The current globalization scheme would have been wiped out and the global economy brought into another great depression if not for the injection of massive amount of fiat money created from thin air by various governments around the globe. So far in this website we have tracked the development of the globalization scheme from its very beginning by the means of phenomenological analysis, that is, to use statistical data to extract trends and correlations. Those results have led us to conclude that the globalization scheme will inevitably destroy itself. In this article a theoretical demonstration based on a series of simplified models is presented to show why this globalization scheme is unstable. This theoretical approach will highlight the basic workings of the globalization scheme and will answer many questions like, who is benefiting and promoting this globalization scheme, why huge amount of loans must be issued to people that are least capable of servicing large amount of debts, why large financial institutions must fail if without government bail out, and so on. This theoretical approach also provides a platform for us to discuss what is going to come in addition to various issues like currency market manipulation and tighter regulation on financial institutions.
An overview of the current globalization scheme is given in the next section, and a pre-globalization era model is introduced in Section 3 as the base of further analysis. In Section 4 a workable globalization era model without saving is discussed. The model of Section 4 is modified to allow saving in Section 5, and is shown that the modified model becomes not sustainable and will self destruct eventually. The impact of a truly free currency market is also considered there. The last section is reserved for some concluding discussions.
The current globalization scheme has been promoted strongly by every U. S. administration since early 1980s. The essence of the scheme is to lower barriers that hinder the movements of goods, services and capitals across national boundaries. Under the scheme businesses can outsource their manufacturing and other operations to places with lower labor and pollution control costs. However, this globalization scheme is not sustainable because its basic rules contain fateful omissions that deliberately sabotage the natural policing mechanism of the free currency market to prevent the runaway global trade imbalances. The first fateful omission is to allow participating countries to intervene in currency market to manipulate the value of their own currencies at will. The second fateful omission is to allow participating countries to set their own monetary policy without coordination with other participants, resulting again in wide gyrations of currency exchange rates. In the subsequent sections, through a series of models we will see how such omissions have brought down the globalization scheme along with the global economy. Here we will look more closely into the impact of manipulations of currency exchange rates.
Natural resources, like crude oil, are distributed unevenly around the globe. Resource consuming countries have no choice but to import the deficit from resource exporting countries to fuel their economy no matter at what level the currencies of the exporters are. The trades of natural resources are not very sensitive to the exchange rates of the currencies of resource exporting countries. On the other hand the trades of manufactured goods are very sensitive to the value of the currencies of the exporting countries. When an exporter runs large trade surplus, net influx of U. S. Dollar, that is still the most popular international trade settlement currency, increases sharply and will push up the value of the currency of the exporter vs. Dollar. As the consquence the cost of production in the country rises rapidly, and the export binge will be curbed. That is how the natural policing mechanism of a free currency market works to prevent runaway international trade imbalances. Developing countries that heavily depend on exports and run large trade surpluses do not want to see their export boom crushed by the vigilante of free currency market, so they use the freedom of currency market manipulation to buy up those unwanted Dollar to prevent the appreciation of their currency vs. Dollar. By preventing the appreciation of their currencies, they will be able to continue to attract foreign direct investments to set up factories and manufacture goods mostly to be exported to America. Through this process their under utilized labor resources are put into work, at the same time the matching amount of local currency released into the market for buying those Dollar creates enormous amount of liquidity that stimulate massive infrastructure constructions, resulting into a quick rich condition called by awed experts as "economic miracle". With phenomenal growth , thanks to the flawed globalization scheme, those developing countries gain economic, political and military power rapidly to the degree that will even threaten the domination of America, ironically the designer and the promoter of this globalization scheme.
One sided monetary policy is another tool to influence currency exchange rates. The best example of this practice is the near-zero interest rate of Japan introduced since the middle of 1995. As discussed in article 1 the near-zero interest rate of Japan induced massive waves of Yen carry trades. Yen carry trade is the strategy of large speculators like hedge funds to borrow Yen at near zero interest rate, dump those borrowed Yen for Dollar, and use those Dollar to buy high yielding securities and/or U. S. stocks. Those Yen carry trades thus push down the value of Yen sharply against Dollar, and had allowed Japan to sustain its massive trade surplus for many years.
