The G-8 ignores basics
By Hossein Askari and Noureddine Krichene
In the wake of earlier summits dealing with rampant food and energy inflation,
the Group of Eight (G-8) Hokkaido meeting in Japan last week was yet another
setback as leaders of eight industrial countries, disappointingly, stated that
they were powerless with respect to runaway oil prices. All that they could do
was to urge oil producers to increase output and rely on new technologies to
curtail oil consumption.
Such a declaration can only usher in the worsening of food and energy price
inflation, a faster decline in real incomes for wage earners and retirees, and
more hardship for the poor around the world. Runaway prices for oil and food,
as well as for many other
commodities (gold, iron, copper, platinum to name but a few), combined with a
collapsing US dollar, are purely a monetary phenomena.
Oil production has risen considerably in the past seven years, from 77 million
barrels per day (mbd) in 2001 to 87 mbd this year, large enough to cause a
decline in oil prices under stable demand conditions; yet oil prices climbed
sixfold, from US$24 per barrel in 2001 to $145 per barrel in 2008 and the US
dollar fell from $0.84 to the euro in 2001 to $1.6 per euro in 2008. There is
only one explanation for such a dramatic rise in oil prices and the collapse in
the value of the dollar: a rapid increase in money supply and credit.
Novices, politicians and journalists wrongly put the blame on speculators, but
not on unlimited money creation. Futures markets have existed in some form for
the past 150 years, yet speculators were not able in the 1950s , 1960s, 1970s,
1980s or even the 1990s to propel oil or commodities prices beyond underlying
market fundamentals.
Why should speculators have become more powerful now than they had been in the
past? Why were speculators impotent in preventing oil market crashes in 1985
and 1998 when prices tumbled to $9 per barrel? The more central banks inject
liquidities, the faster money supply and credit grow, the more excess
liquidities have to be dispensed with, and higher prices will rise. This very
simple monetary theory should not have eluded the G-8 leaders.
The Hokkaido summit should have urged central banks around the world,
especially the US Federal Reserve, to rein in overly expansionary monetary
policy as this is the most pressing requirement for stabilizing food and oil
prices and paving the ground for a non-inflationary and stable economic growth.
Only by restoring monetary discipline and setting strict ceilings on respective
money and credit aggregates can we hope to stabilize prices.
There is no inflationary experience in the past that did not end without
applying the money brakes and contracting monetary and credit growth. Only by
abandoning interest rate setting and swiftly controlling monetary aggregates
can inflation be subdued. That is how Paul Volcker when US Federal Reserve
chairman was able to arrest the stagflation of the 1970s. By following their
own domestic priorities, beggar-thy-neighbor policy, and competitive
devaluation, the G-8 leaders have deliberately sidestepped the true cause for
oil and food price inflation and decided instead to pursue destabilizing cheap
money policies, irrespective of the dangers that such policies pose for the
world economy.
The monetary character of the present financial crisis and rampant inflation
have been underlined by many eminent figures. George Soros, in his 2008 book The
New Paradigm, considered the present financial crisis as the worst
since the 1930s and attributed it to the Fed's overly expansionary policy since
2000, with interest rates at lowest levels in half century, and real interest
rates becoming largely negative.
He wrote: "Cheap money engendered a housing bubble, an explosion of leveraged
buyouts, and other excesses. When money is free, the rational lender will keep
on lending until there is no one else to lend to. Credit safety standards have
been relaxed and monumental loans went to subprime borrowers."
In the same vein, Theodore J Forstmann, in a recent article in Wall Street
Journal (July 5, 2008), titled "The Credit Crisis is Going to Get Worse",
attributed the present crisis to over money supply by the Fed since 2001,
noting that the Fed pumped so much money into the financial system that it
distorted the incentives and the decision-making of everyone in finance.
When real interest rates are negative, borrowing money is effectively free -
the debt loses value faster than the interest adds up. When money becomes too
plentiful, bankers and other financial intermediaries end up taking on more and
more risk for less return. Contending that there was no other episode in the
history of the US during which money was ever this inexpensive, he indicated
that the creation of too much money caused all kinds of excesses and was
responsible for the worst financial instability in the post-World War II
period.
