Obama's choice: Straight talk - or more chaos
By Hossein Askari and Noureddine Krichene
The scale of the financial crisis facing the incoming Barack Obama
administration almost beggars description, with the US financial crisis
certainly the worst in the post-World War II period. The new government will
inherit, besides sheer financial chaos, the largest fiscal deficit, projected
at US$1.5 trillion in 2009, the highest level of public debt, and arguably the
most expansionary and destabilizing monetary policy in US history.
The financial crisis is largely due to disorderly monetary policy of the
Federal Reserve first under Alan Greenspan and now Ben Bernanke, in combination
with lax financial supervision. The banking crisis has been triggered by the
deliberate attempt of the Fed to re-inflate the economy since August 2007 and
to prevent
housing prices from adjusting to market fundamentals.
This expansionary policy was supported by a US$300 billion package adopted by
the US Congress in July 2008 to support housing prices. Unfortunately,
speculation shifted from housing to commodities and foreign exchange markets,
sending food prices to unprecedented levels, oil price to $147 per barrel and
the dollar to record lows.
The Fed has pursued an aggressive cheap monetary policy to inflate the economy,
with fixed-income and wage earners having to pay for much of the bank losses.
It has inadvertently undermined the health of the US banking system and caused
economic recession.
By forcing real interest rates to negative levels, the Fed has eroded the
income margins of the banking system at a time when banks have suffered huge
losses and are in dire need of reconstituting their profitability, reserves,
and price risks.
By circumventing banks and lending directly to borrowers at artificially low
interest rates, the Fed is further undercutting the banking system and
squeezing bank incomes. In order to keep interest rates low, the Fed has been
injecting liquidity at a phenomenal rate, about $200 billion a week, pushing
its outstanding credit to close to $2.5 trillion. This money is being used in
part to monetize the fiscal deficit which has widened under the TARP, stimulus
packages, housing bailouts, and war spending.
What does a combination of record fiscal deficits and overly expansionary
monetary policy portend for US economic growth, inflation, external deficits,
and the dollar? Real economic growth has slowed and unemployment has risen
since August 2007, essentially under the effect of high food and energy price
inflation and declining real savings.
Maintaining the same policy stance, that is to say excessive fiscal deficits
and record monetary expansion, can only deepen real economic recession and
increase unemployment because the deficit will increase consumption and depress
savings and investment.
Hence, the amount of investment required for economic growth will be
diminished, unless foreign financing becomes available to cover the
savings-investment gap. In view of the prospects of a collapse of the dollar
relative strong currencies (Japanese yen) and gold and the prevalence of low
interest rates in the US, foreign financing may not be as readily forthcoming
as in the past.
What will be the impact on inflation? The massive injection of liquidity after
August 2007 combined with low interest rates that triggered high commodity
price inflation are finally bringing world economic growth to a significant
slowdown. The recent massive liquidity injections by the Fed have yet to find
their way into aggregate demand. As this liquidity translates gradually into
new credit to the government and the economy, aggregate demand will expand
rapidly in nominal terms and will drive inflation upward.
Although, commodity prices have recently retreated, the outlook would be a
resumption of rapid inflation with serious social consequences. The
inflationary impact will operate through a lag that could extend up to two
years. Once liquidity is fully transmitted and the lag is completed, the
inflationary impact could be much stronger than witnessed during 2007-08. The
massive liquidity is hoarded within the banking system. Banks have learned
painful lessons from their recent debacle. In spite of the government pressure
to lend regardless of risk, since the government provides unlimited bailouts,
banks do not want to lend money they will never recover again. Most of their
placement is in Treasury bills, or earning interest from the Fed on excess
reserves.
The impact of the fiscal and money expansion on the external deficit and the
dollar are evident. When fiscal or money expansion exceeds available savings,
they translate into higher external deficit and a depreciating currency. The US
external deficit widened to 7% of gross domestic product in 2007 and the US
dollar tumbled relative to gold and the other major currencies.
The present policy stance in the US, that is free spending by the Congress,
unlimited bailouts, and an expansionary Fed, is unsustainable. It could lead to
high inflation, or even hyperinflation, a falling currency, and a more severe
banking crisis in the future. The fiscal deficit cannot expand beyond real
resources without fueling inflation. The government cannot for ever control or
subsidize housing prices. Similarly, the Fed cannot keep interest rates
negative in real terms for a prolonged period without damaging the real
economy.
