Page 2 of 2 Unpleasant arithmetic
By Hossein Askari and Noureddine Krichene
the Bush administration. So many uncertainties loom ahead as a result of more
such frightening monetary and fiscal policies. So far the incoming Obama
administration has indicated no clear economic program; it is following a
patchwork program driven by populist economics and by the media and academics.
Some are calling for running a devastating hyperinflation as a way out of the
financial crisis.
A stabilization program should emphasize supply-side policies. These include
tax incentives in the form of investment tax credit and lowering corporate
income tax rate; expanding energy production; stepping up agriculture and
livestock production
mainly in staple products that witnessed exorbitant inflation; expanding
economic and social infrastructure; emphasizing human development and improving
education; vocational training and re-training; enhancing competitiveness in
labor and product markets; research in agriculture and industry; adequate
supply of energy and water; and emphasis on sectors for which the US has
comparative advantage.
Unquestionably, supply side policies under the Ronald Reagan administration
provided the US with a prosperity that extended over two decades and enabled it
to recover from a long stagflation that seriously weakened the economy during
1969-1982.
It is easy to plan a stimulus program of any magnitude; the most difficult
question is how the fiscal deficit can be financed? Are there enough real
savings for financing these deficits? Could the public debt created by these
deficits be serviced?
Obama's team seems to have ignored the financing question of the stimulus
package and its fallout on the US economy and the US dollar. Certainly, taxes
cannot be raised by another trillion. Hence financing has to come from default
or from borrowing. Since the US dollar is a reserve currency, the US government
has the luxury of monetizing the deficit. Such certainly is not the case of a
non-reserve currency, which may fall in default due to foreign debt
obligations, which it could not repay.
The Bush deficits were essentially financed by foreign borrowing as illustrated
by wide deficits of the external current account. A question naturally arises.
Would foreigners be willing to finance the fiscal deficit as they were during
the outgoing Bush administration? If they would, then the stimulus program will
have no stimulus on the US economy, and will end up stimulating other
economies, mainly China and Japan.
With ridiculously low interest rates on US Treasury bills and bonds, high risk
of a dollar collapse, and with China, Japan, and India forcing an expansion of
their respective aggregate demands, a smaller volume of foreign savings will be
available for financing the US fiscal deficit. Hence, Obama's team will be
facing some unpleasant arithmetic; namely, a monetization of the deficit is the
most likely course, that is, financing of the deficit through the banking
system.
In view of low savings, such financing will turn inflationary, will depress the
US dollar to record lows, will impose excessive effective taxation on
fixed-income dependents such us pensioners and wage earners, and will have to
crowd out private sector investment.
Hence, the job creation from the stimulus program will be more than offset by a
decline in real consumer spending as illustrated by latest figures and a sharp
decline in private investment. Furthermore, building an unsustainable level of
government debt will increase the real future tax burden and may be a source of
future hyperinflation when such debt becomes no longer manageable.
Obviously, the Obama administration is set on a very slippery path with no
brakes for either monetary or fiscal policy. Such a course bodes a worsening
economic and financial crisis, and most likely Obama will preside over a super
inflationary economy combined with declining real growth, heightened
uncertainties, and instabilities.
The growing external deficits of the past decade demonstrated clearly that the
US had large shortcomings in its production potential and cannot afford a
demand led growth. It has major shortfalls in producing cars, electronics,
petrochemicals, appliances, clothing, energy and many food products.
The US economy is in dire need for a stabilization program more than in need
for a stimulus and demand led program. Certainly, a stabilization program is
not a populist one; however, it would enable the US economy to get out from
this deadlocked situation and stave off dangerous downturns that may lie ahead.
Top priority is to rein in monetary policy and set a fixed rule for money
supply and credit growth that cannot be arbitrarily exceeded. The latest growth
of money supply M1 at 37% a year is destabilizing.
It is time to allow interest rates to be market determined and to avoid further
interference with the housing markets. Market-determined interest rates will
enable banks to resume lending to productive and safe customers, consolidate
their income position and reconstitute reserves. The government should no
longer interfere with housing prices. The government can enhance ownership by
low-income families not by preventing foreclosures but as in many countries
through construction of low-cost housing.
Non-government interference with housing prices will enable highly speculative
home prices to re-adjust to market fundamentals rapidly and the housing markets
to return quickly to normalcy.
The budget deficit has to be drastically reduced to sustainable and safe levels
as soon as possible in order to be compatible with available savings and
without crowding out the private sector or becoming inflationary. A fiscal
deficit in the range of 2-3% of GDP would be conducive to stable economic
growth; it could be financed without crowding out private sector investment.
With federal funds rate at zero bound, Bernanke has to realize that he has been
under an illusion for a long time and his policy of rate cuts has turned
disastrous not just for the US economy but for the rest of the world.
On the fiscal front, the new administration has to draw lessons from the
excessive fiscal deficits of the Bush administration that drew down US savings
and had to be financed essentially through large external accounts deficits and
foreign borrowing.
A stimulus package when savings are low will amount to a redistribution of a
smaller cake, a stimulus in one part of he economy will be simultaneously
eroded by a de-stimulus in another part of the economy. The US economy in no
way resembles the US economy during the Great Depression. In particular,
government deficits did not exist, government debt was negligible, there was a
protracted deflation of consumer prices, namely agriculture products; the US
economy had an external current account surplus.
A stimulus program under Franklin Roosevelt made considerable sense and was
appropriate given the underlying conditions. To succeed, a stimulus program
under Obama must be supply-side focused; anyone can spend the money but to
spend it wisely is something else.
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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