US regulator needs regulation By Hossein Askari and Noureddine Krichene
The world economy could be in the initial stages of its worst inflationary
episode of the post-World War lI era. Oil prices have risen from a stable range
of US$15-$20 per barrel during 1985-2000 to a volatile and record level of $140
per barrel in June 2008. Food prices have risen so fast and so high that food
riots have occurred in a number of poorer countries around the globe.
The dollar has fallen from $0.84 per euro to around US$1.60 per euro in a span
of about six years, threatening the dollar's reserve currency status. Prices of
basic necessities, including utilities, rent and healthcare are increasing at a
pace well above reported official rates of inflation. The high cost of fuel has
fueled airfares and bankrupted an increasing number of airlines.
A number of respected oil forecasters are confidently expecting oil
prices to rise to $200 per barrel within a year, and prices of basic food
products (rice, corn, wheat, cooking oil and others) to continue their rapid
With oil and food prices increasing at a runaway pace, the US dollar continuing
to fall, and inflationary expectations fully met, the outlook for inflation is
deteriorating on a daily basis.
Inflation is the most feared economic illness; its impact so far has been a
substantial cut in the food intake of millions of people, triggering food
riots. But there is much more to come. Inflation rapidly erodes real incomes
and standards of living. It imposes a heavy tax in favor of the state (a
debtor) and private debtors. Inflation is known to deflate real output, reduce
both demand and supply, and cause a contraction in savings, investment and
Meetings and the diagnosis
As if taken by surprise in the wake of energy and food crises, riots and
protests, world leaders and high-ranking officials have been frantically
meeting in Rome, Brussels, Tokyo and most recently in Jeddah, Saudi Arabia.
They have appeared bewildered by the rapid energy and food inflation yet have
so far failed to diagnose the root cause of this latest inflationary spiral and
come up with a plan to avert dire consequences for world economy.
Put simply, runaway inflation in energy, food and basic necessities prices, and
sharp depreciation of the dollar, are pure monetary phenomena, which can be
caused only by an unduly expansionary monetary policy and unchecked credit
expansion. There is no way that oil prices can rise from $20 per barrel to $140
per barrel with no major supply disruption in such a short period of time
without an excessive supply of dollar liquidity. Speculators could not be the
root cause as they only affect short-term prices.
A general price increase in oil, food and basic amenities and a sharp
depreciation of the dollar can take place only when money supply, originating
from credit to the government and the economy, becomes overly abundant. Holding
money supply fixed, an increase in oil prices would necessarily lead to
depressing other commodity prices. Only when money supply is accommodative or
expansionary can there be inflation. These are basic tenants of economic theory
for the last five centuries.
When supply of liquidity exceeds demand for money, the result has always been
inflation, with its attendant negative effects on savings, investment and
economic growth. As long as politicians remain oblivious to money matters and
do not rein in their respective central banks or fiscal deficits, the present
energy and food crisis can only worsen. Money did matter in the Great
Depression, the financial chaos in the 1930s, and in the stagflation of the
1970s. Money matters today and is again the main cause of the present world
The simple facts
Since August 2007, the US Fed, by pursuing an aggressive re-inflationary policy
in a bid to bailout large financial institutions and prevent debt deflation,
has sent oil prices racing to $140 per barrel and the dollar falling from $1.27
per euro to $1.60 per euro. The injection of abundant liquidity in the banking
system, together with the setting of real interest rates at negative levels,
have led to a speculative boom in commodity markets. Low yields on bonds have
pushed investors to seek higher yields in speculative commodities and currency
markets. Fed policy is known to reward speculation and penalize the real sector
of the economy.
Following the collapse of hedge funds and the stock market bubble, the Fed has
followed an overly expansionary policy during 2001-2007, setting the federal
funds rate at 1%, the lowest level in the post-World War ll period. Such an
expansionary policy has created a speculative boom in housing markets and
unchecked expansion of credit. The massive expansion of liquidity led to
pushing of loans in subprime markets irrespective of the creditworthiness of
the borrower, with underwriting standards reduced to nothing at all.
Typical housing loans are "NINJA" loans, rated high-grade assets by rating
services yet extended to no income, no job and no asset borrowers. This policy
turned out to be highly inflationary; housing prices increased up to fourfold
and became misaligned with household incomes; and oil prices and other
commodity prices rose at unprecedented rates during 2003-2007.
The Fed has been trapped in a vicious circle of cheap money inducing a
speculative boom followed by financial collapse, which necessitates a new round
of bailouts and cheap money. The more expansionary is monetary policy, the more
widespread the ensuing financial crisis, the larger the scale of bailout
operations, and higher and longer the inflationary episode.
Bailouts socialize private losses that have resulted from speculative booms. By
acting as a lender of last resort and re-inflating the economy in order to
support banks to stay afloat and prevent a debt deflation, the Fed is making
the public pay for errors it did not make and sustain the high salaries of
bankers and financiers. In other words, the homeless, by consuming much less
food, are paying for the lavish salaries of bankers and financiers and for the
gains reaped by speculators during a speculative boom.