While the G-8 Summit in Hokkaido was underway, Fed chairman Ben Bernanke
reassured the financial system of the Fed's continuing availability of bailout
money. Bernanke was certainly ignoring the plight of millions of people, oil
prices, or the value of the dollar. His twin objective is to finance Wall
Street and the US budget deficit.
By injecting billions of dollars in bailout money since August 2007, Bernanke
has not created any additional oil, corn, or rice; he only put more flames into
the oil and food markets, sending oil prices racing from $65 per barrel to $145
per barrel and the dollar tumbling from $1.27 per euro to $1.6 per euro. Corn
and rice prices rose two-fold, triggering waves of food riots.
Bailout money, besides increasing moral hazard, is highly inflationary,
imposing a heavy tax burden on cash holders, creditors, retirees and workers,
and socializing the losses of unsafe banking. It is an abhorrent form of social
injustice because of its tax burden and impoverishment effects. It punishes the
public for errors the public did not make.
Certainly, Bernanke does not want to be remembered as liquidationist of the
financial system; however, by cutting real incomes, he will be remembered as a
liquidationist of millions of retirees, workers and vulnerable groups, as cheap
money policy was carried while he was chairman of the Counsel of Economic
Advisors and as Fed chairman.
The sharp contrast between Bernanke's cheap-money policy for fiscal deficit
financing and bailout and his strong words against inflation and currency
depreciation makes the Fed chairman the most ambivalent and least transparent
of all previous Fed chairmen. Absence of consistency between his policy and
words creates more uncertainty and disorder in foreign exchange, commodities
and financial markets.
The setting of interest rates by central banks, or what is known now as
Taylor's rule (designed to adjust rates to stabilize the economy in the short
term and maintain long-term growth), has been severely criticized, and
continues to be an unsafe monetary policy rule which confers absolute and
arbitrary powers to the central bank, and is totally in contradiction with the
mandate of a central bank: to manage safely liquidity and not to control prices
or the economy at large.
An interest rate is a price, like many other prices. Fixing any price in the
economy will create distortions and cause inefficiencies. The fixing of
interest rates at negative levels by the Fed in the past seven years has
contributed to the housing boom, followed by the meltdown of subprime loans,
financial crisis, faltering Bearn Stearns, Fannie Mae and Freddie Mac, and many
other financial institutions, and explosive inflation in oil and energy prices.
Consider the yield of a six-month treasury bill; it is 2.074% per year in July
2008. Compare it with the return from oil futures. With oil prices climbing
from $65 per barrel in August 2007 to $145 per barrel in July 2008, the annual
return on oil has been 122%. Fantastic annual yields and hedges exist in gold,
copper, corn, rice, soybeans and so forth. Such a difference in yields,
combined with unmistakably upward trends due to cheap monetary policy, will
entice more institutional investors and speculators to invest in commodities
markets and hedge their incomes and assets against inflation.
Only when yields are close in yield will investors seek traditional investments
in the form of securities and bonds. By fixing interest rates at low levels,
the Fed has forced traders and investors to seek income opportunities in freer
and more predictable speculative markets. This is the fundamental notion of
parallel markets, or smuggling of commodities across borders from low- to
high-price countries.
Bernanke's stated goal for aggressive low interest rates is the same as
Greenspan's: boost economic growth, restart a new housing bubble, and support
government bonds prices. Do low interest rates always succeed in boosting real
economic growth? The answer is "no" when the economy is low on gas.
It would be unfair to say that low interest rates and abundant credit do not
stimulate the economy. They did stimulate economic growth under Greenspan's
tenure and even caused the asset price bubble. They were the driving force of
reputed speculative booms, including the 1929 stock market boom. In 1933,
renowned economist Irving Fisher argued that only over-indebtedness followed by
deflation could bring dramatic booms and traumatic contractions. He strongly
ruled out any real shock as a source of major fluctuation in the economy. The
boom phase is limited to a short period as long as real interest rates remain
positive.
