Question

In: Economics

2. Please read the following excerpt from James Galbraith’s The Predator State (Free Press, 2008: pp....

2. Please read the following excerpt from James Galbraith’s The Predator State
(Free Press, 2008: pp. 197-200).
QUOTE
Is the United States a fully open economy? Well, of course it is: it is certainly
fully open to trade and capital, it certainly trades in a highly unbalanced way, and it
certainly borrows on a phenomenal scale. And yet precisely because the United States
operates in global capital markets in a way open to no other country, the rules as they
apply to the United States are different from what they are for anyone else. To put it
crudely, the United States is not subject to the normal rules of the world system. It
does not have to accept the terms and discipline of the capital markets. Rather, it is in
a position, up to a point, to make the rules, impose them on others, and exempt itself
from their harshest implementation. This is hardly fair, to be sure. But it is the way the
system has worked.
How did the United States get into this position?
The answer goes back to the dominant fnancial role the United States played in both world wars and in the construction of the postwar fnancial order and the cold
war. In World Wars I and II, the United States was far more than a military ally: it was
also the “arsenal of democracy,” and in addition to that, democracy’s banker. Both wars
strengthened America’s fnancial position, moving the world’s stock of gold to our
shores and ultimately permitting us to dictate the terms of the postwar monetary
order. As agreed at Bretton Woods in 1944, that order would be centered on the
dollar as the anchor currency, to which the value of all the others would be pegged.
Underlying that agreement, there was an implicit bargain between the United
States and the anticommunist, democratic governments of Europe and (eventually)
Japan. We provided and would continue to provide military security, including the
nuclear umbrella represented by U.S. strategic forces. (At the beginning, we would also
supply steel, machinery, and credit to get European and Japanese recovery under way.)
Those countries in turn accepted a subordinate diplomatic and fnancial role, and
continued to accept it long after their own economies had fully recovered from the
war. Indeed, they continued to accept it long after they had gone on to create new
areas of industrial and technological advantage, even dominance on world markets, and
despite the fact that in the 1970s, their currencies, especially the yen and the mark,
were in increasing demand on world markets. In much of the developing world as well,
particularly through Latin America, Africa, and Southeast Asia, friendly governments –
anticommunist but not always democratic – put themselves under American
protection. And the United States assisted them in repressing both external subversion
and internal dissent, whether real or imagined, legitimate or otherwise. This bargain –
security for seigniorage, defense for dollars, in effect – defned the global economics of
the cold war.
Thus for a half-century the United States led a world community centered on
a common defense of managed capitalism…The American trade defcit is nothing
more, or less, than the normal consequence of that system, and particularly what
emerged after the formal mechanisms of international fnancial management and
exchange rate stabilization were abandoned between 1971 and 1973.
Bretton Woods still partook of the idea, rooted in ancient practice and folk
wisdom, that every country in the world had to run a balanced current account – a
rough parity of imports and exports – over time. Under the discipline of the gold standard, foreign accounts before 1913 had to be settled in precious metal. If you ran a
defcit for too long, gold would drain away. Eventually your domestic prices would fall
(because there was not enough gold in the system to support the economy at current
prices) or your domestic output would collapse (because credit could not be had at
any cost), or you would fnd that you could not pay your import bills on your
contractual debts (often, if you were a small country in debt to a larger one, a cause for
war). Bretton Woods created a peaceful and orderly means for easing those trade
adjustments that might be necessary from time to time, but it did not obviate the need
to adjust. Faced with a defcit, a country could in the frst instance borrow from the
IMF. If the defcit proved intractable, it could devalue – adjusting the parities of the
world currency system. Eventually, the theory had it, a general pattern of trade balance
would return.
By putting the dollar at the center of the system, Bretton Woods had
removed the possibility that the dollar could devalue, and at the same time insulated
the United States alone from the need to adjust to a defcit in our trade. But not
entirely. As noted, central banks retained the option of demanding trade settlement in
gold. And as tensions within the system built in the 1960s, notably over Vietnam, they
increasingly did so.
The contradiction in the system for the United States was that unlike other
countries, it could not adjust its trade defcit using devaluation; devaluation by the
currency to which other currencies were tied was a system-breaking move. Thus if
other countries were not prepared to tolerate U.S. defcits at high employment, the
United States could either retreat from full employment at home or break the system.
In 1969-1970, Richard Nixon had tried the frst course of action, to near political
disaster. In 1971-1972, he took the second course, ensuring his own reelection at the
expense of plunging the world economy into turmoil. For a time, in consequence, the
future of the world fnancial system was very uncertain; many thought that the dollar
might fail and be replaced by some combination of currencies, including the German
deutsche mark, the Japanese yen, the British pound and the Swiss franc. The entire
decade from that point forward was fnancially unstable, and the United States itself
paid part of the price in the form of infation and periodic recessions.
Reagan’s macroeconomics ended the uncertainty – and resolved the contradiction. And although monetarism and supply-side economics wrecked major
sectors of American industry, drove up the rate of unemployment, and made the nation
far more unequal, they also fundamentally reestablished American fnancial power. The
same high interest rates that did so much damage to Ohio and Michigan were even
more devastating outside the country than within. And, in the relations between the
United States and the rest of the world, they turned the fnancial tide, creating a new
dollar-based system that became the foundation of the world economy. From a purely
national perspective, this would lead to huge benefts to the United States, at everyone
else’s expense. For now, most countries came to protect themselves against the
worldwide fnancial instability, itself often generated from within the United States, by
holding fnancial reserves, which consisted mainly of U.S. Treasury bonds.
Now the Prometheus was truly unbound; even the largely self-imposed
macroeconomic and trade discipline of the Bretton Woods period became a thing of
the past. The post-1981 position of the dollar meant not only that Americans could
import much more than we export; actually, it meant that we must import more than
we export. We routinely cover the difference with nothing more than a note and a
promise to pay interest down the road. The extent to which we can do this – the
extent to which we must do this --- is determined, entirely and exactly, by the
willingness and desire of other countries to hold the bonds. As the world economy
grew, and particularly as China emerged as a global fnancial player with reasons of its
own for holding dollar bonds, that extent appeared to have few practical limits.
As a result, the United States has been running trade defcits continuously.
And every year as the world economy grows, they grow larger. At this writing, they are
greater than 6 percent of annual GDP, more than $800 billion. To repeat, the main
reason for this is that other countries, for reasons of their own, have wanted to anchor
their fnancial portfolios in U. S. Treasury bonds. We could not do it otherwise, and we cannot avoid doing it, given those desires.

