Page 2 of 2 Paulson plan throws oil on fire
By Hossein Askari and Noureddine Krichene
economies will be seriously affected. Furthermore, as recent experience has
shown, substantial dollar depreciation will cause dangerous commodity price
inflation. With the expected MFI-induced dollar depreciation, energy prices can
rebound to exorbitant levels, accentuating further inflation and undermining
economic growth.
All of this cannot but impair
the global financial and economic reputation of
the US. Just in a matter of days the dollar has declined from
$1.39 to $1.48 to the euro, oil has climbed from $90 to over $120 (at one point
rising by more than $20 in one day, September 22) and gold has jumped from $750
per ounce to over $900 .
The declining value of the dollar will adversely affect the value of
foreign holdings in the US. China Investment Corporation (CIC) and a number of
other sovereign wealth funds are major stakeholders in US financial and
non-financial sectors, as holders of US government securities, debt of Fannie
Mae and Freddie Mac, and owners of manufacturing companies.
Asia and Persian Gulf oil exporters will no longer continue to trust the United
States with their money. Financial trust, a needed but already a rare commodity
in finance, will evaporate. Countries will withdraw from participating in the
global financial system and autarchy will once again raise its ugly head.
Moreover, oil exporters with large financial surpluses, Kuwait, Qatar, Saudi
Arabia and the United Arab Emirates, may cut back their oil exports. Why would
they want to sell their depleting oil reserves for worthless paper?
It is unfortunate to see that both presidential candidates rushed to support
the MFI plan, as did most of the political, academic and media circles. In
fact, very few politicians have paused to ascertain the implications of this
institution, as they do not want to take any blame for delaying the rush to
create MFI.
Among
the few
that have paused and considered, the maverick congressman Ron Paul expressed distrust
in the MFI plan, and understood its far-reaching dangers and ability to make
the financial crisis worse and escalate further into unmanageable economic and
financial dimensions.
Paul rightly expressed concern about its systemic potential damage to public
finance, economy, and the dollar. He emphatically objected to the Fed's fixing
of interest rates and to its interference with market prices to prevent an
orderly adjustment of housing prices to economic fundamentals represented by
household income and the average cost of houses. He strongly opposed buying
illiquid and unworthy assets by the government and suggested market solutions
to the crisis, consisting essentially of recapitalization of banks by own
shareholders and strengthening of prudential safeguards.
The Fed’s actions in coping with the present financial crisis, which it created
through cheap monetary policy during 2001-2008 and monetization of large fiscal
deficits, have been so far characterized by stampede, confusion, and excess.
Not a single action since August 2007 was based on full understanding of the
underlying problem and none of its impacts were properly assessed. There was no
comprehensive assessment of the financial sector soundness, and no evidence for
systemic risk was established.
Except for investment banks that were involved in speculative hedge funds and
credit derivatives, the commercial banking system remains largely salvageable.
As evident, most of the Fed's actions were made at behest of Wall Street and
were not warranted by the ample liquidity of the banking system and fast growth
of credit since 2001; bank credit continued to expand at very high rate of 12%
per year during 2001-2008, implying absence of any credit freeze for the
economy at large. Most notorious was the cutting of the federal funds rate from
5.5% to 2%, which was highly applauded by bankers, politicians, and
academicians, yet failed to stimulate the economy.
Similarly, massive injection of liquidities since August 2007 and the
facilities put by the Fed to lend to the banking system have allowed banks to
pour money into speculative oil, food, and other commodities markets; they
aggravated food inflation, disrupted transports sector, slowed down economic
growth, and pushed unemployment to 6.1%.
For now, if Paulson and Bernanke were correct in their assessment of systemic
risk, then a preferred vehicle to addressing the short-term problem would be to
invest in any viable institution (note not all institutions) in return for
ownership. Capital can be injected into otherwise sound institutions based on
some agreed share price (average of recent market prices) with the option for
the institution to buy back these shares at an agreed upon price and at some
future date.
At the same time, the Treasury, or the institution created to oversee such
public investments, must put limits on executive pay and bonuses in these
publicly supported financial institutions. This approach would at least afford
taxpayers something for their investment and limit corporate excesses. At the
same time, for such a plan to succeed at the global level, the US should
coordinate its actions with other major economic powers; if not, impaired banks
outside of the US will adversely affect the fragile US financial system.
For the longer term, the lesson is that mistakes cannot be fixed by more
mistakes. Fundamental solutions were proposed by eminent writers including
Milton Friedman, Maurice Allais, Irving Fisher, Henry Simons, Paul Volcker, and
may others. They decidedly advocated reforms at the central banking level and
at the regulatory level.
At the central banking level, it is important to reduce discretionary power of
central bank chiefs and to put in place fixed rules and predictable and stable
monetary framework. The so-called interest rate rule has turned out to be most
destabilizing. Only by controlling money and credit aggregates can central bank
restore financial stability. Monetary policy should be freed; it should not
become a tool for serving interest groups, as it is now, through large bailouts
and discretionary fixing of interest rates. It is worse when fiscal policy, as
under the MFI, combines with monetary policy to serve interest groups.
At the regulatory level, financial enterprises are granted the privilege, and
not the right, to practice banking and financial intermediation. Their license
should be revocable if they indulge in unsafe banking. This implies that many
financial innovations and contracts, specifically those which are not fully
understood by regulators and customers, should not be allowed. Speculation
should be strictly controlled both in stock, commodities, and housing markets;
its main cause, namely excessive and uncontrolled credit expansion should be
eliminated. Without fundamental reforms, financial instability is here to stay
and economic agony will persist.
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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