America's untested management team - By Henry C K Liu

By Henry C K Liu
Jun 17, 2006
Source

All top posts in the management team of the world's biggest economy are now headed by untested appointees with little high-level experience in government or proven policy predilections.

First Ben Bernanke, a respected academician with little market experience, replaced Alan Greenspan as chairman of the US Federal Reserve in February. So far, every time the new Fed chairman has made a public statement about his resolve on price stability, a technical euphemism for inflation and deflation, the market has shown its lack of confidence by a substantial price correction.

Edward Lazear, a noted labor economist among whose published papers is "The Peter Principle: A Theory of Decline", replaced Bernanke as chairman of the president's Council of Economic

Advisers (CEA). For those who are not familiar with the Peter Principle, it states that routine promotion in organizations continues until incompetence surfaces.

Then Rob Portman, former Republican congressman from Ohio and recent US Trade Representative, replaced Josh Bolten as director of the Office of Management and Budget, while the latter moved to the White House as chief of staff in April. Word was that Bolten was instrumental in persuading Henry Paulson, his former colleague at Goldman Sachs, to accept the post of treasury secretary, replacing John Snow.

According to the Center for Responsive Politics, Bolten had originally joined the White House as President George W Bush's deputy chief of staff to handle domestic policy. However, as the administration soured on the independent-minded national economic adviser Larry Lindsey, Bolten gradually began increasing his influence over economic policymaking by framing economic issues for presidential consideration. As chief of staff, Bolten is credited as the chief architect of the Bush tax cuts as well as the hiring of another former colleague from Goldman Sachs, Stephen Friedman, to replace Lindsey as assistant to the president for economic policy and director of the National Economic Council.

At Goldman, Friedman was a fearsome strategist for corporate takeovers. He was co-director along with Robert Rubin from 1990-92 and sole director from 1992-94 after Rubin left for Washington to become treasury secretary under president Bill Clinton. After leaving Goldman Sachs in 1994, Friedman became a senior principal for March & McLennan Capital, an investment-insurance unit whose parent company faced a government probe into bid-rigging and price-fixing that has since been settled out of court.

Many are puzzled why Henry Paulson would leave his top job at Goldman Sachs, the world's pre-eminent investment-banking powerhouse, to take the job of US treasury secretary under a prematurely lame-duck president with an approval rating languishing in the low 30% range. After all, David Rockefeller declined a personal telephone appeal from president Jimmy Carter to join a demoralized administration after Carter, in response to popular discontent and declining presidential authority, desperately imposed wholesale resignation of his entire cabinet in 1979, the third year of his first and only four-year term.

After isolating himself for 10 days in introspective agonizing at Camp David, Carter emerged back in the White House to make his disconcerting speech of "crisis of the soul and confidence" to a restless nation facing rising gasoline prices at US$1.25 a gallon (33 cents a liter), with gold rising to $300 an ounce but with the US enjoying a trade surplus with China for another 14 years. Today, gasoline is above $3 a gallon and gold broke above $700, while the US trade deficit with China is at a record high of more than $200 billion a year and still rising; yet President Bush continues to tell Americans that the US economy is fundamentally strong, which raises the question: Why the wholesale cabinet changeover?

The Treasury Department, whose head leads the president's economic team, has not been performing at its most effective level in the past six years of the Bush administration. This was not because of a shortage of talent at the top. Both Paul O'Neill, who ran the Aluminum Company of America, and John Snow, who headed the CSX transportation network, were successful captains of industry with outstanding performance records in the private sector. But in a world where industry has been increasingly dominated by finance, their experience in industry might not have prepared them to deal with the complex challenges facing a treasury secretary of the world's top economic hegemon, or to survive in the political jungle of a faith-based ideological administration.

Both men had difficult tenures as cabinet officers, routinely sidetracked by White House inner-circle cliques whose members aggressively guarded executive prerogative to set erratic economic policies driven reactively by neo-conservative ideology and near-term domestic political considerations rather than long-range, rational responses to developing global economic conditions.

