* Supply-side financial markets: Enormous amounts of US debt are being held by East Asian countries, notably China, Japan and Korea. These countries are keeping their currencies artificially low (thus propping up the dollar) to fuel their growing export market. If they change their policies, the US dollar could crash.
* Supply side politics: If countries lose faith in the dollar, they could start moving their reserves and transactions to other currencies, causing the US dollar to crash.
* Demand-side US markets: US consumers are fueling the current world financial system by buying enormous amounts of cheap imported goods. (Ninety percent of Wal-Mart's sales are from imports.) If US consumers reduce their demand, say because of a housing market crash or rising interest rates, the whole financial system could topple.
The current system evolved somewhat by accident. There were a series of financial crashes in 1997, notably in Russia, East Asian and Brazil. Countries responded by building reserves of dollars in case of future crises. This caused the US dollar to rise, which fueled exports from those countries. The countries liked that and started to manage their exchange rates to keep their exchange rates low against the US dollar, which caused them to hold more US currency and debt.
Meanwhile, back in the US an ideological president was elected who didn't believe in government intervention. To be fair, currency exchange intervention had been declining in the US before Bush, but Clinton's Treasury Secretary, Robert Rubin, did intervene in the currency market a couple of times. Under Bush, there has been no currency market intervention whatsoever. The US dollar - a key component of economies the world over - has been largely ignored by the US government.
This has had some benefits. The US has enjoyed a ton of cheap goods, and the reliance on cheap imports has helped dampen inflation. East Asia has seen enormous growth. Multinational corporations are making a ton of money off the cheap labor. Stock markets are booming.
But there is a huge downside. While US consumers are getting great prices, this situation is keeping their wages down. East Asian exports are growing, but the wealth isn't flowing to citizens who could in turn create a domestic market for goods. In fact, we're in a bizarre situation where capital is flowing from poor countries to the US.
Furthermore, the whole system is becoming increasingly unsustainable and could result in a huge crisis. If it does, the world economy is very vulnerable. The problems of capital flight which caused the 1997 currency crisis have not been addressed and could happen again, worse. The countries who rely on exports will be devastated if the US dollar collapses. The US currently has a huge deficit and will not be in a good position to help soften the blow for its citizens.
In addition (and this may be meandering into the genre of conspiracy theory), the US could react to such a financial crisis in a very bad way. I'm not just talking about protectionism and nationalism. Is it a coincidence that the Bush administration is trying to position China as a national threat to the US? China holds enormous amounts of US debt and the US seems to be positioning China as an enemy. Who knows what might happen.
I went to a lecture today by Thomas Palley, who argued that the solution is to create a revised Bretton Woods system. He proposes two main mechanisms:
* Managed capital flows: Put in place systems that will avert currency collapse due to capital flight. For example, a "speed bump" law on capital inflows: when someone brings capital into a country, they have to park it for a set period of time with the central bank at a set interest rate. Another example of this sort of safeguard is to require hedging on foreign exchange-denominated borrowing.
* Managed exchange rates: Currency rates should be managed to ensure sustainable trade deficits/surpluses. But the onus must be on the strong currencies to bail out the weak currencies: financial markets are now so strong that they can muster more financial clout than just about any economy, so the weaker currencies can't defend themselves. Also, the stronger currencies are reaping a benefit that they should pay for.
Palley wants these innovations to be put in place before there is a crash, to avert it. However he sees no political will in the US or elsewhere to do so. He suspects there will be a worldwide financial crash, and soon, and hopes that we can put his policies in place at least after the fact.
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