went.

Social welfare has transformed into corporate welfare, with the World Bank clinging to the party line that what is good for Northern industry is also good for the poor of the South. The Summers' infamous World Bank memo, in which he, as the United States' chief economist, argued that the export of pollution to poor countries represented "immaculate" economic logic because Third World lives were worth less, is a classic example of warped neo-liberal mentality.

The amount of money the World Bank is throwing in the direction of the private sector and its new belief that corporations can handle development on their own, without government involvement, is manifested in the bank's shift from project lending to "policy" lending in the form of loans for removing trade barriers, privatizing government-owned companies and restructuring whole sectors of the economy to allow the entry of transnational corporations from the advanced economies. Private-sector projects have weaker information and disclosure policies, less accountability and less stringent environmental policies than public-sector projects.

For example, the World Bank has been one of the most powerful forces behind genetic erosion around the world for the past 50 years. This devastation has resulted from a wide range of activities in most of the sectors at the bank - in particular, agriculture, energy, forestry, infrastructure and industry. In the 1950s, the bank's agricultural focus was on cash crops (such as cacao, rubber and palm oil), which started the decline of diversity in farming systems and the crops themselves.

When the Ford Motor Co fell into decline after founder Henry Ford's death in 1947, it was "saved" by the "Whiz Kids" who managed to turn the company back toward profits by producing the worst cars in the industry through the application of a systems approach to management in which the quality and safety of a product was only a tradeoff component in the quest for profitability.

The Whiz Kids were led by Robert S McNamara, who went on to mislead US president Lyndon Johnson into the Vietnam War quagmire as the secretary of defense who promised to win an unwinnable war by committing more and more troops and money, after which he went on to become president of the World Bank (1968-81) with equally disastrous impact on the world's poor. McNamara's top-down anti-poverty strategy accelerated a process of agricultural modernization and integration into the global market that increased inequality, exacerbated poverty and had a devastating impact on biodiversity and the environment.

Ambitious land-clearing and settlement projects were another important component of the World Bank's purported poverty-alleviation strategy in the McNamara era. These often involved the decimation of vast areas of prime biodiversity habitats, particularly tropical rainforests. For example, in the 1970s, the bank approved a series of loans that cleared 526,000 hectares, or 6.5%, of Malaysia's rainforests, mainly to install mono-cultural plantations for the production of palm oil. Such areas experienced dramatic losses in biodiversity: in one fell swoop, diversity plummeted from thousands of species per hectare to a single lonely palm tree. All told, plantation forestry systems cover some 15 million hectares today, and they are still expanding.

These kinds of escapades continued into the 1980s. Brazil's infamous Polonoreste agricultural development program, funded by the World Bank to the tune of $443 million, singlehandedly increased the deforestation of the Brazilian Amazon from 1.7% in 1978 to 16.1% in 1991. More than half the loans financed the paving of a 1,500-kilometer dirt track through the rainforests of Rondnia. Most of the rest went into constructing feeder and access roads, and the establishment of 39 rural settlement centers to consolidate and attract settlers who were to raise tree crops (mainly cocoa and coffee) for export. Instead of the tens of thousands of settlers anticipated, half a million arrived in the space of five years.

Agricultural extension services and credit never materialized and resettlement officials were overwhelmed. To survive, the settlers tried, largely unsuccessfully, to grow crops such as rice, beans and corn (maize) in the poor soils, which would become exhausted in a year or two. Slash-and-burn went completely out of control, as the settlers were constantly forced to move on. The impact on the fragile rainforest environment was of course devastating. By the mid-1980s, the burning of Rondnia was identified by the US National Aeronautics and Space Administration as the single largest, most rapid human-caused change on Earth visible from space.

Indonesia's Transmigration program had an equally devastating impact on both biological and cultural diversity. Between 1976 and 1986 the World Bank lent $630 million to support the movement of millions of Javanese people to outlying islands. In addition, it provided $734 million for agricultural development, which either did not materialize or was used to provide rice that people tried, and failed, to grow in totally inappropriate environments, razing the environment in the process. By the late 1980s, transmigration was responsible for deforestation rates in the fragile forests of the outer islands reaching a rate of 5,000 square kilometers a year.

The results of the program were particularly devastating in Irian Jaya, now called West Papua, one of the world's great reservoirs of biological and cultural diversity. Here, transmigration was little more than an attempt to "Javanize" what the authorities viewed as backward and disrespectful ethnic groups. The original plan was to match the 1 million ethnic people, belonging to numerous tribal groups speaking more than 200 languages, with 1 million Javanese. This target was never actually reached because the program proved so disastrous, but transmigration did have its desired effect in decimating Papua's social and cultural fabric.

In the wake of the World Bank's advertising campaign, the US Treasury subsequently issued a report demonstrating that in just two years (1993-95), the World Bank and other multinational development banks had channeled nearly $5 billion of contracts to US firms. One major beneficiary was Cargill, the third-largest food corporation in the world. Cargill's 1995-96 sales were a mind-boggling $56 billion, which is roughly equivalent to the gross national product of Pakistan, Venezuela or the Philippines. Company earnings reached almost $1 billion and profits were 34% higher than in the previous year.

Next: The US-China trade imbalance

Henry C K Liu is chairman of a New York-based private investment group. His website is at HenryCKLiu.com.

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