In the US system, cabinet officers are politically appointed captains of the bureaucracy. Executive power often regards the bureaucracy as an obstructionist enemy, yet it is the bureaucracy that provides stable continuous implementation of national policies that transcend partisan politics. Just as a strong White House National Security Council chairman can overshadow a weak secretary of state, most glaringly evidenced in the case of Henry Kissinger over William Rogers, and the case of Zbigniew Brzezinski over Cyrus Vance, White House political adviser Karl Rove - at least until the Central Intelligence Agency leak scandal - overshadowed all cabinet appointees over the setting of US economic policies. The difference is that Kissinger and Brzezinski formulated foreign policies based on the long-range geopolitical interests of the nation, while Rove formulated economic policies based mostly on short-term partisan political expediencies.

The Washington Post reported that before finally and reluctantly agreeing to be nominated treasury secretary, Paulson sought assurances in a long meeting with the president that "the post, which at times has been seen as subordinated by the White House, would have the proper kind of stature".

The importance of the post of treasury secretary
The power of modern nations rests on economic foundations. Historically, the treasury secretary has been the vicar of US economic policy.

The post was first held by Alexander Hamilton, who created the Bank of the United States in a national-banking regime that provided needed sovereign credit to finance the development of the young nation and thus launched the United States on the path toward becoming a major economic power in record time. Hamilton engaged Thomas Jefferson, then secretary of state, in a fateful contest between centralized elitism and decentralized populism in economic policy. He also fought Albert Gallatin, then a congressman, over the creation of a powerful Treasury for the federal government with financing authority independent from the states of the union. He designed the collection and disbursement of federal revenue for the promotion of the economic development of the young nation in an era when market fundamentalism in the context of free trade was an economic weapon employed by a hostile and belligerent Great Britain against its former colonies.

The secretary of the US Treasury is responsible for formulating and recommending domestic and international financial, economic and tax policy, participating in the formulation of broad fiscal policies that have general significance for the economy, and managing the public debt. The secretary oversees the activities of the Treasury Department in carrying out major law-enforcement responsibilities; in serving as the financial agent for the US government; and in manufacturing coins and currency. The chief financial officer of the government, the secretary serves on the president's National Economic Council. He is also chairman of the boards and managing trustee of the Social Security and Medicare Trust Funds and chairman of the Thrift Depositor Protection Oversight Board, and serves as US governor of the International Monetary Fund (IMF), the International Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, and the European Bank for Reconstruction and Development.

Today, with a globalized economy dominated by financial institutions framed largely by the United States, the post of US treasury secretary is even more critical, for no nation can carry out its foreign policy with its domestic economy in disarray, much less a superpower. Logic would suggest that the top post of the cabinet in today's world should be the treasury secretary rather than the secretary of state, as supranational financial institutions emerge as powerful agencies of superpower financial hegemony. Instead, in today's White House, the national economic adviser is subordinate to the national security adviser. Apparently, in the high temple of free markets, national security trumps market fundamentalism. The nation that leads in the promotion of global free trade is also the most vocal nation in promoting economic nationalism.

Albert Gallatin came of an old and noble Swiss family in Geneva and played a vital part in establishing the financial soundness of his adopted nation, the United States. He graduated with honors from the Geneva Academy, but in 1780 gave up fortune and social position to move to the US, a nation barely 14 years old, to fulfill "a love for independence in the freest country of the universe". In 1785, he took the Oath of Allegiance in Virginia and settled finally in Pennsylvania. A member of the state legislature before being sent by voters to the US Senate, his tentative citizenship caused him to be rejected by that august body, but not before he called on the Senate floor for a statement of the public debt as of January 1, 1794, from the treasury secretary, listing revenue received under each government branch and money expended under each appropriation.

When Gallatin was returned by voters to the House of Representatives, he immediately became a member of the new Standing Committee on Finance, the forerunner of the Ways and Means Committee, the most powerful body on US government finance. While opposing Hamilton on the issue of expanding federal authority, Gallatin actually reinforced Hamilton's ambitious plan for a powerful United States by making certain that the nation's finances and currency remained strong.

