No end to financial disorder By Hossein Askari and Noureddine Krichene
The United States economic recession that the National Bureau of Economic
Research officially declared two weeks ago had started in December 2007 - a
recession that the world had suspected for quite some time - is likely to be a
significant one.
The US manufacturing-activity index and the services-activity index have been
declining for some time; unemployment in November rose to 6.7% (for a monthly
job loss of 533,000 and the biggest one-month rise since 1974, and resulting in
total job losses of 1.9 million so far in 2008); stock and bond indices keep on
falling sharply; the auto industry (GM, Ford, Chrysler) begs for massive
bailouts or, in the case of Ford, a large loan facility; and
consumer confidence continues to evaporate, with the largest monthly decline in
consumer confidence since the University of Michigan started its polling in the
1950s. It is not a pretty picture for anyone to behold and worse is most likely
yet to come.
Given the record of Federal Reserve chairman Ben Bernanke and Treasury
Secretary Henry Paulson, such an ominous landscape should have been largely
predictable. After almost two years, their ill-designed attempts, with no
comprehensive plan and program, have been unsuccessful in stemming the economic
and financial deterioration. It would even appear that they believe in
financial chaos and disorder as a solution to restoring financial order.
Bernanke has vowed to cut interest rates further - this week they came close to
zero - and to aggressively cut long-term interest rates by buying long-term
bonds and inundating banks with more liquidity. Bernanke sees no limit to
interest-rate cuts and to money injection, while Paulson sees no limit to
fiscal deficits.
For interest-rate Bernanke and deficit Paulson, their plan is simple: cut rates
and increase the fiscal deficit and hope for the best. Since Bernanke is the
creator of money, he can set interest rates as low as zero and provide an
unlimited supply of money. Their combined knee-jerk reactions to cut interest
rates, inject more liquidity and push for massive bailouts will only further
deflate the real economy.
Most pundits expect unemployment to be in the 8% to 9% range by the end of
2008. That would make this recession the worst for the jobs market since the
contraction of 1981-82, when unemployment hit 10.8%.
A new economic tradition, or order, seems to be taking hold in the US and
Europe: give credit to all, irrespective of risk and return, supported by
unconditional government bailouts, and prevent market adjustment for asset
prices (such as home prices). Such is the approach being forced by policymakers
and academics as a way out of the recession.
Conservative bankers might call this anarchy, legal bank robbery, or organized
looting. Accordingly, consumers are entitled to borrow any amount of money from
banks or finance companies simply by asking tellers to hand them money as
loans, and acquire homes, cars, goods and services as these purchases will
boost real economic growth and employment. Consumers are encouraged to default.
Who will pay for this extravagance? Such an order is not a fiction. Bernanke
and Paulson have shown that the Fed would buy bad loans of finance companies
and inject billions of dollars every day into the economy. The Treasury has
been buying billions of worthless financial assets from banks. So banks should
trust the Bernanke and Paulson doctrine, lend without limit the money they will
never recover, and fully trust the Fed and the Treasury for full repayment of
their principal and interest.
However, since Bernanke is only printing money out of thin air to buy financial
paper, his action is tantamount to shoplifting. The shoplifter walks away with
stolen goods. The shop owner, realizing part of his merchandise has
disappeared, has no choice except to hike the price of the remaining goods.
Call it inflation.
Disappointingly for the proponents of this new order, or more accurately
disorder, banks happen to be saddled with bad loans following former Fed
chairman Alan Greenspan's credit orgy, and continue to suffer huge losses.
Consequently, despite government pressure, they are not ready to replay the
credit boom of the recent past, or incur the cost of processing more bad loans,
let alone incur legal fees for recovering non-recoverable loans.
Banks will become mostly confined to prime customers or government papers. This
more prudent banking environment is being wrongly called a credit freeze by
policymakers or liquidity trap by academics. A bank is not an institution to
hoard money, nor is it an institution to shower free money. It has operating
costs that have to be covered by revenues. In such a high credit risk
environment, banks will shun issuing loans that will amount to outright capital
losses.
