Who served the cheap booze?
By Hossein Askari and Noureddine Krichene
The end of the George W Bush era at noon on January 20, 2009, was
unflatteringly prefaced on January 5 by Senate majority leader Harry Reid
(Democrat, Nevada): "I really do believe President Bush is the worst president
we've ever had." The current economic and financial turmoil cannot contradict
this opinion.
After inheriting a stable and prosperous economy from president Bill Clinton,
with a budget surplus of more than US$200 billion, Bush has bequeathed
President Barack Obama a record-shattering $1,200 billion projected deficit for
2009, an unemployment rate exceeding 7.2% of the labor force and expected to
rise rapidly possibly into the double-digit range, rapidly declining real
incomes, a contracting real gross domestic
product (GDP), and a government debt that has more than doubled to exceed 90%
of GDP.
Bush said, "Wall Street got drunk and left us with the hangover." The Wall
Street Journal, January 19, 2009, in an article titled the "Bush Economy"
replied, "Who does Mr Bush think was serving the liquor?"
This free-flowing booze is the consequence of the cheapest monetary policy in
US history (frequently referred to as Greenspan's put, after the policy of
former Federal Reserve chairman Alan Greenspan), underlined by a fully
deregulated financial system following the repeal of the Glass-Steagall Act in
1999. The Bush administration has caused the most spectacular housing bubble in
US history, accompanied by an unprecedented commodity speculative bubble, a
record depreciation of the US dollar, capped by pushing interest rates to the
zero bound in December 2008. The dire consequences for the real economy are
only beginning to emerge and have a long way to go before we should expect a
significant turnaround.
The financial calamity that has followed the bursting of these bubbles has
caused the worst financial crisis in the US since the Great Depression, with
fallouts across the Atlantic to European banks exposed to the US subprime
markets. Historic bailouts by governments in the US and Europe have had to be
undertaken, socializing losses from Ponzi schemes and preserving private
speculative gains. Many financial institutions have fallen into bankruptcy, and
all of the accumulated gains in financial wealth in over a decade has been
wiped out overnight as illustrated by the collapse of stock indices.
With the nationalization of major financial institutions and the highly
subsidized credit policy, many conservatives now accuse Bush of being a
"socialist".
In spite of a monumental bailouts, financial institutions continue to suffer
huge losses and to shed jobs. With writedowns of about $1 trillion (and
growing), nonperforming portfolios are afflicting most major banks. Bank of
America recorded its worst losses ever in 2008 and announced plans to shed
4,000 jobs. It required a government capital injection of $20 billion and a
liquidity injection of $138 billion. Citigroup, even after suffering huge
losses and receiving $45 billion injection and $306 billion in guarantees from
the government, has decided to split itself into a banking institution and a
brokerage institution. The Royal Bank of Scotland reported a loss of $41.3
billion in 2008 - the biggest loss in British corporate history, prompting the
UK government to announce a second bank rescue plan. Still, there is no end in
sight.
While the Bush administration has ended, Bush appointee Ben . Bernanke, who as
the chief of the Council of Economic Advisers (CEA) and then as the chairman of
the Federal Reserve, has been in charge of Bush financial policies, will remain
a most powerful decision-maker under the Obama administration.
Bernanke, as a historian of the Great Depression, has been a staunch supporter
of ultra-expansionary policies under Greenspan, serving up the cheap booze to
Wall Street. By conviction, he continues to run the most expansionary policy in
the US history. Despite the ravages that this policy has already caused the US
and the world economy, Bernanke and his supporters have all along promised a
quick turnaround through magic reductions in interest rates. Their motto is
that the economic crisis would have been far worse if interest rates had not
been cut to the zero bound.
How much worse could it be? They have no answer to this question. While the
banking sector, as illustrated above, has kept on collapsing and the economy
deteriorating, in spite of record low interest rates, they strongly believe
that unlimited money expansion will eventually bolster the health of the
banking system and bring about economic recovery!
In a speech at the London School of Economics (LSE), on January 13 [1],
Bernanke stated that, "In the near term, the highest priority is to promote a
global economic recovery. The Federal Reserve retains powerful policy tools and
will use them aggressively to help achieve this objective ... The virtue of
these policies in the current context is that they allow the Federal Reserve to
continue to push down interest rates and ease credit conditions in a range of
markets, despite the fact that the federal funds rate is close to its zero
lower bound ... Fiscal policy can stimulate economic activity, but a sustained
recovery will also require a comprehensive plan to stabilize the financial
system and restore normal flows of credit."
More explicitly, Bernanke, following the program in Sweden in the 1990s, called
for setting up a bank at the US Treasury that would buy all bad assets, redeem
all write downs, and provide guarantees against defaulting loans or securities.
Being aware of the controversy over the Troubled Assets Relief Program,
Bernanke admonished policymakers to be responsible: "Responsible policymakers
must therefore do what they can to communicate to their constituencies why
financial stabilization is essential for economic recovery and is therefore in
the broader public interest."
