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     Jul 15, 2008
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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