Policy Recommendations for Dealing with the Global Financial Crisis - Part 2

(Part 2 of a two-part series)
(Japanese version published on September 22, 2008)

KOBAYASHI Keiichiro

Following the collapse of Lehman Brothers, the U.S. authorities' response to the financial crisis changed drastically. On September 18, the U.S. Department of Treasury and the Federal Reserve proposed a framework of stabilization measures for the financial system that called for deploying up to $700 billion (approximately ¥75 trillion) of public funds to purchase bad assets from financial firms. It is not clear at this moment whether the ceiling of $700 billion is sufficient, or if the emergency package will materialize smoothly. However, if a mechanism under which the government purchases soured mortgage loans and mortgage-backed securities directly from ailing financial firms is put in place, it might be able to stop asset deflation, a phenomenon in which financial firms contribute downward pressure to falling housing prices by selling off assets at a loss. Once asset deflation comes to an end, fear and the possibility of the ongoing financial crisis dragging the real economy of the United States or the whole world into depression might be eliminated.

When the immediate situation does calms down, it will become clear that the growth mechanism of the post-Cold War world economy is no longer sustainable. Over the past dozen years or so, the U.S. financial sector generated enormous value and American consumers spent freely under the influence of the wealth effect (from rising stock prices initially, but more recently from higher home prices). Supported by this robust consumption in the U.S., China and many other economies across the world also achieved strong economic growth. However, it is unlikely that U.S. stock and housing prices will trend upward in the coming years, and before this could happen structural changes would have to be made to the U.S. economy, which currently depends on the financial sector for a large portion of earnings. That is, the present growth model in which the U.S. drives the world economy as its "ultimate consumer" is probably unsustainable.

Based on these observations, in what follows I would like to ponder crisis management measures that look beyond the immediate financial crisis and incorporate a future direction for the international monetary system.

A new framework for international cooperation to change the course of events

In my previous column, I suggested that the deepening U.S. financial crisis and weakening dollar would eventually impose a huge burden of economic adjustments throughout the world, particularly on China and other emerging economies. Theoretically, China should be able to reduce its burden of economic adjustments by allowing the renminbi (RMB) to fluctuate freely under a free-floating exchange rate system. In reality, however, an excessively sharp drop in the value of the dollar would impose huge costs on China. From a long-term point of view, the appreciation of the RMB with respect to the dollar is unavoidable for China. Still, slowing the pace of the dollar's decline could be beneficial for China, because decelerating RMB appreciation would substantially reduce China's noneconomic adjustment costs, such as those associated with social unrest and ethnic minority problems.

Thus, as a new framework for international cooperation to change the future course of events, it may be possible to consider a scheme under which Chinese public funds (foreign reserves) would be injected into capital-depleted U.S. financial firms to shore up their capital bases, thereby propping up the dollar. Such a scheme - needless to say it would be beneficial to the U.S. - would bring considerable benefit to China in terms of reducing the unwanted social adjustment costs that would accompany a sharp decline in the dollar. This would be a win-win strategy for both the U.S. and China.

Of course, given the current delicate relationship between the two countries on the military front, it is unthinkable that the Chinese government would be permitted to become a major shareholder of leading U.S. financial firms. Such an event would surely invoke the argument that U.S. security could be undermined by the acceptance of such capital infusions that would effectively place major U.S. financial firms under Chinese control. This problem, however, could be averted by devising an appropriate multilateral funding mechanism.

As a specific example, we can consider a multilateral scheme under which the Japanese government sets up a fund and the Chinese government purchases bonds issued by the fund. That is, China would lend money, but limit its role to that of creditor, to the Japanese fund. This Japanese fund (hereinafter the "East Asia foreign exchange stabilization fund") would then inject funds into capital-depleted U.S. financial firms and government-affiliated housing corporations through the purchase of non-voting preferred shares or subordinated bonds. Under this scheme, the Chinese government's influence over the East Asia foreign exchange stabilization fund would be kept to a minimum because it would only be purchasing bonds issued by the fund. Furthermore, the fund's influence over the management of U.S. financial firms would be limited because investments would be made in the form of non-voting preferred shares or subordinated debt. By thus creating double walls to block the Chinese government's influence over the management of U.S. financial firms, the possibility of Beijing interfering with the U.S. financial system would be reduced to a considerable extent.

If this multilateral cooperative framework can be designed in such a way that countries other than China also purchase bonds issued by the East Asia foreign exchange stabilization fund, the Chinese government's control would be further reduced. This should be a welcome scheme for the U.S. provided that these other countries investing in the fund are friends and allies of the U.S. - namely Asian countries such as Japan and South Korea - and do not attempt to strategically interfere with the U.S. financial system. Chinese public funds would be beneficial to the U.S., too, as far as they are invested via the East Asia foreign exchange stabilization fund to effectively block the Chinese government from obtaining influence over U.S. banks.

Meanwhile, China would not necessarily lose out on the deal by offering public funds under this scheme. In the short run, China is bound to incur substantial unrealized losses if U.S. housing prices continue to decline because the public funds are destined to be invested in capital-depleted U.S. financial firms. However, things appear quite different from a much longer-term point of view looking beyond the next ten years.