The chaotic nature of these policies can be felt only when disastrous economic
and financial consequences prevail in the form of falling real incomes, rising
unemployment, and waves of bankruptcies. Otherwise, policymakers will remain
oblivious to the consequences of their wrongdoing, the same as Greenspan
ignoring the housing bubble or Bernanke the commodity bubble.
The new administration has to accept the reality and pain of repairing the
financial and economic disorder of the George W Bush years. The panacea of
interest rates cuts or instantaneous fixes for the economy, a la Greenspan or
Bernanke, have to be discarded. Similarly, the bailouts and interference with
housing price adjustment have to be abandoned.
While the new administration has not yet announced a comprehensive economic
program, beyond popular campaign speeches and vague promises, a stabilization
program for the US economy should have four objectives if economic prosperity
with financial stability is to be regained. These objectives consist of
reducing the fiscal deficits; restraining monetary policy; allowing market
determination of housing prices, interest rates, and securities prices; and
restoring a supply-oriented growth strategy.
Certainly such a program is not a populist one and may be rejected by
policymakers. However, it is unavoidable and will lead the economy from
stagflation to sustainable non-inflationary growth. What are the benefits of
each objective?
The reduction of fiscal deficit will allow national savings to increase and the
private sector to invest and grow. It will avoid excessive monetization of the
deficit and therefore reduce excess aggregate demand, external deficits,
inflationary pressure, and currency depreciation. The restraint of monetary
policy would allow interest rates to become market-determined and turn positive
in real terms. Savings will increase; the banking system will regain its
strength, reconstitute its income and reserve, and recapitalize. Credit to the
economy will be realigned with savings and will be re-directed toward
profitable and productive investment, and away from speculation and riskier
credit.
Speculation can thrive only in a context of cheap monetary policy. For instance
the housing or commodity bubbles and insolvent consumer loans would not have
taken place in the context of a tight monetary environment.
Bailouts should be suspended; the central bank plays the role of last resort
lender only for viable and solvent banks. No economy can growth with
indefinitely negative real interest rates, which are only propitious for
speculation and consumption.
Housing prices, interest rates, and security prices have to be
market-determined. The US Congress and the Fed should not combine forces to
keep a two-bedroom mobile home in California at $1.4 million when its true cost
does not exceed $100,000, or prevent overly speculative housing prices from
adjusting to market fundamentals. The government cannot for ever control the
prices of more than 300,000 million dwelling units or millions of real-estate
properties. Such control will maintain huge price distortions in the economy;
it is too costly for the taxpayers; it will require renewed housing packages;
and will be too disruptive for the economy. Moreover, knowing that the
government will pay for mortgages, debtors will default on their payments even
though they are in a position to make payments.
A demand-led growth program, as under the Bush administration where credit was
showered on consumers and homeowners who could not afford it, has proven to be
destabilizing for the financial system, costly for public finances, and
creating excessive uncertainties and violent price and exchange rates
instability. Moreover, such economic growth is not durable; it goes from a boom
to a bust where real income gains during the boom are more than wiped out
during the bust.
A supply-side economic growth requires neither an expansionary fiscal policy
nor an expansionary monetary policy. It is oriented toward long-term investment
in infrastructure and research, human development in education and health, and
productive long-term investment in agriculture, industry, and services.
The recipes of this strategy are well known. The government should concentrate
on social and economic infrastructure, such as roads, hospitals, schools,
sanitation, environment protection, water, and energy; enhance factor and
product markets competitiveness; reduce or eliminate factor and product price
distortions; adopt reasonable income and corporate taxation; reduce trade
barriers; and preserve financial stability. Such strategy is not consonant with
over-indebtedness, booms and busts, or speculation, but will lead to stable and
durable non-inflationary growth.
Will the Obama administration rein in the super inflationary policies of
Bernanke's Fed and reduce fiscal deficits? Absent straight talk with the
American people and a clear program, political and Wall Street pressures will
most likely shape the new administration's policies and practices.
Unfortunately, it seems that there is still no clear path towards economic and
financial stability in our future.
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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