In July 1800, Gallatin prepared a report titled "Views of the Public Debt, Receipts and Expenditure of the United States", still regarded as a classic, which analyzed the fiscal operations of the government under the US constitution. In Congress, he worked relentlessly and successfully to keep down appropriations, particularly those for "warlike purposes". Thomas Jefferson believed the Sedition Bill was framed to drive the foreign-born Gallatin from office. When Jefferson was elected president in 1801, he tendered Gallatin the post of secretary of the Treasury.

Gallatin took office on a "platform" of debt reduction, the necessity for specific appropriations, and strict and immediate accountability for disbursements. He reduced the public debt by $14 million to build up a surplus even after expending $15 million for the Louisiana Purchase, an acquisition that established the United States as a great continental power. Many accounting practices still in use in the Treasury date back to those introduced by Gallatin. He also sponsored the establishment of marine hospitals, the forerunner of the present Public Health Service. In 1807 he submitted to Congress an extensive plan for internal improvement through the construction of highways and canals. Under Gallatin, the Treasury began the practice of submitting to Congress a detailed annual report of the country's fiscal situation with a breakdown of receipts, a concise statement of the public debt, and an estimate of expected revenue.

After leaving government, Gallatin became the president of the National Bank of the City of New York, later known as the Gallatin National Bank of the City of New York, a forerunner of today's CitiGroup. He was a founder of New York University, the New York Historical Society and the American Ethnological Society, making valuable contributions on the study of languages of the native American tribes.

Andrew Mellon and Alan Greenspan
Andrew Mellon, the 49th treasury secretary, demonstrated precocious financial ability early in life. At 17, he started a successful lumber company, joined at 19 his father's banking firm, T Mellon & Sons, and became controlling owner in 1882 at the age of 27.

In 1889, he organized the Union Trust Co and the Union Savings Bank of Pittsburgh, branched out from banking into industrial activities and built a great personal fortune from oil, steel, shipbuilding, and construction by investing in growth industries such as coke, coal and iron. Mellon established the Aluminum Company of America, the Gulf Oil Corp (1895), the Union Trust Co (1898) and the Pittsburgh Coal Co (1899). In 1937, he gave the nation his magnificent art collection, plus $10 million, to build the National Gallery of Art in Washington, DC.

Mellon was appointed by president Warren Harding in 1921 to be treasury secretary to deal with the post-World War I economy. Herbert Hoover was appointed secretary of commerce. Harding's presidential address on March 4, 1921, reflected Mellon's ideas of a revision of the tax system, an emergency tariff act, readjustment of war taxes and the creation of a federal budget system. Mellon campaigned to Congress for tax cuts and lower government spending to reduce the public debt.

In November 1923. Mellon presented to the House Ways and Means Committee what has come to be known as the Mellon Plan, a program for tax reform that subsequently became law as the Revenue Act of 1924, reducing the top income-tax rate to 25%. Through the Roaring Twenties, Mellon was a popular official, much as Alan Greenspan was throughout the irrationally exuberant 1990s.

Despite his open conservatism in government finance, Mellon presided over an unprecedented growth of private debt in the economy during his tenure. Total private debt at the time of the 1929 stock-market crash reached $200 billion, the equivalent of more than $3 trillion in 2005 as relative share of gross domestic product (GDP), or about 25%.

As late as 1930, secretary of the Treasury Andrew Mellon held that a financial panic might not be such a bad thing. "It will purge the rottenness out of the system," he said. "High costs of living ... will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

But the rottenness came from easy credit that Mellon was centrally responsible for releasing. And predators picked up the wrecks from unfortunate hard-working people who had lost everything they owned through no fault of their own.

It was comparable to Greenspan's testimony before the Joint Economic Committee of Congress on October 29, 1997, on "Turbulence in World Financial Markets": "Yet provided the decline in financial markets does not cumulate, it is quite conceivable that a few years hence we will look back at this episode, as we now look back at the 1987 crash, as a salutary event in terms of its implications for the macroeconomy."

The Asian economies saw their assets lose up to 80% of their market value within a few days during the 1997 crisis; the US did better. From the market peak to the October lows, the S&P 500 lost 35.9% of its peak value but regained the lost value about two years later through the Fed's massive injection of liquidity. The Greenspan formula was to print money whenever the market faltered. The Asian economies were less lucky. As international finance was denominated mostly in US dollars, the Asian central banks were not able to print local currencies to provide needed liquidity to their collapsing markets. They learned from direct experience that dollar hegemony is not benign.

