Page 2 of 2 Danger - Ben and Henry at work
By Hossein Askari and Noureddine Krichene
subsidize banks, more specifically the speculative component of bank practices
that has no direct bearing on investment and growth. Besides increasing
distributive injustice, such spending is non-productive and yields no social
benefit to taxpayers and to the broader economy in the form of health,
education and infrastructure.
It is absurd to have the government (ultimately the taxpayer) pay for the
speculative losses of banks and hedge funds. Had banks invested wisely in
productive activities they would not have faced their current problems of
frozen speculative assets. In the case of hedge funds it is even more galling
in that their billionaire executives pay a lower tax rate than do their
secretaries! Will
these funds now use the taxpayers' money to lobby Congress for continued, or
even enhanced, tax preferences?
Let's not forget that the current financial disorder stems in part from the
Fed's over-expansionary policy and the monetization of large fiscal deficits,
and inadequate regulation and supervision of financial institutions.
Speculative credit has expanded at dangerous rates at the expense of credit
worthiness. Securitization has absorbed ever-increasing liquidity injected by
the Fed to keep interest rates very low.
Economists have often argued that excessive credit can cause financial disorder
and may result in financial dislocation as many borrowers will simply default
both at the government (for example, developing countries) and private sector
level. The policy mistakes of the Fed are too numerous and carry severe
implications. Besides following too cheap a monetary policy that led to the
credit boom, the Fed under Bernanke has persisted with the same policy,
propelling speculation in commodities and assets markets and undermining
financial stability. At the same time, the Fed did not pursue adequate
supervision of financial institutions.
The most enlightened understanding of the present crisis and its solution comes
from the maverick Congressman Ron Paul. To quote him:
Unfortunately,
the government's preferred solution to the crisis is the very thing that got us
into this mess in the first place: government intervention. �This
lowering of prices (ie, home prices) brings the economy back into balance,
equalizing supply and demand. This economic adjustment means, however, that
there are some winners - in this case, those who can again find affordable
housing without the need for creative mortgage products, and some losers -
builders and other sectors connected to real estate that suffer setbacks.
The government doesn't like this, however, and undertakes measures to keep
prices artificially inflated. This was why the Great Depression was as long and
drawn out in this country as it was. I am afraid that policymakers today have
not learned the lesson that prices must adjust to economic reality. The bailout
of Fannie and Freddie, the purchase of AIG, and the latest multi-hundred
billion dollar Treasury scheme all have one thing in common: they seek to
prevent the liquidation of bad debt and worthless assets at market prices, and
instead try to prop up those markets and keep those assets trading at prices
far in excess of what any buyer would be willing to pay.
There
is no easy way out of the mess the Fed has created. The proposed bailout - or
whatever it takes when it eventually secures Congress backing - will only
aggravate the financial crisis. The Fed's attempt to prevent highly inflated
speculative prices from adjusting to market fundamentals has disrupted
financial markets and created more disorder in the banking sector.
By lowering interest rates and injecting massive liquidity with a view to
re-inflating already high home prices, Bernanke has brought economic growth to
a halt and on a declining trend from here on, undermined the dollar,
destabilized food and oil markets, disrupted the airline industry and brought
the US and world economy to a long-term slowdown. Highly expansionary monetary
policy is only setting the ground for an even more severe credit crisis,
nationally and internationally.
Financial sector crises are not a novelty, and no single country has been
immune to them. Approaches to solving these crises are classical.
Responsibility of the financial sector falls under the central bank
jurisdiction. Depositors are usually covered under the Federal Deposit
Insurance Corporation. Failing banks have to be audited, on a case by case
basis, and the root cause of their difficulties must be properly assessed.
Solutions should be bank-specific.
Besides rediscounting safe assets, solutions may involve reinforcing contracts
and recovering impaired assets through legal means, making provisions against
losses, increasing the capital base and reducing costs. If financial
difficulties are not solvable, they will go through judiciary liquidation. The
disappearance of a bank or of a number of banks does not mean the disappearance
of the financial system. Extending unlimited subsidies to speculative banks is
not the way to solve a financial crisis.
Paulson and Bernanke should allow the price mechanism to operate more freely to
find its long-term equilibrium. They should remember that a credit boom has to
be followed by a temporary recession. Their present course of overloading the
government with intoxicated speculative debt, undertaking massive bailouts and
blowing up the fiscal deficits to unbearable levels will only undermine further
macroeconomic stability, turn present inflationary pressure out of control and
heighten social discontent. Soon their successors will face the same realities.
The option of doing nothing is far better and safer for taxpayers and American
families than adopting Paulson and Bernanke's inequitable plan to save
speculative bankers while the house burns.
Most ominous is how the Paulson/Bernanke approach will play out on the world
stage in the months to come. Will the rest of the world finance America's
exploding deficits? Will the US economy contract into a double digit and
prolonged recession if global financing is not forthcoming? Will the dollar go
into a freefall? Will cross-border flows of capital remain relatively stable?
These are the questions that are likely to haunt us in the days to come.
But one thing is absolutely clear. The United States has consumed beyond its
means for far too long. It has borrowed from the rest of the world (running
current account deficits) and has used this borrowed money to finance
consumption and not investment. If the rest of the world decides that it is
time to stop throwing good money after bad money, then we are in for a severe
and prolonged recession, a recession that will also significantly affect global
prosperity.
Where do we go from here? We are in somewhat unchartered territory. The US
president and congressional leaders have been unable to deliver a bill that
they have touted. Stock markets around the world have plummeted. Financial
experts and economists cannot agree what will follow. US elections are only
five weeks away. Politicians may dislike the bailout but how can they go home
to campaign with financial markets and the economy in such a disarray?
A modified bill, with the purchase of debt largely replaced by a much smaller
equity participation by the federal government, will probably come back to the
House. It is sad that this whole process was fueled by scare tactics and not by
thoughtful analysis over the last few months. But here we are and some form of
a bailout is all that politicians have to hang their hats on.
For historians, the real innovation in Paulson and Bernanke's approach, both
toward political Washington and the US public, may have been to act as chicken
littles and try to frighten US savers, retirees and politicians (who want to
get elected or re-elected) into submission by shouting that the sky is falling.
If this legacy gains traction and becomes the way of doing business in
Washington, heaven help us all from the falling sky!
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. (Copyright 2008 Asia Times Online (Holdings)
Ltd. All rights reserved. Please contact us about
sales, syndication and
republishing.)
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