Page 1 of 2 Bernanke blighted by tunnel vision
By Hossein Askari and Noureddine Krichene
United States Federal Reserve chairman Ben Bernanke on July 16 presented yet
another myopic testimony before the House of Representatives Committee on
Financial Services. He reported on setbacks since his previous testimonies of
July 2007 and February this year: a failing financial system, an economic
slump, and abhorrent and paralyzing energy and food inflation.
Like his predecessor Alan Greenspan, Bernanke squarely placed the blame for the
growth in total market credit (rising from 280% of gross domestic product in
2000 to 349% and increasing at the rate of 11.6% a year during 2008) on
speculators and securitization and not on the Fed's overly loose monetary
policy. And, like Greenspan before him, Bernanke took no responsibility
for the unfolding economic and financial crisis.
Besides ignoring any direct link between his ill-advised re-inflationary
monetary policy and its devastating effects on the US economy and financial
system, Bernanke presented a wrong analysis of the causes of ongoing economic
slowdown, rising unemployment, and skyrocketing food and oil prices.
The Fed's excessive re-inflationary policy, aimed at forestalling millions of
foreclosures and paying for the phenomenal losses of financial institutions,
has so far cost the US one year of economic agony, stifling inflation, a
faltering currency, a collapsing financial system, and an inflationary tax
burden at the expense of retirees and workers. Even more ominous is the
ever-mounting future tax burden on average Americans, a burden that can be
directly linked to financial excesses of the past.
If the past is any indication for the future, Bernanke will almost certainly
replay the same testimony in February 2009, but with even gloomier prospects.
While Bernanke and the Fed's Federal Open Market Committee (FOMC) were unable
to control the present downward forces through aggressive cuts in interest
rates, they still remain strongly convinced that they succeed in the future.
They will repeat the same policies and hope for different results the next
time.
The major causes for the US economic downturn, according to Bernanke, were
contraction in the housing sector, sizeable losses at financial institutions,
and rapid commodity price inflation. To quote:
The contraction in
housing activity that began in 2006 and the associated deterioration in
mortgage markets that became evident last year have led to sizable losses at
financial institutions and a sharp tightening in overall credit conditions. The
effects of the housing contraction and of the financial headwinds on spending
and economic activity have been compounded by rapid increases in the prices of
energy and other commodities, which have sapped household purchasing power even
as they have boosted inflation. Against this backdrop, economic activity has
advanced at a sluggish pace during the first half of this year [2008], while
inflation has remained elevated.
It should be needless to
remind chairman Bernanke that residential construction represents only about 3%
of US GDP and therefore cannot be a driving force in the economy; exports,
however, accounting for 14% of GDP, have expanded rapidly on account of a very
weak dollar, largely offsetting housing contraction. Furthermore, in view of
the large fiscal deficits, one should expect that there has been a strong
fiscal stimulus on real GDP.
Consequently, contraction in housing cannot by itself explain the sharp decline
in US economic growth, which decelerated abruptly from 5% per year in the
second quarter of 2007 to 1% per year in the first quarter 2008, while
unemployment rose from 4.6% in 2007 Q2 to 5.5% in 2008 Q2.
Indeed, August 2007 was the major turning point for the US economy. Prior to
that date, the US economy was growing at a healthy rate. Last August, the Fed
resumed an aggressive re-inflationary policy in a bid to reverse falling
housing prices and bailing out large falling banks. To quote Bernanke: "The
FOMC has responded aggressively to the weaker outlook for economic activity,
having reduced its target for the federal funds rate by 225 basis points since
last summer [2007]. The intent of those actions has been to help promote
moderate growth over time and to mitigate the risks to economic activity."
The Federal Funds rate was further lowered to its current 2%. Meanwhile,
Bernanke stepped up his policy of money creation "out of thin air" to finance a
huge and ever-growing fiscal deficit and to bailout large banks. Money supply
measured by MZM (money of zero maturity, an often-used measure of money stock)
expanded at an annual rate of 17% a year. These actions precipitated a sharp
fall of the dollar against major currencies and fired up oil and food prices to
the sky, triggering widespread protests over fuel prices and even food riots in
some disadvantaged countries.
It is simply disturbing that the Fed chairman did not see the pure monetary
aspects underlying the collapse of the dollar and the acceleration of already
high oil, food, gold, and other commodity price inflation. How could billions
of dollars created out of thin air and injected into the economy by the Fed not
affect prices? How would negative real interest rates affect investor
decisions, savings, and lending?
A general price increase can only be a monetary phenomenon. As higher general
price levels are accommodated by the central bank, inflation leads to a higher
money supply and becomes self-sustained. John Maynard Keynes explained that
when interest rates reach low levels, investors turn away from bonds, fearing a
collapse in bond prices when interest rates start rising (creating a liquidity
trap, or preference for liquidity).
Extremely low interest rates have created a flight to commodities in an
inflationary context. They would have created a flight toward liquidity if
commodity prices were depressed as they were during the Great Depression. A
counterfactual question should have been answered by the Fed’s economic model:
where would commodity prices have been if money supply had been restrained and
interest rates freed?
Bernanke's diagnosis of the economic slowdown was vague. In macroeconomics, one
cannot explain recent economic performance without invoking past macroeconomic
policies. he ignored the impact of the Fed's cheap money policy since 2001,
which forced real interest rates into a negative range for an extended period,
causing extraordinary growth of credit, a sharply falling dollar, declining
savings, huge external current account deficits, and commodity price inflation.
Moreover, Bernanke did not acknowledge the stagflation prevailing in the 1970s,
the fiscal deficits and the inflationary forces originating in the Vietnam War
that generated it, or the resulting decline in real GDP. The parallels between
stagflation in 1970s and the ongoing economic slowdown should not be dismissed.
Irving Fisher (1933) showed that only over-indebtedness and asset deflation
explain economic booms and contractions. It is a fact that the very low
interest rates engineered by the Fed since 2001 have caused over-expansion of
credit at an extraordinary rate of 11.6% a year. Combined with large fiscal
deficits, cheap money policy has fueled an era of strong demand-led economic
growth, causing external deficit to widen considerably to 7% of GDP in 2006; it
has exhausted savings, with personal savings falling quickly to zero and
national savings turning negative in 2007.
Because of abundant liquidities and dwindling savings, this economic growth was
inflationary all along, accompanied by rapidly rising commodity inflation, and
was to a great extent dependent on foreign financing of the large US external
(as measured by the current account) deficits.
The aggressive money relaxation since August 2007 has exacerbated ongoing
inflation and re-kindled inflationary expectations. Accelerating inflation of
food, energy, rent, utilities, health, and basic amenities prices has sharply
reduced real balances, eroded real wages, and re-switched demand from
non-essential spending to vital food, energy, and basic amenities spending.
Real consumption of food, itself, has been severely compressed. Suppliers of
commodities were induced to curtail supply as their expectations of rising
prices were fully met.
Very low interest rates discouraged savings and, by squeezing bank margins,
curtailed lending. Combined with the dollar
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