Under Greenspan, the US had amassed $44 trillion of debt by 2005: $10 trillion by the federal government, $2 trillion by state and local governments, and $34 trillion by the private sector, of which the business sector held $8.3 trillion, the finance sector held $12.5 trillion and the household sector held $11.5 trillion. In addition, the United States faces an unfunded contingent liability of $7 trillion in Social Security and $37 trillion in Medicare obligations. The Greenspan debt monkey is 10 times as large as Mellon's after adjustment for inflation. The delayed but unavoidable bursting of Greenspan's debt bubble will make the 1930s Depression look like a minor storm.

Ironically, the onslaught of the Depression in 1929 was blamed by voters on Mellon's fiscal policies, not on his monetary policy or his tolerance if not promotion of private debt. And it contributed to the presidential-election defeat of Herbert Hoover in 1932 by Franklin D Roosevelt.

There are clear indications that history will not treat Greenspan's liquidity joyride with more lenience. This time, since the Greenspan legacy spanned both political parties, US voters, having no third party to turn to as they did in 1930, may well vote against the apocalyptic black knight of neo-conservative foreign policy galloping on a neo-liberal free-trade horse.

Henry Morgenthau
Henry Morgenthau was nominated by president Roosevelt to be the 52nd secretary of the Treasury and served from January 1, 1934, until July 22, 1945, in FDR's "New Deal" and War Administration.

During his historically long term, Morgenthau exercised a stabilizing effect on US monetary policies through progressive taxation and sovereign credit, raising $450 billion ($45 trillion in 2005 dollars in relative share of GDP) for anti-depression government spending programs and for war costs. This amount was more than all the money raised by all of the previous 51 treasury secretaries, enough in current dollar equivalent to pay off all the debts in the US economy today. This shows that under effective leadership the US can be debt-free with the proper resolve and fairly distributed sacrifice to re-emerge as a great nation with unprecedented prosperity without exploitation either at home or abroad.

For seven years during the Depression, from 1934 through December 7, 1941, the day Japan attacked Pearl Harbor, Hawaii, Morgenthau defended the US dollar against devaluation by intervening in the world financial markets in an effort to make the dollar the strongest currency in the world despite a weak domestic economy, particularly from the rising strength of the German currency as the Nazi economic miracle took off. This effort led to an international monetary-stabilization agreement among the great powers after the Munich Pact of 1938, which did not have a chance to test its worth.

When war in Europe broke out in 1939 over the German invasion of Poland, Morgenthau established a procurement service in the Treasury Department to facilitate the purchase of US munitions on credit by Britain and France. He then provided the US economy with unlimited sovereign credit to meet enormously expanded spending requirements that followed the attack on Pearl Harbor. Mobilization for World War II began first in the financial sector.

Morgenthau financed the war with a program of war bonds, which in the first year of the war alone amounted to a $1 billion distribution. The war bonds not only supported war spending, but also prevented a serious inflationary wave by siphoning off excess funds from the private sector to prevent the emergence of a black market out of the government's wartime price control program. The wartime black market did not flourish, simply because few people had the money to pay black-market prices.

In 1944, the Morgenthau plan, under which postwar Germany would be stripped of its industry, the basis for warmaking, and be converted into an agricultural nation, became policy until the beginning of the Cold War, when the US decided it needed a strong capitalistic Germany with a credible military to resist the spread of communism in Europe. At the Bretton Woods conference in 1944, Morgenthau assumed a leading role in establishing postwar economic policies and currency stabilization with the introduction of a gold-backed US dollar with a fixed exchange rate to finance a revival of world trade under US leadership.

In July 1945, three months after the death of president Roosevelt, Morgenthau resigned as treasury secretary, but remained in office until president Harry Truman returned from the "Big Three" conference in Potsdam, Germany, in early August. The Potsdam Conference and the surrender of Japan on August 14, 1945, brought on the beginning of the Cold War.

