The Finances of the Nation-State and the Global Foreign Exchange System

This essay was written on April 24, 1995, in the wake of the collapse of the European Monetary System in 1992 and the North American currency crisis of 1994/1995, during a period featuring high budget deficits among most of the early industrialized countries. In the ensuing years, fiscal balance was restored in the United States and improved in Europe in the run-up to the introduction of the single currency. Since then, however, nation-state finances have once again begun to erode in the face of war in the case of the United States and continued relative economic stagnation in Europe. A new element in the equation today is the impact of China and, eventually, the role of the Chinese yuan, both present and going forward.

What we are witnessing is the erosion of the financial solvency of the nation-state. This erosion is most clearly expressed by the current developments in the foreign exchange market. On the one hand it has hit North America, beginning with Canada about a year and a half ago, and most recently with the United States in the wake of the financial disaster in Mexico at the end of 1994. On the other hand the erosion has hit Europe, beginning in Italy, Spain, and the United Kingdom in 1992, followed by the debacle of the European Monetary System in August 1993, and until today as the meteoric rise of the DEM, CHF, and JPY has again exposed the financial weakness of nation-states like Italy, Spain, and Sweden, and the continuing decline of Great Britain as an industrial, political, and financial power on the global scale.

A currency is the standard bearer of a national financial system, the financial system of a nation-state and all the activities which fall under its legally recognized jurisdiction and its international linkages. And what we see now is the damage that uncontrolled debt can do. The cause of debt is the moral profligacy and lack of civil and human responsibility of the bands of men in power who occupy the institutions of legally recognized systems of social control. The consequences of debt, the consequences of the erosion of the financial solvency of the nation-state may be terrible, but not necessarily so. Some good may come of it. The current phase of this process may come to an end within a few months. But the long-term trend will continue, at different paces in different countries, and there will be more intense periods like the one we are living now. We should like to examine some aspects of the process as they apply to certain nation-states, examine some of the common problems which give the process an international character, and the relative strengths and weaknesses of the several nation-states as the process affects them, as it spirals down its unpredictable path. For now I shall limit myself to a summary of the fundamentals of the global foreign exchange system as it currently stands.

We can conceive of the global foreign exchange system as consisting of several overlapping layers the most broad of which is the very globality of the system itself. The sub-layers consist of what some consider regional blocs which reflect geographical proximities, commercial patterns, and cultural and historical ties. These blocs are mostly distinguished as the Yen bloc, the D-Mark bloc, and the dollar bloc, without forgetting the global interconnections. I conceive of the system as an ensemble of rhythms and pressures. The most broad rhythm runs across geography over time ... Tokyo, London, New York ... Tokyo, London, New York ... Tokyo, London, New York. You know they "pass the book". It never ends. Right now, wrestling at the pinnacle of the system is the Japanese Yen. It is the strongest currency on the planet owing to the hard work of the Japanese people, their propensity to save, their brilliant success in global commerce, and the tenacity with which they strive to protect and enhance their position. They have achieved these things together as a nation-state and the national accounts are in order. (Though some make a strong argument that the huge perennial trade surplus is a gross and distorted imbalance.) On top of that, they are located in the geographical region of the Earth that is presently enjoying the highest rate of economic growth as measured in national income accounting terms. So, for at least these reasons, the Japanese Yen is acting as the pivot in the global foreign exchange system. On the days when the Yen exerts pressure, the effects reverberate throughout the system. The most important currency relationships then, globally speaking, are USD/JPY and DEM/JPY. Of these two, which is the more important protagonist depends on the day and the dynamic within the D-Mark bloc or the dollar bloc during a particular phase of movement of global and regional rhythms and pressure points. What is fair to say is, that for the better part now, the USD/DEM relationship is more a function of USD/JPY and DEM/JPY than a direct function of itself. That is not to say that the direct USD/DEM relationship has no importance. It means that the influence of USD/JPY and DEM/JPY on USD/DEM has greater weight than it ever has had in the past. The coefficients are changing. This reflects changes in the foreign exchange composition of stocks of reserves, and it will affect how savings from new flows of global income will be held in reserve.