The United States of America has been the sole counter party to all those trade surpluses accumulated by various countries around the world. As the result he United States has been running mind boggling amount of trade deficit since the onset of this globalization scheme. As has been chronicled in article 2 and article 2A, and summarized in article 12, it is the runaway trade deficit of the United States of America that is shaping up the global economy, not the expanded total global trades as many experts want to claim. Data shows clearly when the U. S. trade deficit runs wild, a huge credit/debt bubble develops beyond anyone’s control, and when the bubble bursts, a painful recession sets in. That is why we want to trace in detail how this globalization scheme will inevitably collapse through a series of theoretical models in the following sections.
A simple yet realistic model of the pre-globalization era is constructed here so that the model can be extended accordingly when the globalization scheme is introduced in later sections.
The unit of the currency of a developed country A is represented as $. Company X in Country A produces something called "Source". The company pays $50 million to Company Y for parts, and pays $60 million as wages to its workers to turn the parts into one million units of source. Company X budgets $10 million as its profit that is distributed to its stock holders as dividend, so it sells this one million units of Source to Company Z for $120 million.
The $50 million that Company Y has received consists of $40 million as wages to its workers and $10 million as profit/dividend.
Company Z is actually a collective name of many businesses that use Source to produce various kinds of consumer goods, called "Goody" as a whole. Company Z pays $20 million as wages to its workers to produce Goody based on the one million units of Source, and books $10 million as profit/dividend. Company Z thus sells those Goody to consumers for $150 million. Who are the consumers in this model? They are the workers and stock holders of Company X, Y, and Z respectively. Consumers receive $150 million in total and spend all the income to buy and consume $150 million Goody sold by Company Z. After receiving $150 million from consumers, Company Z buys another one million units of Source from Company X for $120 million and Company X buys another batch of parts from Company Y for $50 million. Thus another cycle of the production of Goody starts. This cycle of producing Goody from Source can continue indefinitely without any price change to the final product, Goody. Let us tabulate the distribution of income for various consumer groups during one cycle of production below:
|Workers of Company X||60|
|Stock holders of Company X||10|
|Workers of Company Y||40|
|Stock holders of Company Y||10|
|Workers of Company Z||20|
|Stock holders of Company Z||10|
Under the globalization scheme Company X wants to outsource its manufacturing facility in Country A to a developing country B to save its labor cost. The unit of the currency of Country B is represented as # with exchange rate of $1 = #1. The labor cost in Country B to produce one million units of Source is only #30 million, that is, $30 million compared to $60 million in Country A as discussed in the previous section. Company X brings $80 million into Country B. $50 million is used immediately to buy the parts from Company Y. This $50 million becomes import of Country B and export of Country A. Company X sells $30 million to the government of Country B for #30 million, pays this #30 million to the workers of Country B to produce one million units of Source, and then ships this one million units of Source back to Country A. Since the cost of this one million units of Source is $80 million, when those Source pass through the customs of both countries, it is recorded as $80 million export of Country B and $80 million import of Country A. Company X is not as greedy as many assumes and sells this one million units of Source to Company Z for only $110 million, that is, $10 million less than the case in the previous section. Company Z then passes along this $10 million saving to consumers and sells final Goody for $140 million in total, again $10 million less than in the case of the previous section. Company X books profit of $30 million and pays this $30 million out as dividend to its stock holders. It should be noted that the distribution of income from Companies Y and Z to their workers and stock holders remain unchanged from the case of the previous section. To complete the analysis of a cycle of production of Goody, we need to look into the workers of Country B and the former workers of Company X, too.
The workers of Country B, after receiving #30 million from Company X as wages, spend all of those money on something called "Tasty". It turns out Tasty can only be produced in Country A. Former workers of Company X rush to produce $30 million of Tasty and ship them to Country B. With all the processes completed in one cycle of production, the total income of consumers of Country A adds up to $140 million, exactly equal to the sale price of all the Goody produced from one million unit of Source. Thus the next cycle of production can progress exactly as the previous one. We need to make sure about the trade balances of both countries and the exchange rate between $ and # to make sure that this model is stable.
