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'The Way Forward' Is Way Off: Global Reforms Needed

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (TheStreet) -- In my last article, I wondered how the authors of The Way Forward could completely ignore the role of banks as contributors to our global economic malaise. In this piece, I will look at their recommendations on what needs to be done globally to rectify the situation.

Capital Flows: The authors of the study, Daniel Alpert, Robert Hockett and Nouriel Roubini, or AHR, argue that capital inflows from emerging market countries contributed significantly to the U.S. housing/spending bubble that burst in late 2008. They assert further that a significant portion of those capital inflows came from emerging market governments (primarily China) trying to keep the U.S. dollar strong, so as to give their exporters a competitive advantage. They are critical of "China's continuing policy of pegging the yuan to the dollar."

There are several problems with these assertions.

U.S. Capital Inflows: Table 1 gives data on foreign government and private investments in the U.S. for the 2000-2007 period. While foreign governments purchased $1.4 trillion of U.S. government securities during this period, the foreign private sector purchased far more, $3.8 trillion, with most purchases being equities.

These figures suggest to me that the Chinese government was not the main driver of what happened during this period. Instead, U.S. dollar investments were attractive worldwide. In short, this global demand for U.S. financial assets was far more important in keeping the U.S. dollar strong than Chinese Treasury purchases. These "portfolio choices" had more to do with what foreigners saw as good investments than efforts to keep the dollar strong.

U.S. Policies: To ease the threat of currency appreciation or inflation, central banks often attempt to "sterilize" capital flows. In a successful sterilization operation, the domestic component of the monetary base (bank reserves plus currency) is reduced to offset the reserve inflow. The Fed had the tools via its discount window and open market operations to mop up excess liquidity resulting from capital inflows. They chose not to use them.

Other AHR Policy Recommendations: The majority of AHR's other recommendations are directed at least in part at China. Inasmuch as I ran a company with Chinese partners for more than a decade working in Asia, I believe I have a pretty good sense of how Chinese authorities would view the AHR suggestions. Consequently, my comments below reflect my sense of how China thinks.

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