Bernanke's unenviable legacy By Hossein Askari and Noureddine Krichene
On the heels of successive interest cuts, US Federal Reserve chairman Ben
Bernanke continued his relentless monetary expansion on October 29 by reducing
the federal funds rate to 1%. He could have just as easily set the interest
rate to zero, since banks are obtaining liquidity with no collateral and
without limit from the Federal Reserve and are even paid an interest rate of
1.25% on their excess liquidity. Moreover, the Fed is bypassing banks and
lending directly at negligible interest rates to borrowers.
What is the rationale for Bernanke's latest interest rate cut? There may be two
explanations: his paranoia about the Great Depression, and to reverse an
impending economic recession and
promote a return to "moderate", not vigorous, economic growth.
The latter reason is clearly apparent in the Federal Open Market Committee
(FOMC) statement last week:
The pace of economic activity appears to
have slowed markedly, owing importantly to a decline in consumer expenditures.
Business equipment spending and industrial production have weakened in recent
months, and slowing economic activity in many foreign economies is damping the
prospects for US exports. Moreover, the intensification of financial market
turmoil is likely to exert additional restraint on spending, partly by further
reducing the ability of households and businesses to obtain credit. ... Recent
policy actions, including today's rate reduction, coordinated interest rate
cuts by central banks, extraordinary liquidity measures, and official steps to
strengthen financial systems, should help over time to improve credit
conditions and promote a return to moderate economic growth. ... The Committee
will monitor economic and financial developments carefully and will act as
needed to promote sustainable economic growth and price stability.
The contrast between this statement and FOMC's statement on August 7, 2007,
that is prior to the start of Bernanke's aggressive series of cuts in interest
rates, is striking: "The Federal Open Market Committee decided today to keep
its target for the federal funds rate at 5-1/4%. Economic growth was moderate
during the first half of the year. Financial markets have been volatile in
recent weeks, credit conditions have become tighter for some households and
businesses, and the housing correction is ongoing. Nevertheless, the economy
seems likely to continue to expand at a moderate pace over coming quarters,
supported by solid growth in employment and incomes and a robust global
economy. Readings on core inflation have improved modestly in recent months.
However, a sustained moderation in inflation pressures has yet to be
convincingly demonstrated. Moreover, the high level of resource utilization has
the potential to sustain those pressures."
Within a span of a year, Bernanke's policies have handcuffed US real gross
domestic product growth from 4.8% in the third quarter of 2007 to -0.3% in Q3
2008, depressing personal consumption expenditures from 2% in Q3 2007 to -3.1%
in Q3 2008, and gross private domestic investment from 3.5% to -1.9%.
His policies have pushed unemployment up from 4.7% in September 2007 to 6.1% in
August this year and helped bring down the world economy from strong growth to
a complete standstill in 2008, with GDP contracting in the UK, the euro zone,
and slowing down in Japan, China, and many emerging markets.
Bernanke's impetuous actions have destabilized the US financial system as well
as the financial system of other industrial and emerging market countries. By
opposing an orderly adjustment of housing prices and credit conditions,
Bernanke has devastated both the financial system and real economy, both in the
US and in the rest of the world, causing a freeze in capital markets and
precipitating the downfall of long established banks.
Two important counterfactual questions should be addressed? First, would the US
and world economies have maintained the solid growth enjoyed prior to the
crisis if Bernanke had maintained a neutral or even tighter monetary stance?
Second, if Bernanke had not opposed a market adjustment of asset prices, had
not injected excessive liquidity and had not adopted bailouts for financial
institutions, could the crisis have been contained in August 2007?
The answer to the first question is affirmative: Bernanke's policies are in
large measure to blame for the recession. By setting real interest rates at
negative levels and injecting massive liquidity, Bernanke engineered a free
fall of the US dollar and sent food and energy prices sky-high. This unbearable
inflation set off food and energy riots around the world, destabilized the auto
industry, airlines, shipping, and forced lower energy use in agriculture and
industry.
Food and energy inflation soared not only in the US, but also in Europe and in
most developing countries, forcing consumers to cut back on both essential and
non-essential spending. The combination of contraction effects on the
production side, as well as the consumption side, has contributed to a marked
contraction of GDP growth and rising unemployment in the US and elsewhere.
Affirmatively, without Bernanke's deliberate re-inflationary policy, food and
energy prices would have remained below their July 2007 levels. Neither the US
economy, nor the world economy, would have been jolted by such powerful energy
shock and would have maintained the pace of growth. This counterfactual
question is similar to the one asked by academicians: had influential New York
Fed governor Benjamin Strong lived (he died in late 1928), the Great Depression
would not have taken place. Had Bernanke not been Fed's chairman, the US and
world economy would not have been precipitated into recession.
The answer to the second question is affirmative: Bernanke escalated the
financial crisis. The US, Europe, and many other countries have been
experiencing a credit boom and speculative bubbles in asset prices, mainly
housing, stocks, and commodities, caused by record low interest rates in the
post war period. Domestic credit has been increasing at 12% in the US during
2001-2007. Total credit stood at 346% of GDP in August 2007 as against 268% in
2000 and 162% in 1980.