Country A has exported $50 million parts for Source and $30 million Tasty to make it $80 million in total, whereas it has imported one million units of Source for $80 million so its trade is balanced. Country B has imported $50 million parts and $30 million Tasty whereas exported $80 million of Source, so the trade of Country B is also balanced. With the trades of both countries balanced, there will be no pressure to push the exchange rate between $ and # to deviate from $1 = #1 level.
The designers and the promoters, at this point, will claim a magical win-win situation created by the globalization scheme. They will point out that consumers of Country A still have the same quantity of Goody to consume but at lower price compared to the pre-globalization era, meaning that $ has gained value, whereas Country B now has $30 million of Tasty to enjoy compared to none in the pre-globalization era of Section 3. Furthermore, the trades of both countries are balanced and the exchange rate between $ and # is stable. Is the situation really as rosy as those people claim? If we dig a little deeper, we will find that such claims are misleading at best. In the following Table 2, income distribution for six consumer groups under this globalization model is listed in the middle column, and for the purpose of comparison income distribution in the pre-globalization era, taken from Table 1 of Section 3, is listed in the rightmost column.
|Consumer group||Income, globalization era||Income, pre-globalization era|
|Former workers of Company X||30||60|
|Stock holders of Company X||10||30|
|Workers of Company Y||40||40|
|Stock holder of Company Y||10||10|
|Workers of Company Z||20||20|
|Stock holders of Company Z||10||10|
From the above table we can see that the stock holders of Company X is the biggest winner with their income tripled under the globalization scheme, and the biggest loser is former workers of Company X with income halved compared to the pre-globalization period. Seeing the huge windfall gain of stock holders of Company X, stock holders of Companies Y and Z naturally want their companies to follow the foot print of Company X and outsource their operations to Country B, too. At the end all the workers that form the majority of the society of Country A will be big losers and a handful people, that is, stock holders will be enriched enormously. Such a situation we will never call rosy as those promoters of the globalization scheme claim. From this analysis we can clearly see who are promoting the globalization scheme and for the benefit of whom the designers of the scheme are working.
Readers probably will claim not realistic to assume that the production of Tasty cannot be outsourced to Country B. We direct our attention to the prerequisite of this globalization model, "without saving" as stated in the title of this section. The "saving" we are talking about is not with regard to Country A, but is about Country B. If the production of Tasty, even only a portion of it, is outsourced to Country B, Country B does not need to spend all $30 million it received from Company X on the import of Tasty. With any $ left in the hands of the government of Country B, it becomes the saving of Country B so the situation is not covered by the model of this section. Actually the more natural way for Country B to save is not necessarily to require the outsource of the production of Tasty. If the workers of Country B just save a portion of their earning, like putting them into a bank, Country B will achieve some saving. In the next section we will show that "with saving" the globalization model becomes unstable and will eventually destroy itself.
The stable model without any saving for Country B as discussed in the previous section is rather unrealistic. Here we assume that the workers of Country B save #10 million after they have received #30 million wages from Company X, and only consume #20 million worth of Tasty. This means that the government of Country B only needs to import $20 million worth of Tasty. Since the government has $30 million that was sold by Company X before the import of $20 million Tasty, it holds $10 million after the cycle of production is completed. Thus Country B runs $10 million trade surplus in one production cycle and this $10 million is added to the foreign currency reserve of the country.
Let us consider first the case that the government of Country B holds all of its foreign currency reserve in cash and
stores them in a secured warehouse. We will see very strange phenomena happening in Country A under this rather abnormal
arrangement. Let us call the total income in Country A, that are all earmarked to buy Goody, as the "Demand" of Goody, and
the aggregate monetary amount that Company Z wants to sell its Goody as the "Supply" of Goody. Since the income of former
workers of Company X now is only $20 million that is $10 million less than in Table 2 of Section 4,
the Demand (total income) of Goody becomes $130 million if the incomes of other five consumer groups in Table 2 do not
change. The Demand of Goody is thus $10 million less than the Supply of Goody, that is, $140 million planed by Company Z.
