2008-10-02

Contagion

One of the more interesting flash games you can play on the internet these days is called Pandemic II. The game is suited to all sorts of proto-evil overlords like myself. In order to win the game, you need to create and maintain a deadly virus that eventually wipes out the entire planet. At every step you are faced with problems such as nations wearing face masks or burning dead bodies to prevent your killer virus from spreading.



One sure-fire way for a nation to remain isolated from the contagion - or to bravely prevent it from escaping - is to close its borders, its airports and its shipyards. One island nation that almost always seems to survive is Madagascar - oftentimes it is the only nation left uninfected and, once your virus has killed everybody else and burned out, the game ends with the unlikely scenario of Madagascar ruling the world.

So now that I've talked about some unrealistic game about destroying the world, let's move to another game about destroying the world - the current economic contagion.



One of the arguments that I have been presenting lately is the importance of following the austerity measures outlined in the Washington Consensus - the guidelines adopted by supranational entities like the IMF and the World Bank to help third world nations create ideal conditions for economic growth. These austerity measures were designed to be imposed upon third world nations in order for them to receive IMF and World Bank help.

The reason why such guidelines should be imposed upon the US is because of the danger of Capital Flight - the selling of US Dollars (in the form of bank accounts, bonds, etc) in order to purchase other currencies (such as the Euro and the Yen). While it might seem incomprehensible that the US should follow guidelines intended for developing nations, the threat of capital flight makes it necessary - if you think the current crash is bad, a crashing US Dollar would make it 100% worse.

But, of course, the US is not looking for the IMF or The World Bank to support the US Dollar. The only institutions capable of giving stability to the US Dollar during this crisis are international central banks like the Bank of Japan, the European Central Bank, the Bank of England and a multitude of others. The Federal Reserve has little foreign currency reserves that it can upon to boost the dollar. If the dollar should crash, the only thing the Fed can do to save the US economy from a dollar crash would be a substantial hike in interest rates - an action that no one really wants to contemplate but may be necessary.

Frightening as it might seem, the US Dollar is now looking fragile. While a glance at the US Dollar index indicates that the dollar seems to be rising in value, the events of the last couple of weeks has seen the dollar rise and fall and rise in price continually - in other words, the US Dollar has become volatile, just like the sharemarket. If investors finally decide that the US is no longer a worthwhile place to invest - and that feeling is closer now that at any time in history - then the result would be a dollar crash. Financial armageddon.

The only people stopping a dollar crash from occurring - and the only people capable of acting against the market to save the dollar - are foreign central banks. If capital flight occurs and investors dump the dollar, the only people capable of reversing it are the ones who control the supply of foreign currency. Thus the ECB, the Bank of Japan and the Bank of England could sell off their own currencies and purchase the US Dollars that are being sold by the frightened investors.

Yes America, your national financial security is now in the hands of foreign governments.

But why would these central banks choose to save the US Dollar? While such an action would help the US, it would also lead to further contagion. Just like Pandemic II, a crashing dollar would help to limit the crash to the US. Keeping the dollar higher via foreign central bank intervention would end up hurting the entire world more than if the US were left alone.

This is not to say that a dollar crash would not hurt other nations - of course it would, especially those nations whose economies depend upon US consumption. But the choice is not between good and bad, but between bad and worse. If the dollar crashes and foreign central banks do nothing, the result for the international community will be bad. But if the dollar is propped up by the international community, the result will be worse for them - the contagion would spread.

This assumes, of course, that foreign central banks would be able to act in unison to protect the US dollar without letting their own interests get in the way. It also assumes that these foreign central banks would also be successful in saving the currency of the world's largest economy. While the US government was big enough to "bail" a number of important financial firms, it is questionable whether foreign central banks are big enough to "bail" the US economy. While the US might be too big to fail, it might also be too big to bail.

So in order for foreign governments to place their own economies on the line to save America, there must be some sort of guarantee that America will do its utmost to repair its own economy through harsh but necessary austerity measures. Not only would these austerity measures assuage foreign central banks, but they may also assuage the entire market. They won't be popular - they will certainly make the US economy sicker in the short term - but they will be necessary for the market to have confidence in the US.

America is facing the greatest economic threat since the 1930s and maybe even of all time. Just as political leaders made fierce, courageous and uncompromising decisions in the face of war, so they must now make similar decisions in the face of possibly the greatest economic crisis of all time.

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