Monetary data showed that, in August 2007, the only problem with the financial
sector in the US was the speculative subprime component of the mortgage loans;
the default rate on bonds and corporate debt was almost zero. Macroeconomic
data showed that external deficit was at a record level of 7% of GDP and
national saving was negative.
Evidently, at a very high percentage of GDP, domestic credit becomes difficult
to service both in terms of interest and principal payments. A prudent central
banker would check the growth of domestic credit to a rate compatible with real
economic growth, lower external deficits, and higher national savings, with
greater emphasis to productive sectors and less to speculation. This assumes
allowing free interest rates to be commensurable with profit rates in the
economy, rewards for savers, risks faced by banks, and sound bank incomes. This
assumes allowing asset prices, including housing prices, to be fully market
determined.
Particularly, housing prices were propelled upwards with joy and euphoria in a
speculative frenzy by three to fourfold, boosting property taxes by two to
threefold, with the Fed refusing to step in and arrest the speculative mania.
The Fed and the US government should not deploy so many resources to prevent
housing prices returning to non-speculative levels, compatible with incomes,
construction costs, and normal profits. Instead, Bernanke wanted to have the
best of all the worlds: the lowest (and negative) real interest rates,
unlimited liquidity for banks, the lowest possible value for the dollar, and
the highest prices for housing, shares, and commodities.
He put in place a facility to buy all he could of mortgage backed securities
and to prevent millions of foreclosures. In conjunction with the congressional
$300 billion homeowner bailouts, this triggered mass default on mortgage
payments. In turn, Fannie Mae and Freddie Mac could no longer have the cash
flow to service their debt. This triggered the credit default swap and Bear
Stearns crises, then the collapse of AIG, Lehman Brothers, and so on.
Very low interest rates combined with massive writedowns weakened considerably
the incomes of banks, sending their stocks tumbling and forcing the Securities
and Exchange Commission to preclude short-selling.
Cheapness of money created an international speculative frenzy in food and oil
markets, and in stocks in the US, Europe, and in emerging market countries.
With oil hitting $147/barrel, oil demand had clearly fallen. Hedge funds rushed
to close positions, creating a de-leveraging process that spread from
commodities to stocks.
The financial system comprises a "web of interlocking commitments" - a vast and
complex network of interconnected balance sheets and cash flows; preventing the
market mechanism in interest rate setting or in housing price adjustments
destabilizes not only mortgage finance but also the whole financial system
locally and internationally.
By staunchly opposing a market adjustment of asset prices, Bernanke and company
have decided to inject as much liquidity and bailouts for all financial
institutions in the US and elsewhere that are impaired by distorted asset
prices, except Lehman Brothers, which itself was a victim of Bernanke's policy.
The only outlet Bernanke and Treasury Secretary Henry Paulson wanted for these
assets was the government's balance sheet. Affirmatively, without Bernanke's
policies, the financial crisis would never have escalated to financial chaos,
as a result of an impairment of the asset pricing process; Lehman Brothers
would have never fallen arbitrarily; and financial disorder created by its
demise would not have occurred.
Bernanke and Paulson have certainly created a fiscal and monetary disorder that
will have serious drawbacks on the real economy and the banking system. Will
the Bernanke and Paulson doctrine of immense fiscal deficits, negative real
interest, and unlimited money creation succeed in returning the economy to a
moderate growth? So far, their record has been disastrous.
Certainly under former Fed chairman Alan Greenspan, low interest worked, but
paved the ground for financial instability. As the classics put it: the
cheapness of money facilitates speculation, just in the same way as the
cheapness of beef and of beer facilitates gluttony and drunkenness.
Unfortunately, this time around, banks are willing to take the beef, but are
not willing to get drunk on the beer! The Keynesians call it the liquidity
trap.
The socialization of the mortgage sector and prevention of foreclosures have
dealt a long-term blow to home loans. Banks will remain reluctant to provide
home loans, knowing that these loans have no legal recourse.
Will the fiscal stimulus, as proposed by Paul Krugman, Lawrence Summers and
others, bring back economic growth? US GDP data shows that US growth was
propelled by real increase in government spending at 13.8% in Q3 2008. Hence,
in spite of full deployment of fiscal policy and pushing the fiscal deficit to
record level, the US economy recorded a contraction at -0.3% in that quarter.
In view of negative savings, higher fiscal deficits require more external
financing or much higher inflation. In view of low interest rates, external
financing will be dwindling. Inflationary fiscal deficits will only curtail
further real growth, as in Zimbabwe. Apparently, in the presence of large
internal and external deficits, a sounder strategy would rely essentially on
supply side policies.
Certainly, Bernanke will never accept basic pricing mechanism, or safe banking.
He, and his re-inflationist supporters, will not accept the reality and pain of
adjustment. So far, he has succeeded only in bringing the economy from one
crisis to a bigger one, spreading financial and economic disorder around the
globe. Not only banks are in distress, auto industry and many industrial
corporations need large bailouts, and state and local government are in red.
So many will suffer from Bernanke's policies, including Princeton University,
where students may shun anti-market Bernankeconomics.
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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