Back in 1998 when Japan's financial crisis was at its critical stage, major Japanese banks were perceived to be on the verge of collapse. Today, however, they are generating significant profits and the public funds injected in these banks in 1998-99 have brought significant returns to Japanese taxpayers. Likewise, Chinese public funds injected into U.S. financial firms would bring huge returns to the Chinese government in 10 to 15 years' time, after the U.S. financial system eventually does regain stability. The injection of public funds into U.S. banks on the verge of collapse may be defined as a reasonable means of ultra-long-term investment of foreign reserves. Furthermore, when foreign governments inject public funds in a concerted effort, the U.S. financial system will become more stable, which in turn will increase the credibility of the dollar. In addition, because the use of foreign public funds will slow the increasing U.S. fiscal deficit, it will mitigate the effect of fiscal factors that have been driving down the dollar. Thus, if realized, this international scheme would slow the decline of the dollar against other currencies, including the RMB. Given the enormous social and political costs China would have to bear if the dollar depreciates rapidly, public funds injected into U.S. banks as a means of tempering the dollar's decline may also be a politically viable option for Beijing.

The key element of the East Asia foreign exchange stabilization fund scheme is that it combines foreign exchange-rate policy measures and financial system stabilization measures. Normally, measures for ensuring financial system stability are regarded as an issue of domestic concern kept independent from the international monetary order. Conversely, it is unthinkable to consider the possibility of using measures to rescue financial firms as a exchange-rate stabilization policy tool; international policy discussions usually focus solely on foreign exchange interventions. However, because the U.S. issues the world's key currency, problems in its financial system are just as much international currency problems as they are domestic financial problems. Measures designed to bring stability to the financial system are directly linked to the stability of the dollar, which is a foreign exchange-rate policy goal. Considering the public significance of a stable dollar to the global economy, capital injected into the U.S. financial system under such an international cooperative framework involving China and other countries should be a practical option.

Reversing the logic of the international monetary system

The East Asia foreign exchange stabilization fund scheme discussed herein may present a completely new view of the current international currency system based on the dollar. Stabilizing the U.S. financial system and the value of the dollar with public funds from other countries means that the dollar's value will be supported by taxpayers in other countries (or the tax-collecting power of these countries).

Under the current international monetary system, the dollar's value is supported by U.S. taxpayers or the tax-collecting power of the U.S. government. (Although there are several different theories explaining the mechanism that determines the value of a national currency, the standard view would be that the real value of the currency and sovereign bonds of a country is determined by the present value of the discounted expected future tax revenue of the government.)

In a simplified picture that ignores international politics and security issues, the current international monetary system can be described as one in which the value of the world's key currency, which is an international public good, is being supported solely by the U.S. with all the other countries enjoying a free ride. It may be said that countries with trade surpluses, such as Japan and China, are supporting the dollar's value by making massive purchase of U.S. Treasury bonds. However, this only makes them purchasers of U.S. debt securities because they are not buying any "share" in the responsibility of safeguarding the dollar's value. The value of the dollar hinges on the tax collecting power of the U.S. government, whereas countries with trade surpluses are only buying debt securities denominated in the dollar, not making commitments to support the dollar's value (though in reality these countries are involuntarily playing a role, to some extent, in helping support the dollar's value by transferring huge wealth to the US through the secular depreciation of the dollar).

Investing foreign taxpayers' money (foreign reserves and other public funds) in dollar-denominated equity securities of U.S. financial firms is tantamount to foreign taxpayers' commitment to supporting the dollar's value by accepting risks associated with the volatility of the U.S. economy.

Up until now, international currencies such as the dollar, euro, and yen have been supported solely by the tax collecting power of the respective issuing country or region. In other words, the domestic currency of each country or region happened to have come into wide use in international trade and investment. Reversing this logic, it would be reasonable to consider an international monetary system in which the value of a key currency used in international transactions is supported not only by the issuing country, but also by other beneficiary countries (or the tax collecting power of other beneficiary countries).

Even without the current financial crisis, the relative economic power of the U.S. is likely to decline as emerging economies such as China, India, Russia, and Brazil assume a greater presence in the world economy.

In the coming years, the U.S. will become comparable to other major countries in terms of economic size. On the other hand, however, the U.S. hegemony as a military superpower remains unchallenged. In the context of the global economy, having military power means possessing the authority to ultimately guarantee the settlement of transactions. Therefore, the fact that the U.S. possesses overwhelming military power means that the U.S. economy is in exclusive possession of almost all violent enforcement devices that provide the ultimate guarantee for the execution of settlements in the world economy. That is, the legitimacy of the use of the dollar as a settlement currency in the world economy, i.e., the dollar's status as the world's key currency, is secured by U.S. military power. This will not change in the coming years.

Given that prospect, it is hard to imagine another country's currency unseating the dollar as the predominant currency in the world economy. For the time being, it is necessary to maintain the dollar-based international monetary system in order to ensure the world's political and economic stability. Eventually it may become impossible to support the dollar's value solely by means of the tax collecting power of the U.S. government, given the expected decline of the U.S. economy relative to the world economy. If so, the idea of the combined tax-collecting power of the world's major economies underpinning the value of the dollar, instead of the U.S. alone, may be worth considering for a new and more stable international monetary system.

The U.S. financial crisis facing us today may be pressing the world to make a historic choice.

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