Massive bailouts have always caused rapid inflation, yet those operations have
been afforded the highest priority, regardless of their inflationary and
exchange rate impact. At best, the Fed has been expressing its strong stand
against inflation, words that are not backed by action to stem the huge cost in
terms of loss of real incomes and protracted period of sluggish growth and
The lessons of history
The US as well as Western Europe enjoyed a period of financial stability,
robust banking system and price stability during 1946-1966, when central banks
adhered to monetary conservatism following the trauma of the Great Depression
and the financial chaos of the 1930s.
This period of financial tranquility was succeeded by a period of growing
financial instability, frequent bailouts and chronic inflation, including the
great inflationary episode of the 1970s. Explanations for the recent financial
crisis have attributed the crisis to the growing complexity of the financial
system and increasing number of financial innovations, including
securitization, and to the delay in strengthening the regulatory framework to
preserve the soundness of financial institutions in an evolving environment.
According to these explanations, the gap between rapid financial innovations
and the regulatory framework has led to high leverage and Ponzi finance and
therefore to the recent massive bailout operations.
While these explanations may be plausible and there is a need for strong
regulatory power, the root causes of recurrent instability do not fall at the
doorstep of financial intermediaries. There are always isolated cases of bank
failures or foreclosures and the responsibility could be idiosyncratic;
however, when a massive financial crisis erupts and millions of foreclosures
are taking place, the responsibility falls primarily on the shoulder of the
It is not advisable to keep re-inventing the wheel. Elementary textbooks teach
undergraduate students how banks create loans from bank reserves and the
functioning of the credit multiplier. When banks are flooded with reserves,
they compete to extend loans; the lower the value of liquidity for banks, the
more risk they take. The central bank, in any country, could increase reserve
requirements, or could act through the discount window, open market operations,
and other means to keep credit in check.
When the central bank keeps pumping liquidity to maintain low interest rates
and therefore pushing banks toward taking higher risk, the blame should not
fall on the banking system or on financial innovations, but it should fall
directly on the central bank.
The financial stability that prevailed during 1946-1966 and the recurrent
financial instability from 1966 onwards should be contrasted with the Fed's
procedures during these two periods.
During the first period, the Fed was controlling banks' reserves and money
aggregates, mainly through the discount window, and had direct relations,
through its district banks, with member banks to detect risks to the financial
system early on. Starting in the mid-1960s, the Fed was targeting the federal
funds rate, relying essentially on open market operations to achieve target
interest rates, and entrusted most of the operations to the New York Fed. It
has narrowed the role of the Fed district banks and has reduced direct contacts
with member banks, except when lending as a lender of last resort.
Interest rate setting had been sharply criticized and was seen as distortionary
and conducive to instability. The setting of interest rates at low levels
during 1927-1929 led to fast economic growth and a speculative boom in housing
and stock markets, which resulted in the Great Depression. Similarly, the
setting of interest rates at negative real terms during 2001-2008 led to rapid
economic growth and housing and commodities booms.
For any given interest rate set by the central bank, financial intermediaries'
demand for reserves can be unlimited. Unless strict quantitative limits are
imposed by the central bank, financial intermediaries will be prone to expand
their liabilities and assets beyond safety margins. In these conditions, even a
strong regulatory framework would not prevent a financial crisis when a boom
comes to an end.
Regulate the regulator
The sensible and time-tested policy is to regulate the regulator. This is even
more urgent today than adapting the regulatory framework or arresting mortgage
borrowers and lenders or for that matter anything else. It is essential that a
central bank be bound by strict rules for managing the money supply, a
well-defined mandate, and not be entirely left to its own discretionary whims.
Although the Fed is an independent institution, such independence has conferred
absolute powers to its chairman and governors. De facto, the Fed's
discretionary power has caused an inherent financial instability. No one knows
what the Fed's move will be in the near or medium-term. It is uncertainty
surrounded by personal and political pressures.
If the Fed remains unaccountable for its erroneous policies, which has led to a
full-blown financial and banking crisis, millions of foreclosures, and
dangerous inflationary pressures, then the social and economic cost will be
very high. Besides eroding real incomes and pushing millions of people to
malnutrition and even starvation, these policies have already undermined the
foundation for growth in the US economy and have created recurrent financial
While many Wall Street economists and bankers, understandably and for personal
gain, applaud the Fed's bailouts and claim that the worst is over for financial
institutions, the worst is still to come for the real economy and the working
classes who will suffer an endless and costly inflationary episode. If the US
Congress remains unaware about regulating the Fed and bringing it to the realm
of orthodox, transparent and fully stable banking practices, the cost for US
economy, and the world at large, will be immeasurable.
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.