Furthermore, being squeezed by lower interest rates, and therefore lower income
margins that do not cover their fixed costs, banks have been forced to lay off
thousands of their employees, such as in the recent dismissals by Citigroup,
Goldman Sachs, Credit Suisse and the like. With the return to safer banking,
Bernanke's free-credit policy cannot work. The only channel for him to bring
money to consumers is to rent a fleet of helicopters and start releasing money
from the air all over the US, something that may be later remembered as the
Bernanke airlift or money drop.
US policymakers remain oblivious to the economic and financial losses caused by
unrestrained money and fiscal policies. Such a policy mix has not only caused a
slowdown of the US economy, but it has spread economic recession to the rest of
the world. As in previous bailouts and stimulus packages, the question of who
pays for this stimulus package has never been asked. Of course, not one penny
will come from Paulson, Democrat House speaker Nancy Pelosi, or Bernanke;
foreigners perhaps, but most likely it will be shoplifting, that is,
redistribution and forced inflation.
Undeniably, real resources for financing such monstrous deficits or money
expansion have become scarcer. Intensifying fiscal deficits and money expansion
can only erode real savings, redistribute wealth toward debtors, and become
highly, if not super, inflationary. No economy has sustained meaningful real
economic growth with negative real interest rates. Bernanke's miracle for the
US to recover with indefinitely negative real interest rates has not yet
materialized.
Like other economies in the past, the US economy will most likely settle in
stagflation equilibrium for the future, with no prospects for ending the
current fiscal and monetary expansion.
The US has constitutional laws that have served the country well, such as
limiting the presidential term of office. However, US banking legislation has
not been able to safeguard the stability of the banking system either in the
distant past or at present. While the recent Group of 20 economic summit in
Washington only concentrated on enhancing the regulatory framework, such an
emphasis was totally useless when the Fed and central banks in Europe are
slashing interest rates and forcing banks to lend money irrespective of risk
and return.
The Fed is buying US$600 billion in mortgage loans to force mortgage rates
further down and re-inflate home prices. Policymakers in the US so far do not
get the message that managing the economy and achieving full employment is not
the responsibility of a central bank. As long as central banks insist on
becoming the central economic agency of the government, instead of the monetary
agency, it is unlikely that there can be economic stability.
Following the Great Depression, eminent economists, particularly those who
formulated the Chicago Reform Plan, called for a restrained central bank that
should adopt a fixed-money rule to create certainty and stability. In view of
ongoing knee-jerk interest rate cuts, credit injections and bailouts, an
out-of-control inflationary process and collapse of the dollar could readily
materialize in the not-so-distant future.
We face unprecedented uncertainties for economic growth, employment, inflation
and exchange rates, from the full effects of the monumental money injection of
central banks, gigantic fiscal deficits, and negative real interest rates. If
the way out of the stagflation of the 1970s required the federal funds rate to
climb to 19%, would setting this rate at zero promise recovery and financial
stability? That is a real dilemma.
What would happen if central banks decided to mop up liquidity? There is a
total absence of long-term policy for economic and financial stability both in
the US and Europe. Central banks are embroiled in competitive devaluations
through frequent interest rate cuts and unlimited money injection, practice
stop-and-go policies, ignore all bank safety regulations, and are desperate for
short-term outcomes. By being allowed a free and unrestricted role, central
banks create a tremendous real wealth redistribution and loss.
Combating financial disorder with more financial disorder will not help. It is
not the role of a central bank to force home prices upward. If the Fed strongly
refuses to arrest the housing bubble, why should it deploy every means to
arrest adjustment of speculative home prices? A central bank is not created to
manage housing markets, labor markets, or any market, or to force resource
waste and misallocation through price distortions.
A central bank has to restrict its role purely to managing liquidity and
safeguarding banking soundness, according to rules and not the absolute
discretion of a chairman. The economic and financial costs of the Fed's
unrestricted and absolute power have been so far in trillions of dollars in
bailouts, stock-price collapses, bankruptcies, and loss in growth and
employment. More instability and disorder lies ahead in a world where financial
disorder has no boundary.
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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