From 1947 until 1950, Morgenthau was chairman of the United Jewish Appeal, which raised $465 million during that time, and from 1951 to 1954 he served as chairman of the board of governors of the American Financial and Development Corporation for Israel, which handled a $500 million bond issue for the new nation. It is an ironic tragedy of history that the anti-Semitic sins of Europe are being atoned for by the Arab nation with intractable conflicts in the Middle East that will endanger the future peace of the whole world.

Nixon's treasury secretaries
Appointing Democrat John Connally as treasury secretary was a shrewd political move by Republican president Richard Nixon, who had to reorganize his cabinet in response to Democratic gains in the 1970 mid-term congressional elections.

In response to deteriorating domestic and international economic conditions, Nixon announced his "New Economic Policy" (NEP) in 1971. In monetary terms, this meant "closing the gold window", ending US legal obligation to exchange dollars held by foreign banks for gold at $35 per ounce, abandoning the 1944 Bretton Woods regime of a dollar pegged to gold, and fixed exchange rates for world currencies to keep trading partners honest. Floating exchange rates allow countries an escape valve from having to correct their economic inefficiencies through currency devaluation.

With Nixon proclaiming, "We are all Keynesians now," Connally resurrected New Deal anti-cyclical deficit spending with a "full-employment budget", and imposed a wage and price freeze to halt inflation. Connally was described by New York Times columnist James Reston as "the spunkiest character in Washington these days ... He is tossing away computerized Treasury speeches, and telling American business and labor off the cuff to get off their duffs if they want more jobs, more profits and a larger share of the competitive world market."

Nixon's left-leaning NEP, not dissimilar to Lenin's right-leaning NEP, failed to work because it was merely a revisionist label with little substantive content for lack of ideological commitment. Price controls without central planning caused supply bottlenecks in failed markets. The most bizarre example manifested itself in a shortage of toilet seats for new residential construction that delayed occupancy and created cash-flow problems for the mortgage banking sector.

Roosevelt had forbidden US citizens to buy or own gold and devalued the dollar by 60% and kept interest rates at historical lows. Still, US export trade did not rise with dollar devaluation, nor did employment in the domestic private sector pick up. Most of the unemployment was absorbed by the expanded public sector. The economy did not revive until World War II.

In contrast, Nixon's NEP aimed to prevent the dollar from falling by allowing interest rates to rise. Monetarily, the US was heading for runaway inflation not from excess money in circulation, but from fiscal deficits caused by the Vietnam War, the burden of which, unlike World War II, was not equally or equitably shared by all. Foreign wars cannot be sustained without evenly shared nationwide sacrifice. Conversely, an all-volunteer army takes the wind from antiwar movements and makes undeclared executive wars routine. A more warlike foreign policy can then prevail because it is easy to risk other people's lives for one's own patriotism.

Having served as secretary of labor in 1968 and head of the Office of Management and Budget in 1970, George Shultz was appointed treasury secretary by Nixon in 1973. During his tenure, Shultz reversed the NEP begun under Connally by lifting price controls domestically and shifted his attention to the international arena to deal with a renewed dollar crisis that broke out in February 1973. Shultz organized an international monetary conference in Paris in 1973 to formalize the 1971 US decision to close the gold window and the abolition of the fixed-exchange-rate system, which had actually begun to collapse in 1971, causing all key currencies since to float. However, cross-border flows of funds continued to be restricted to keep contagious financial instability at bay.

The year 1973 was a very bad one for the US economy. Phasing out domestic price controls released pent-up inflation in the United States, causing the dollar to fall in the new foreign-exchange market in London. Then, in the autumn, the Organization of Petroleum Exporting Countries induced an oil crisis, pushing the US economy into a severe recession not seen since 1929, with industrial production shrinking 15%, unemployment reaching above 9% and economic output declining 6%. Shultz resigned shortly before Nixon did, only to return to Washington in 1982 as president Ronald Reagan's secretary of state.

William Simon, deputy secretary of the Treasury under Shultz, served concurrently as the director of the Federal Energy Office during the oil crisis of 1973. He was named as the 63rd secretary of the Treasury by Nixon in 1974 and continued under president Gerald Ford after Nixon resigned.