Apparently the price of Goody needs to be lowered. Let the total profit three companies make be P million $. The Supply
becomes $(40 + 30 + 20 + P) million, where $40 million is the wage to the workers of Company Y, $30 million is the wage to
the workers of Country B paid by Company X, and $20 million is the wage paid to the workers of Company Z. The Demand for
Goody, or the income, is $(40 + 20 + 20 +P) million, where $40 million and $20 million are the incomes of the workers of
Company Y and Company Z respectively, and the second $20 million is the income of former workers of Company X. Writing out
explicitly, we have
Supply = $(40 + 30 + 20 + P) million = $(90 + P) million,
Demand = $(40 + 20 + 20 + P) million = $(80 + P) million.
Supply - Demand = $10 million.
This means that as long as P is positive, Supply and Demand cannot be made equal. To make Supply and Demand balance, P must be negative. Negative P means a loss instead of a profit for the companies involved. Suppose all three companies share the loss. The Supply is still $(90 + P) million with P now negative. When a company has a loss, it does not pay out dividend so the income of its stock holders becomes zero. Thus the Demand becomes only $80 million. Equating supply with Demand, we get P = -10, that is, the aggregate losses of three companies should be $10 million. Under such a condition there is no reason for Company X to outsource its manufacturing operation to Country B and the globalization scheme becomes meaningless. What should be done to kick start the globalization scheme?
The problem encountered in the case of the previous paragraph is for the government of Country B to lock away its $10 million trade surplus so that a chunk of $ is taken out of circulation. What the government of Country B must do in order to allow the globalization scheme to work is to bring that $10 million trade surplus back to Country A and to lend to the consumers of Country A to buy more Goody. Then the Demand for Goody becomes $(80 + 10 + P) million = $(90 + P) million, and is always equal to the Supply of Goody for any positive P. Three companies can allocate P just like in Section 4, that is, $30 million profit for Company X, and $10 million profit for Companies Y and Z respectively. With this set up the globalization scheme becomes meaningful and the production cycle can now proceed.
The government of Country B does not run banks in Country A, so there must be a layer of "Middlemen" who borrow this $10 million from the government of Country B and lend the money to the consumers of Country A. Who in Country A should the money be lent to? Stock holders of Company X has already been enriched enormously and do not need to borrow any money to buy Goody. The stock holders and the workers of Company Y and Company Z, though their incomes stay the same as before, consume more Goody measured by the quantity due to the fall of the price of Goody, so they will not be eager borrowers of the money offered by the middlemen. Only the impoverished former workers of Company X want to borrow and do get the majority of the money offered by the government of Country B through the middlemen. Since in each cycle of production Country B rakes in $10 million and must lend all of them out, the total amount of loans made by the government of Country B keeps increasing as the production cycles proceed, and so are the debt loads of poor former workers of Company X. At certain point, the former workers of Company X cannot afford to pay the increasing amount of interest and default on the loans. With the default, the middlemen will be wiped out, the lending is disrupted, the consumption of Goody falls, the workers of Company Z are laid off to reduce the production of Goody, the stock holders of Company Z get smaller dividend or even nothing. Company Z buys less Source from Company X. As Company X cuts back the production of Source and buys less parts, the workers and the stock holders of Company Y get hit as well as the workers of Country B and the stock holders of Company X. The workers of Country B buy less Tasty so the income of former workers of Company X get squeezed further, and so on and so on. Thus the whole globalization scheme spirals down to the ground spontaneously. At that point the government of Country A is forced to print enormous amount of fiat $ to bail out the middlemen at the same time distribute some of the $ to consumers to spur the buying of Goody, hoping to stimulate the economy to avoid a great depression. The government of Country B is also forced to print enormous amount of fiat # to be distributed to the workers to buy Tasty with the hope that the stimulus will prevent the onset of a great depression.
