Monetary despotism
By Hossein Askari and Noureddine Krichene
The combined recent liquidity injection by Western central banks could exceed
US$4 trillion, yet that vast amount has created nothing real, not even one
grain of corn.
To summarize, continental Europeans a week ago, on October 13, following the
British plan for UK bank recapitalization, unveiled a plan requiring $2.55
trillion to recapitalize their banks, at the same time promising unlimited
dollar funding in coordinated action with the US Federal Reserve.
The Fed, meanwhile, has injected $1.3 trillion in liquidity into the banking
system and has decided to bypass banks and extend directly lending to
borrowers. These sums certainly dwarf the
$700 billion Troubled Assets Relief Plan (TARP) of US Treasury Secretary Henry
Paulson and Federal Reserve chairman Ben Bernanke. If recent bailouts and
liquidity injection are added together, the price tag could easily amount to
70% of US gross domestic product in 2008.
Certainly, Western central banks have not injected this much in real gross
domestic product, that is, in millions of tons of commodities (rice, corn,
milk, oil, vegetables, clothing). If they had done so, their action would have
been most beneficial. They have only created money out of nothing. Some call it
legal robbery, others call legal counterfeiting.
Their action has amounted only to a redistribution of real GDP and real wealth
among two groups: the winners (bankers, debtors) and the losers (workers,
taxpayers, pensioners, creditors). How will this redistribution take place? The
answer is forced inflation.
Bailouts schemes on such a scale have no precedent. They are the outcome of
cheap money policy followed in the past decade and the sophisticated
speculation, call it financial engineering or exotic finance, which developed
complex derivatives, proliferating fictitious credit to gain abnormal returns.
The speculative exponentiation of fictitious assets on the top of each other
has made most banks over leveraged in ratios of 1 to 40. In a credit system
devoid of securitization, the credit multiplier is finite and cannot exceed six
or seven. In a system with securitization, the credit multiplier is
theoretically infinite and in practice could reach 50. Certainly, these giant
bailouts have changed the rules of the game. Speculators, that is asset funds
managers, are now secured by central banks; it is a case of if heads, they win;
if tails, taxpayers loose.
The credit to be bailed out, or, if you will, the capital to be recapitalized,
is not money that has been channeled to agriculture, industry, commerce, or
infrastructure. These sectors rely on long-term capital, financed essentially
through equities, or corporate, government or municipal bonds. All productive
loans are fully performing and have negligible default.
All the bailouts by central banks and governments are purely for replacing
losses of short-term speculative capital that has caused the present financial
trauma. Only speculative capital causes financial instability; such was indeed
the cause of the Great Depression, brought about by default on speculative
loans in stock markets. The bailouts are primarily intended to write off bad
debts, so that borrowers can walk free of their debt obligations and enjoy the
wealth they had acquired earlier on.
Of course, in this new system of free lunch, everyone would like to become a
borrower, as borrowing is the easiest way for acquiring free wealth in form of
houses, cars, stocks, appliances and goods. Bailouts are meant to replenish
liquidity of asset funds (such as hedge funds, equity funds and so forth) so
their skilled managers can keep inventing complex products and earning high
financial profits. Bailouts are also intended to buy intoxicated assets
(identified in the alphabet soup of MBSs, CDSs, CDOs, and so on). Being free
money, some of this money will be used for celebration and retreats in
luxurious hotels.
The banking and political establishment would have us believe that these
bailouts are meant to save the banking system and allow the economy to borrow,
credit markets to unfreeze, and economic prosperity to prevail.
Academics, media and politicians have welcomed with applause the
recapitalization of banks. Many have already declared victory, saying the worst
is over and the crisis, thanks to this giant recapitalization, is fully
resolved. Markets rebounded on the first day in a most spectacular way. Of
course, and to be expected, the market then gave up more than its gain in the
next two trading days. However, the biggest surprise was that banks unanimously
rejected recapitalization but were forced to sign on. They wanted the TARP.
This again shows that policy making is in a vacuum of factual data, sound
economic analysis, and only follows political pressure or market hiccups.
Economic uncertainty has never been as high. Has the crisis been correctly
tackled or has it only been made worse? In view of incredibly huge liquidity
injection by major central banks, has money supply become out of control? In
view of the incredibly huge bailouts and recapitalization by governments, how
will the fiscal deficit will be financed? How long will the crisis last? Which
sectors and countries will it affect? What will be its impact on growth and
employment? What will be its fiscal and inflationary cost? Will inflation
finally run out of control? How soon will another, and far bigger, come due
once speculation resurges again? What will be the social consequences among
workers?