Domestically, Simon faced a worsening economic slump as he took control of the Treasury. In response to the oil crisis, he strong-armed oil-producing nations to deposit their petrodollars in US banks but discouraged them from direct investment in US corporations. This led US banks to lend the petrodollars to developing economies that could only repay the loans with earnings from exports to US markets. This was the beginning of globalization, as the dependence of the emerging economies on US markets for consumer goods forced them to open their financial markets to US capital denominated in dollars. This deregulated flow of dollar-denominated funds across national borders led to financial crises in Mexico and then elsewhere in Latin America and eventually ended up with the 1997 Asian financial crisis.

As treasury secretary, Simon continued the policies begun under Shultz of pressuring Europe, Japan and the Soviet bloc with US financial prowess, keeping international economic policy initiative in US hands to ensure a competitive advantage for the United States. Simon resigned at the end of Ford's partial term when Jimmy Carter won the presidency in 1976.

The Fed under Volcker and Greenspan
William Miller, after only 17 months as chairman of the Federal Reserve, was named the 65th treasury secretary on August 6, 1979, as part of president Jimmy Carter's desperate wholesale cabinet shakeup in response to popular discontent and declining presidential authority.

Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration facing a difficult election in 14 months. In August 1979, Carter felt that he needed someone like Paul Volcker, an intelligent if not intellectual Republican who was highly respected on Wall Street, if not in academia, to be at the Fed to regenerate needed bipartisan support in this time of presidential leadership crisis. Bert Lance, Carter's chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own re-election a year later to a less-than-sympathetic Fed chairman. As it turned out, the fate of Carter's campaign actually rested in the hands of ayatollah Ruhollah Khomeini of Iran.

Volcker continued to lead the Fed into the years of "voodoo economics" under Reagan, but Reagan replaced him with Alan Greenspan in the summer of 1987, over the objection of supply-side partisans. (For more details on the Volcker-Greenspan era, see The Presidential Election Cycle Theory and the Fed, February 24, 2004.)

The current president of the United States recognized Greenspan's importance from the beginning. In his first trip to Washington as president-elect in 2000, the first person Bush visited was Greenspan. After Greenspan stepped down last year, Bush nominated Ben Bernanke to replace him. Bernanke was sworn in this February.

Bernanke's false starts
In a speech to a conference on June 5 in Washington, Bernanke gave hints that future rate increases should be expected because price inflation had reached a danger zone even as the US economy is showing signs of slowing down, pointing to slowing consumer spending, the cooling housing market and slower job growth. Bernanke left little doubt that he was more worried about rising inflation than slowing growth and possibly stagflation by calling them "unwelcome developments".

The Dow Jones Industrial Average (DJIA) promptly plunged 200 points, and fell another 150 points by week's end. What the markets heard was that rate increases might extend beyond the next expected bump up to 5.25% at the Fed's June 28-29 meeting, until inflation pressures ease.

Why Paulson accepted the Treasury job
It is possible that Henry Paulson sees Goldman Sachs facing an uphill battle in the next few years as the US economy slows. Paulson has made enough money in the good years and may consider it smart to leave Goldman at the peak of the market - it's no fun to run an investment bank in a down market.

Paulson is a banker. Bankers are interested in the state of the market, not the economy per se. In two and a half years, a treasury secretary can, with the full power of the Treasury behind him, have a chance of saving the market from imminent collapse from its current structural imbalances.

The formula is to accelerate the crash in order to gain a fast recovery later. The prospect of Paulson engineering a sharp correction in the equity market right after the mid-term congressional election is almost certain. The strategy is to remove the structural bottlenecks and to weed out the weaknesses and have the market resume its upward path by June 2008. This strategy is doable with a heavy dose of government intervention, but it will require a crash to create a serious enough emergency to make government intervention patriotic, possibly including massive bailouts of several troubled giants such as General Motors, General Electric and Fannie Mae (the Federal National Mortgage Association) and the big money-center banks that are up to their necks with credit-derivative exposures.

Strong dollar is the key
The key is to restore the US dollar's strong exchange rate, despite all the talk of the need for a lower dollar to reduce the trade deficit by predictable free-trade economists such as Fred Bergsten of the Institute of International Economics, whose views are distorted by their seeing trade as the entire economy rather than just one aspect of the global economy.