Why does Galbraith write that “the rules as they apply to the United States are
different from what they are for anyone else?”

 Galbraith describes the classical gold standard and the workings of the price-specie
flow model. Where does he do that?

 According to Galbraith, what replaced the gold standard as the international
monetary system?

What historical factors led to the current system? How does it
operate?

 Galbraith writes in the last paragraph quoted that “other countries, for reasons of
their own, have wanted to anchor their financial portfolios in U. S. Treasury bonds.”
What countries do you think he has in mind? What do you suppose are some of the
reasons of their own? Why does this choice by other countries mean that the U.S.
“cannot avoid” running a trade deficit?

Solutions

Expert Solution

1. Galbraith write that "the rules as they apply to the United States are different from what they are for anyone else", because as stated in the text, though United States is an open economy, it trades in a highly unbalanced way. Also, U.S is in a position to make rules, impose them on others and exempt itself from their harsh implementation. Thus, it is not subject to normal rules of the world system nor have to accept the terms and discipline of the capital markets. This is why Galbraith says "it operates in global capital market in a way open to no other country, the rules as they apply to the United States are different from what they are for anyone else". This is so because of its dominant financial capacity since World War I.

2. The classical gold standard and the workings of the price-specie flow model has been done at Bretton Woods, in 1944. It centered U.S dollar as the anchor currency, to which the value of all the other currencies would be pegged. Though this system was eventually replaced in

3. For a half-century, the U.S led the world community centered on a common defense of managed capitalism. Under the gold standard, foreign accounts before 1913 had to be settled in precious metals an if a country ran a deficit for too long, gold would drain away. This may lead to fall in domestic prices or collapse in domestic output, which would also affect the imports. At this point, Bretton Woods created a peaceful and orderly means for easing those trade adjustments that might be necessary from time to time and thus replaced gold standard as the international monetary system. Faced with deficit, a country could initially borrow from IMF and if deficit continues, it could devalue their currency.

4. The factors led to the current system were as follows:

  • failure of the gold standard system - U.S could not adjust its trade deficit using devaluation.
  • U.S being a financially dominant power, historically, since World War I.
  • worldwide financial instability, generated by U.S, by holding financial reserves which mainly consists of U.S Treasury bonds.

Thus, with the above mentioned factors, other countries approached U.S and had to import on the basis of these bonds. The extent to which this can be done is determined entirely by the willingness and desire of other countries to hold the bonds. Though, there were some limits with the emergence of China as a global financial player.


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