The analysis so far in this section is based on the case that the government of Country B buys all the $ that Company X brings into Country B and keeps the exchange rate between $ and # at $1 = #1. What if the role of the government of Country B is replaced by a free currency market? Can the inevitable crash be avoided? When Company X sells $30 million for # in a free currency market, # will be pushed up vs. $. When Country B tries to sell #20 million for $ to buy Tasty in the free currency market, # will be pushed down vs. $. Since there are more $ for sale than $ to buy, # will appreciate vs. $ in every cycle. The effect of the appreciating # needs to be analyzed for two different cases. The first case is that the wage paid by Company X in Country B is always fixed at #30 million. Translated into $, the labor cost of Company X is rising as # appreciates. As the production cycle proceeds, # rises higher and higher and eventually Company X will see not only no advantage but disadvantage to make Source in Country B so it will move the production facility back to Country A. Thus the globalization scheme becomes meaningless. The second case is that the wage paid by Company X in Country B is fixed at $30 million. This means that the wage of workers in Country B declines in # terms as # appreciates. Under this scenario most of the discussion done in this section that leads to the self-destruction of the globalization scheme still applies. In the second case, the savings in # by older workers of Country B become more and more valuable in terms of buying power measured by the quantity of Tasty. This will increase the demand of Tasty in country B and gradually reduces the trade surplus of Country B. When the trade surplus of Country B becomes zero, then the stable model of Section 4 will take over. However, the time required to achieve this stable phase will be much longer than the winding down time of the first case that the wage in Country B is fixed at #30 million and the globalization scheme becomes meaningless at the end. We should note that no matter in which case, during the transition period the trade surplus of country B still accumulates and so is the debt load of former workers of Company X in Country A. Whether a free currency market can prevent a crash depends on whether former workers of Company X default first or the equilibrium condition is reached first. In that sense we may conclude that the second scenario with wage in Country B fixed at $30 million is less likely to prevent a crash than the first case when the wage in Country B is fixed at $30 million.
The globalization model with saving as discussed in Section 5, though is simplistic, is realistic enough to allow us to draw many parallels with the real situation. For example, the middlemen in the model are Wall Street firms and big commercial banks in our society. The former workers of Company X are "have-nots" in our surroundings. The model explains why the "have-nots" are much more likely to stuck with loans like subprime mortgages that they can ill afford to carry. The model reveals that the untenable debt situation that causes the crash of the globalization scheme is due to the structure of the scheme itself but not due to the greed of the middlemen. It is true that middlemen make profit at each production cycle by borrowing from the government of Country B and lending to "have-nots". Those middlemen have every incentive to invent ever imaginative way to push out the loans but by doing so they are actually delaying the crash, since if they give up of lending to "have-nots" earlier, the whole process of the globalization will spiral down to ash as discussed in the first portion of Section 5. It is the necessity of the globalization scheme that has pushed the strict 20% down prime mortgages to 10% down, 5% down, the acceptance of the second mortgage, home equity loans, alternative-A mortgage, subprime mortgages and so on and so on into the final crash. To lend to the categories other than home mortgages is even easier to reach the saturation point and then crash. The junk bond lending for corporate raiding and leveraged buy outs in Reagan era and pouring money into stock market to create a giant bubble during Clinton era are the examples of the latter category. After saying that we do not mean that the middlemen are blameless in this globalization scheme. Rather their blame rests in different area. The middlemen are the strongest advocates of this faulty globalization scheme along with businesses that do the outsourcing. The designers of the scheme are simply acting on behalf of the middlemen and businesses in order to allow them to grab huge wealth from the workers of the country, that is, the general public, through the outsourcing and the runaway trade deficit. Without the runaway trade deficit, the business for the middlemen to borrow from the government of Country B and to lend to "have-nots" apparently does not exist. The wipeout suffered by the middlemen, in that sense, is their self inflicted wound, but unfortunately it brings down the whole country and the global economy with it.
The pending question at present is what should be done with this globalization scheme. The U. S. trade deficit reached the peak of about $800 billion in annualized rate in the third quarter of 2006. With the onset of the financial and economic crisis, the trade deficit has fallen to $339 billion in annualized rate in the second quarter of 2009. As the economy has stopped declining and turned up somewhat thanks to the massive injection of money by the government, the trade deficit is moving up again. At the fourth quarter of 2009 it stands at $440 billion deficit in annualized rate. If the globalization scheme is allowed to operate as it has been, U. S. trade deficit will start to runaway again as the economy recovers further. As has been pointed out in article 10, The Federal Reserve typically loses control of the monetary condition when the trade deficit is running wild. If the current globalization is not restructured radically, another credit/debt bubble, probably centered on stocks and junk bonds again, will become inevitable and so is a more terrible crash following the burst of that bubble.