At the pinnacle of the European sub-system is the D-Mark. The reasons for this are similar to those for which the Yen is at the pinnacle globally. The Germans have achieved success cohesively as a nation-state. They have even managed to absorb their eastern half in a stable manner, so far it seems, in the face of enormous financial pressures. This impressive display of stability, on a complex and often chaotic continent, stands on the discipline employed by the men of the BUBA in pursuing a monetary policy successfully aimed at controlling inflation even under the pressures of the external shock of reunification. It also stands on the coolness with which their political leaders predictably and steadily handled the whole affair. Underneath this, the German social system entails huge costs, and the price of labor is high. It remains to be seen whether German industry can continue to adapt to the high D-Mark by cutting costs and improving productivity, quality, and technology, in the face of competition from American and some other countries' firms who are reputed to be more flexible and innovative in a fast-changing world. But this medium-term risk pales into insignificance when compared to the immediate financial risk confronted by savers and investors based in other currencies in Europe and elsewhere in the world. The financial systems of nation-states on the perimeters of Europe are either de facto insolvent (though not officially recognized as such for political reasons) or they are marching steadfastly down the path to insolvency. It is mainly for this reason that the D-Mark (and the Swiss Franc, the currency of a nation-state which is another island of stability and credibility whose national accounts are in order) enjoys safe-haven status whenever, and it happens often nowadays, the pressures of the burdens of these debts cause the European Monetary System to go again into extremis. The only thing that prevents the European sub-system from going into a coma is the operation of some of the safety valves working to relieve tensions in the global system of rhythms and pressure points on a phase to phase basis which reaches peaks and troughs based on technical, economic, and political cycles. We would intend to examine this in detail, but first let us take a look at the dollar bloc.

The dollar bloc includes not only of course the USD and the CAD, NZD, AUD, but also the GBP (especially considering the UK's political posture towards the EU), many Latin American currencies, and those Pacific Rim currencies somehow pegged to the dollar. The USD's long-term relative decline in global terms accelerated in 1985 and intensified in 1992 and has intensified more acutely in these last four to six months. The principal fundamental reason for this is that the USA was formerly the world's largest creditor nation and is now the world's largest debtor nation in absolute terms. The country's savings to investment gap is expressed by its twin budget and current account deficits. The global foreign exchange system is awash in USD debt. And the stock of debt is increased annually by a combined USD 500 billion+ or so. The USA's main trading partners are Canada and Mexico. These three nations have joined together commercially through NAFTA. This commercial link also implies however political and financial commitments and in this sense we can conceive of the North American financial system. This system has its own internal logic, a logic with respect to other currencies of the dollar bloc, and a logic with respect to the rest of the global foreign exchange system. Canada also sustains national account imbalances in the form of budget deficits, current account deficits, and a high national debt. In addition there is political risk connected with the constitutional and Quebec issues. In recent years, the risks in Canada have been perceived as quite high as against the USD and other major currencies around the world. The USD/CAD has declined from a period peak of around 1.12 in 1989 to as low as around 1.43 in the last weeks. The risks in Mexico have been known for decades, but hopes were high as the NAFTA process was successfully concluded. Mexico's close association with the United States was perceived as providing political guaranties for Mexican risk. When Mexico's most recent wave of macro-imbalances came crashing down in December 1994, it highlighted a new perception that the entire North American financial system is heading for insolvency. The collapse of the Mexican peso was the trigger event which set off the massive and volatile switching of global reserve assets from the USD and into the JPY, DEM, and CHF.

The above paragraphs have outlined the basic state of being of the global foreign exchange system with a view toward the financial systems of the major nation-states, of whose currencies it is comprised, in light of recent events. An analysis of the details, I believe, will show that it is not the foreign exchange system which is in crisis. In fact it has worked quite well globally, within the D-Mark bloc, and within the dollar bloc, as it was designed to do. Rather it is the financial systems of the nation-states themselves which are in crisis. The global foreign exchange system's ensemble of rhythms, pressures, and safety valves operating around technical, economic, and political cycles is indeed the mechanism which allows the nation-states periods of respite (lasting either days, weeks, months, or years depending on the rhythms and cycles) in order to address the fundamental problems of their financial systems. It is this ensemble mechanism which, so far, has prevented a "meltdown" or a drain of cash flow from the weaker financial systems which is so sudden, massive, and decisive that it would cause unavoidable and, above all, unhideable de jure sovereign default. I also believe that an analysis of the details will show that the primary cause of the weakness of the financial systems of certain nation-states is hardly monetary policy, but clearly fiscal policy. And it is these fiscal imbalances which have shaken the financial systems of the nation-states and damaged the credibility of the concept and the institutions of the nation-state in the minds of individuals.