Western central banks and political leaders, like ostriches, have decided to
ignore these questions and perpetuate their misguided policies.
While precise answers to these crucial questions are not possible, it is quite
irresponsible not to assess the implications of such monumental bailouts.
Absent economic modeling, assessing the macroeconomic consequences of these
gigantic bailouts over the short-and-medium-term can only be based on economic
theory, extrapolation of recent trends, and empirical experience.
Many scenarios of economic and social chaos are possible, with intensity and
duration that cannot easily be predicted. The most feared scenario would be
forcefully maintaining unsustainable and overly expansionary fiscal and
monetary policies that will rapidly erode real savings and investment, and
ignite a runaway inflation and unemployment.
This scenario will be in essence similar to Bernanke's aggressive expansionary
policy since August 2007, which set off speculation in commodities markets,
triggering food riots and sending food and energy prices to levels that finally
disrupted transport sectors, brought world economic growth to a remarkable
slowdown and triggered rising unemployment.
Under this scenario, fiscal deficits will soar to unprecedented levels, public
debt will rise rapidly, real savings and investment will decline, external
deficits will widen, currency will depreciate, real incomes of workers will
fall sharply, and real spending will sharply decline, causing unemployment to
increase even more rapidly.
As under former Fed chairman Alan Greenspan's credit boom, overabundance of
liquidity combined with negative real interest does not help productive
sectors; it only fuels speculation by asset funds, Ponzi financing, and
deteriorating creditworthiness. Speculators will take advantage again of real
negative interest rates and abundant liquidity to re-engage in asset and
commodities speculation.
On October 11, the Group of Seven leading industrialized nations stated in a
communique that "Crisis Requires Urgent and Exceptional Action. We agree to:
Take decisive action and use all available tools to support systemically
important financial institutions and prevent their failure. Take all necessary
steps to unfreeze credit and money markets and ensure that banks and other
financial institutions have broad access to liquidity and funding. The actions
should be taken in ways that protect taxpayers and avoid potentially damaging
effects on other countries. We will use macroeconomic policy tools as necessary
and appropriate."
However, in of spite their declaration, Western central banks continue to
reject adamantly the most important tools for stabilizing monetary policy, and
only want to perpetuate, at any cost for the economy, the unsustainable
monetary policy that brought about the present financial and fiscal chaos.
It is not understood why Western central banks insist on a cheap money policy
and on forcing negative real interest rates, despite the disastrous
consequences. Bernanke wants to solve the financial crisis by still reducing
the federal funds rate from its present 1.5%. What did he achieve with previous
cuts? In an environment where many leading banks are overly leveraged and their
assets are impaired, is 1.5% an equilibrium rate for interbank loans? Although
the market mechanism is disrupted, could the equilibrium rate be 20% or 30%
instead of 1.5%?
The only plausible explanation for such negative real interest rates and
massive bailouts is to force speculative losses on taxpayers and workers. Banks
are forced into a loss-making situation under the threat of nationalization.
The US and the European economies are recognized as the world's most advanced.
Unfortunately, they have in the past decade suffered from central banking
despotism. Greenspan ignored criticism for bailing out hedge funds such as LTCM
as well as warnings regarding housing speculation. Bernanke and Paulson have
only been aggravating financial instability and crippling economic growth.
An economy cannot operate optimally or grow with such immense price distortions
or inflationary price pressure. The G-7 has to have a coordinated approach for
reining in money supply, re-introducing money and credit targets, and totally
freeing interest rates and housing prices. The faster an economy returns to
equilibrium prices, the faster recovery will be. In a context of
supply-oriented and employment-promoting strategy, credit has to be selectively
oriented to productive sectors and much less to speculation. The health of each
bank has to be dealt on a case-by-case basis and over a long span of time.
The credit crunch appeared only in speculative financing. If recapitalization
is used to fuel speculative credit, then it will be too damaging for economic
growth, as seen in the past year. The answer to the present crisis is how to
reduce the speculative component of credit without reducing the circulating
media (that is, protecting deposits) and how to reallocate credit to
non-speculative and growth-generating sectors. These aspects have not been
addressed by Western central banks.
It would appear that the Fed and the European central banks have not learned
the real lessons of the Great Depression. But they had better start soon.
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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