The Fed's deformed
maturity By Hossein Askari and
Noureddine Krichene
High prices and
shortages of energy and food, resulting in riots
and higher risks of widespread hunger and
malnutrition, have become recognizable threats to
global economic and political stability. The US
dollar has collapsed to a point of triggering
flight out of that currency to more stable
currencies and to commodities. Inflation has
become rampant.
The elementary lesson of
monetary theory is that prices can never sustain a
general and persistent increase, and the exchange
rate can never sustain a constant depreciation,
without an unduly
expansionary monetary policy.
Why this rampant inflation? To quote
Milton Friedman: "Prices have been rising faster
and faster because the [US Federal Reserve] has
decreed they shall be". There is little hope for
sustained global economic growth and prosperity
until the Fed acknowledges that injecting billions
of dollars into the economy will not add to crude
oil production, currently amounting to about 80
million barrels a day and severely limited by oil
reserves; nor will it increase supplies of rice,
wheat, and other staple foods, limited by
cultivable land and climate; and that any further
reductions in interest rates with its consequent
deliberate expansion in credit and money supply
and dollar depreciation, will simply translate
into faster increases in the prices of oil and
other commodities.
Inflation will disrupt
supplies and intensify speculation and hoarding.
As money illusion has waned, commodity producers
have become reluctant to accumulate depreciating
international reserves and realize they can
generate more revenues by reducing supply.
As long as commodity prices are quoted in
dollars, it is the Fed that controls prices. The
Fed decides how far the US dollar should fall, to
two euros, three euros, or even 10 euros; how far
oil prices should rise, to US$200, $500, or even
$1,000 per barrel; and how much rice, corn, meat,
and other staple food products should rise - two-,
three-, or even 10-fold.
The United
Nations and governments are baffled by world
energy and food crises and are searching for
supply-side solutions, but no such solution will
work in an excessively unstable monetary
environment. In view of their speed and magnitude,
jumps in oil and food prices are purely monetary
phenomena. Until monetary stability is restored,
it will be difficult to identify supply
constraints and solutions.
Adopting an
interest rate rule repudiated as far back as 1802
by Henry Thornton and more recently passionately
criticized by Milton Friedman, the Fed since 2001
has followed the most expansionary monetary policy
in its history, setting interest rates at lowest
levels and real interest rates at negative levels.
In response to the collapse of the credit
and speculation boom, the Fed has set a deliberate
re-inflationary objective in order to reverse
falling asset prices. It has aggressively resumed
its expansionary monetary policy since August
2007, cutting the federal funds rate from 5.25% to
2% with a consequent faster expansion of money
supply, resulting in a rapidly depreciating dollar
and disrupting stability in commodity markets
propelling oil prices from US$65 to US$120 per
barrel and food prices by 80%. The Fed is caught
in a vicious cycle of credit boom, banking crisis,
and re-inflation. Expansionary policy will inflate
credit, expose banks to another credit crisis,
then re-inflation to bail out banks and to prevent
the collapse in the values of speculative assets.
This cycle could go on for years.
The
Fed's policy, after seven years of excessive
inflationary stance, has evolved to a stage that
threatens social and economic collapse and
financial disorder. It has strengthened inflation
dynamics causing an economic recession, which may
be followed by rising unemployment.
The
recession effects of inflation can be explained by
a fall in real cash balances, erosion of
purchasing power of fixed income and wage earners,
and decline in savings and investment. By forcing
nominal interest rates to abnormally low levels,
the Fed is making real interest rates largely
negative and in turn destroying savings needed to
support investment. At the same time the Fed is
making world demand for commodities continuously
outpace long-term supply growth and therefore
causing explosive price inflation. Fed policy
is creating widespread economic distortions. By
re-inflating the economy to rescue banks and
housing markets, the Fed is making the public
liable for mistakes it did not make and pay for
the gains reaped by speculators and debt holders.
Private gains from speculative booms remain
private, while the Fed passes on private losses to
the public. The homeless, eating much less, are
paying for bolstering the value of homeowners'
asset.
Indeed, inflation is known to
impose a heavy tax on cash balances and incomes in
favor of debt holders be they government or
private. The higher is inflation, the higher the
tax burden imposed by the Fed. As inflation
accelerates and the dollar depreciates, real
incomes fall; consequently, vulnerable people in
many countries can afford less food and the basic
amenities of life.
The destabilizing
effects of Fed policy have become obvious. By
ignoring inflationary pressures and striving to
re-inflate the economy, the Fed could precipitate
a large-scale energy and food crisis, putting
millions at risk. The world can address its energy
and food problems only in a stable monetary
framework. While the Europeans are resisting
further relaxation of monetary policy, the Fed is
ignoring all calls from prominent figures,
including Paul Volcker, to restrain monetary
policy.
Interest rate setting is a form of
price control. It has to be repudiated as any
other type of price control. Friedman called for
controlling money aggregates and prescribed a
fixed rule setting money growth in a range of 2-5%
per year in line with long-term real economic
growth. Such a rule is the safest for conducting
stable monetary policy.
It avoids
unnecessary deflationary or inflationary swings.
Keynes shunned active monetary policy, even in
conditions of the Great Depression when inflation
risk was non-existent, because he valued monetary
stability. The Fed's thinking must be that cutting
interest rates will bring a bonanza from the
heavens; it will make oil fields pump more oil,
and rice and corn fields grow more rice! Yet there
will be no relief in energy and food markets until
the Fed decides to reduce money supply and credit.
Cutting the fed funds rate and a pause is
the Fed's current motto after the latest interest
rate cut on April 30. Pause for what? To see the
dollar collapse, inflation accelerate, economy
decline, and millions of people starve?
Maintaining low interest rates and inflating money
supply will intensify inflation, jeopardize
economic growth, and worsen the energy and food
situation.
The Fed's founders in 1913
wanted an institution to manage liquidity, not to
control interest rates. The Fed has been made an
independent institution to safeguard monetary
stability. Yet this independence has allowed the
Fed to deviate completely from its 1913 mandate.
If we are honest, we must acknowledge that
this independence is at best symbolic. The Fed
promptly responds to Wall Street's distress, be it
the downturn in technology stocks, the fall of
hedge funds, the collapse of the housing prices,
and to political pressure for financing large
fiscal deficits by keeping interest rates low.
The Fed has become totally oblivious to
the global impact of inflation, the plight of
millions around the world and even the mirage of
economic justice. For how long will the US
Congress and policymakers remain indifferent to
the crumbling world monetary order and its
widespread economic effects?
Hossein Askari is
professor of international business and
international affairs at George Washington
University. Noureddine Krichene
is an economist at the International Monetary Fund
and a former advisor, Islamic Development Bank,
Jeddah.
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