But as soon as inflation is unleashed and real interest rates become negative,
low interest rates become a drag on the economy. The boom phase is followed by
a prolonged recession or even a depression.
Often, real-income gains during the boom phase are wiped out during the bust
phase. Such was the case during the 1929-1933 Great Depression. Dramatic losses
in real incomes could not be recovered by 1939. Similarly, gains in the 1060s
were significantly wiped out in the 1970s. Currently, gains in real incomes
enjoyed in the 1990s are being rapidly eroded with skyrocketing food and energy
inflation. If cheap money succeeds, Zimbabwe, with is 100,000% annual
inflation, would be most prosperous economy in the world!
Assume the central bank decides to peg interest rates at 2% for the next 20
years. Ask what will happen to real economic growth? To reinforce the peg, the
central bank has to supply any amount of liquidity to prevent interest rates
from rising above 2%. The inflationary aspect of this inflation has been
extensively analyzed using the quantity theory of money.
On the demand side for loans, borrowing can be unlimited. The government will
continue its deficit financing by issuing public debt; private borrowers will
be eager to get more loans at negative real interest rates.
The problem is the supply side of loanable funds. Consider the present subprime
crisis, which was the tragic result of low interest rates. At present, sound
lenders will not buy impaired assets or extend loans to subprime borrowers.
Moreover, a depreciating currency and negative real returns will step up
capital flight, and make foreigners less willing to finance an external current
account deficit. Fearing a sharp drop in bond prices, bankers and institutional
investors will try to hold fewer bonds creating a liquidity trap.
Savers, facing negative real returns, will be inclined to save less. Fiscal
deficit financing, stimulus packages and abundant liquidities will step up
consumption of consumer goods and therefore reduce considerably the amount of
savings, defined as consumer goods available for workers in investment or
capital goods sector. As savings keep dwindling, inflation aggravates, food
prices explode. Inflation severely deflates real output.
The upshot is that the economy will have lower savings and consequently less
investment. In view of the Harrod-Domar growth model, which stipulates that
economic growth rate is a function of the investment rate, lower investment
will yield low or negative economic growth. Hence, over the long run, the
economy will be forced on a downward trail. Such has been the history of
inflationary economies.
Can Bernanke re-stimulate the US economy with low interest rates in the present
subprime crisis? The answer is that it is now a little too late. His unwise
cheap money policy since 2007, aimed at re-inflating the economy and boosting
house prices, has needlessly precipitated the economy towards stagflation,
accompanied by unbearable food and energy inflation. In view of monetization of
large fiscal deficits and unrestricted credit policy, the specter of the
highest inflation in US history and in the world economy has become a real
possibility.
The G-8 leaders in Hokkaido deliberately swept crucial money matters under the
rug. Only stable monetary policy based on orthodox central banking practices,
consisting of controlling money and credit aggregates and renouncing interest
rate fixing, can uproot inflationary expectations in food, oil and other
commodity markets.
How far may interest rates have to rise to rein in inflation? There is the
lesson of history. The federal funds rate shot up to 19% in 1981 when Paul
Volcker decided to control money supply. By forcing the federal rate at 2%,
Bernanke was only fooling the public when he voiced strong words against
inflation and the dollar's depreciation.
What we have in store after the G-8 failure are large fiscal deficits and
Bernanke's super expansionary policy: oil prices will continue to race upwards,
food will become unaffordable for the poor, the dollar will continue its fall
(and may indeed collapse if foreigners stop financing the US current account
deficit), and broader inflation will reduce the living standards of all except
the super rich.
The next US president will have to be another Franklin Roosevelt to clean up a
huge economic and financial mess and prevent economic and social collapse.
While enhancing regulation of financial institutions has correctly become a
crucial issue, the US Congress will also have to learn that restricting the
powers of the Fed and regulating central banking is an equally important issue
in preventing future financial instability and devastating economic hardship.
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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