If China refuses to more quickly revalue the yuan against the dollar in the near term, as it most likely will, Paulson can bring up the dollar along with the yuan against the yen and the euro without adding to the US trade deficit, which is mostly with China, and oil, which is denominated in dollars. The way to strengthen the dollar is to raise the Fed Fund Rate (FFR). Paulson can be expected to apply all the pressure he can muster to force Bernanke to raise the FFR, continuing a gradual pace of 25 basis points on June 25 but more sharply immediately after the November elections to bring on a massive correction in the markets. The FFR can rise to 9% or 10% in the name of national security to save the dollar. The recession will be pre-packaged, and relatively short, from fourth-quarter 2006 to Q1 2008 with a sharp recovery in Q2 2008, providing buying opportunities for those who are smart enough to have cash on hand.

Just like Robert Rubin, treasury secretary under president Bill Clinton, Paulson firmly believes that a strong dollar is in America's national interest. Rubin kept it strong by making the current-account deficit finance the capital-account surplus. Paulson will do it by further erasing national borders in global finance, thus making the US current-account deficit meaningless as long as it is denominated in dollars.

The US has transcended the national economy by operating on the dollar economy that is not location-dependent. The name of the globalization game is making money where money can be made most easily. The United States will prosper as the place where the world's rich will come to spend money made elsewhere, leaving behind the pollution and labor disputes and all the dirty business of making money offshore. Paulson will try to make China an economic colony of the United States (albeit with the full cooperation of the Chinese Communist Party in Beijing, which has designed and promulgated for 28 years an economic policy that leaves China's economy totally dependent on exports to the US) and thus remove bilateral economic conflicts.

Bernanke, not yet a force with confidence, will go along because it is the Fed's duty to support national-security aims and also because a Fed chairman needs a crash to show his wizardry, as Greenspan did in 1987. Besides, no one has opposed Hank "the Hammer" and survived.

Congress and China the wild cards
One wild card is the parochial US Congress. If the Democrats regain the House of Representatives after this year's mid-term election, Paulson will have a tough task ahead.

The other problem is that China is going through a heated debate internally about the wisdom of its economic policy based on exports. Any change in Chinese economic strategy will throw a monkey wrench into Paulson's strategy. Paulson can count on his close links to Tsinghua University in Beijing, where he helped start a business school with several of his Goldman Sachs colleagues. Tsinghua has become in recent decades a hotbed of neo-liberal free-trade market fundamentalism more doctrinaire than Stanford. As a sign of its rejection of progressive policy, the revisionist institution even refused to use the pin-yin romanization (Qinghua) for its name in preference to the Wade-Giles spelling of the Western imperialist era.

There is no guarantee that Paulson will succeed in his possible game plan. The war in Iraq and the pending war over Iran are big uncertainties. In fact, the worst is a gradual, steady worsening of the Iraq quagmire. If the situation in Iraq were to go very badly suddenly, say 3,000 US troops getting killed over one disastrous week, it would be easier for Bush. This slow bleeding in a prolonged occupation is truly deadly for US interests.

Paulson cannot save the economy but he has a chance to create a recovery in time for the 2008 election. After that, whoever rules from the White House will have to face the real music.

Dollar hegemony requires a strong dollar
While I have been pointing out since 2002 (US dollar hegemony has got to go, April 11) the mechanics of how dollar hegemony works, I am not of the opinion that dollar hegemony will die a natural death easily. I coined the term to mean the use of the US trade deficit to finance the US capital-account surplus, both denominated in a fiat currency, thus eliminating any balance-of-payments problem for the United States and depriving the trade-surplus economies of needed domestic capital.

Under dollar hegemony, the exporting economies ship real goods produced with low wages to the United States in exchange for dollars that must by definition be reinvested in dollar assets, not assets denominated in domestic currencies. This is what is hegemonic about the dollar since the emergence of globalization in the late 1990s, not seigniorage, which is not hegemonic by nature because seigniorage is merely a fair fee for services rendered.

Dollar hegemony is the most sophisticated financial regime in history. It is the first time in human financial affairs that currency hegemony is imposed by a fiat currency through floating exchange rates and free convertibility made possible by globalized financial markets. The British Empire was built around the pound sterling, but all local currencies within that vast empire had fixed exchange rates with respect to the pound. After World War II, when the United States took over the British Empire, Bretton Woods was a fixed-exchange-rate regime based on a gold-backed currency - the US dollar, a regime in which cross-border flow of funds were restricted because mainstream economic theory at that time did not consider cross-border flows necessary for trade or desirable for development.

After 1971, when Nixon took the dollar off the gold standard because of the drain of gold from recurring US trade deficits, dollar hegemony still did not arise because cross-border flows of funds were still restricted. After World War II, euro-dollars came into existence because of US military overseas spending, dollar-denominated war debts both from allies and from former enemies paid to offshore US accounts and foreign aid, but the United States was still running a trade surplus and euro-dollars stayed outside the country, mostly in Germany and Japan.

It was during the Vietnam War that the US began to run a recurring trade deficit, at first purposely to prevent Germany and Japan from turning communist. The United States allowed Germany and Japan to build up their automotive and steel sectors for exporting to US markets to keep their economies capitalistic but kept the advanced high-tech sectors for itself. Since it takes several thousand cars to buy one commercial airliner, it was no great loss to lose market share in the auto sector. It did create the Rust Belt in the US Midwest, but domestic political power was shifting to the west and southwest where a new aerospace sector was flourishing.

Dollar hegemony did not come into being until after the end of the Cold War, when the global market was suddenly opened to US companies and financial institutions and cross-border flow of funds became routine with the deregulation of financial markets.

It was through Robert Rubin under Clinton that dollar hegemony became formal US policy in the form of "a strong dollar is in the US national interest" even with a rising and recurring trade deficit. Rubin advanced the notion that the US trade deficit was benign because it was neutralized by the US capital-account surplus.

A trade deficit is never a problem as long as it is denominated in the country's fiat currency. Dollar hegemony is a regime in which a fiat currency issued by one government becomes a supranational currency. Dollar hegemony is the device for globalization of finance to tear down national boundaries and to reduce the authority of sovereign nation states.

Resistance to dollar hegemony
The problem with dollar hegemony is not that it will be resisted by other governments; the US dollar is now a supranational fiat monetary unit accepted by all who own capital, not just US citizens. All other fiat currencies are now derivatives of the dollar.

In every foreign government, from Japan to Germany, from China to Russia, there are powerful forces that see supporting a strong US dollar as serving factional if not national interests. This is because the dollar economy is increasingly detached from US economy, not completely but selectively.

The resistance to dollar hegemony is from a revival of economic nationalism, including US economic nationalism against global trade, particularly in finance, where the game of economic control is being played. This conflict is being waged in the domestic politics of every country, with those who need jobs to make a living pitted against those who make money by the manipulation of capital, known popularly as investing. US big business is allied with foreign state capitalism with US official policy support.

Democracy in Latin America is ushering in a parade of radical socialist leaders against dollar hegemony; and the democratic process in the US is also turning against dollar hegemony. The wars waged by the United States to secure oil for its economy have created $70 oil and $3.50-a-gallon (92-cent-a-liter) gasoline for the US consumer, and the worst is yet to come. The double-digit returns on US pension funds come from investment in companies that ship US jobs overseas and stealth inflation that produced $700 gold. Dollar hegemony to the US economy is turning out to be like the computer HAL in the movie 2001: A Space Odyssey.

Paulson's challenge
The problem Henry Paulson will face is at home in the United States, not in Beijing or Moscow or even Caracas. He will have to explain to an ever increasing number of US voters how globalized financial markets and supranational economic policy have benefited them or will benefit them in the future.

Conflict of interest in policymaking is unavoidable in a complex financial system. It is not surprising nor unreasonable that those who have done well in the private finance sector should be natural candidates to manage the finances of the public sector. And it can be argued that in a system such as the United States', the private and public sectors are two complementary rings of the national economic circus. Conflicts are tolerable if the management of the public sector by private interests produces a strong economy for all of the general public.

When the economy falters, conflict of interest between private and public becomes a critical issue because it is always the general public that bears most of the pain. An economic downturn in the US will produce populist government by representatives of the general public rather than elitist government by the rich and powerful.


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