There were disappointing omissions in the Fed chairman's address. Specifically,
he attributed the financial crisis to a bursting credit boom. He ignored
altogether the role of record-low interest rate policy adopted by the Greenspan
Fed, which he supported as a chairman of the Council of Economic Advisors, in
creating the credit boom and multiplying Ponzi finance in which investors rely
solely on appreciation of their assets to service their debt.
In spite of repeated calls, notably by Fed governor Edward Gramlich, for
arresting housing speculation, the Fed and the Bush administration simply
ignored these calls. Dramatically low interest rates squeezed bank incomes,
pushed loans to sub-prime markets and caused over leveraging through
securitization and credit derivatives (such as credit default swaps). Finally,
they precipitated the collapse of banking institutions, including those
considered "too big to fail".
Bernanke went on ignoring the evils of extremely low interest rates that he
persistently implemented since August 2007 saying that the Federal Open Market
Committee "maintained the view that the rapid rise in commodity prices in 2008
primarily reflected sharply increased demand for raw materials in emerging
market economies, in combination with constraints on the supply of these
materials, rather than general inflationary pressures".
But who pushed the dollar to record lows and the gold to record highs in 2008?
Certainly not the emerging countries. If Bernanke's claim was true, why did all
commodity prices fall simultaneously and rapidly while emerging countries were
still growing in 2008? Assuming Bernanke was right, then the sharp demand for
commodities by emerging countries was primarily ignited by record low US
interest rates and the record US external current account deficit. It is
unfortunate that. Bernanke ignores the Fed's responsibility in igniting
commodity inflation since 2003 through speculation and in intensifying it in
2007-2008 until it finally depressed real growth and real spending.
Bernanke was not clear regarding his objectives: whether he wanted again to
stimulate aggregate demand through free money to consumers, or he had a
nostalgia for another credit boom, or he wanted a banking system that was sound
and could support traditional and safe banking business. If Bernanke was after
one of the first two objectives, then certainly banks are still awakening from
a hangover and will not be willing to get drunk again no matter how much free
booze Bernanke will serve them. The Fed's overleveraging of its balance sheet
and extensive liquidity injection have only led banks to buy government papers
or build excess reserves.
If Bernanke wants the US financial system to be like the financial system in
many other developed countries, essentially guided toward traditional banking
and less toward speculation, then that goal is without a doubt within reach.
Warren Buffet showed how it could be done when he extended a loan to GE at 10%.
With Bernanke pushing interest rates to zero bounds and short-cutting banks
through direct lending to finance companies and private companies, banks will
be stifled and cannot survive under such a monetary policy. In spite of the
abnormal squeeze on their incomes, banks have continued to extend loans to safe
and traditional business.
The Fed data [2] clearly shows the absence of any credit crunch whatsoever for
safe business in all sectors of the economy. The types of credit that have been
impaired are essentially the subprime sectors that suffered large defaults,
namely subprime housing and consumer loans. It is quite understandable that
banks cannot not extend such highly risky loans at insignificant interest
rates.
Bernanke has expressed the view that President Barack Obama's $1 trillion
stimulus package may not work unless the government sets up an institution at
the Treasury that would buy all bad assets, redeem all writedowns and provide
guarantees for loans and securities. As in the case of TARP, Bernanke's plan
has found large supporters in the banking sector and in the media. Such a plan
would call on Congress to sign a blank check for an indefinite period for
bailouts. Is it equitable to socialize speculative losses and preserve private
speculative gains? In other words, is it legitimate for the homeless to pay for
the fat salaries of the financiers? Is it legitimate to deny American children
education in order to refund Ponzi losses?
As Obama's stimulus package is projected to push the fiscal deficit to over $2
trillion, or about 16% of GDP, by how much would Bernanke's additional TARP
plan expand this deficit? How could such monumental deficits be financed? We
are asked to take at face value his warning that our survival hinges on his
plan, and therefore it matters less how much sacrifice we have to make for
repairing Fed's errors.
Besides socializing speculative losses, Bernanke wanted the government to
prevent foreclosures, implying the Treasury should pay the mortgage of every
homeowner. That would be indeed the ultimate socialist society, where citizens
are secured money for free spending and free houses. While it is a laudable
policy to keep people in their houses, it should be done in a way that the
housing bubble is allowed to burst while lenders and borrowers incur the
losses.
It is unfortunate that US policymakers have not yet grasped the heavy toll of a
decade of expansionary policy in terms of fiscal cost, financial anarchy,
crumbling economy and collapsing banking institutions. By blowing up the US
external deficits, cheap money policy has increased dramatically US imports; it
has ultimately benefited the exports of other countries and weakened US
industries. It appears that the Obama administration is embarking on a fast
track of expansionary fiscal and monetary policies. Such policies could only
prolong the economic agony and could trigger the highest inflation in US
history.
Would Bernanke's zero interest rates and unlimited cheap money achieve the
objective of a quick turn around? Since August 2007, such a policy has brought
only a succession of economic and financial setbacks. This is the clear result.
Continuing with the same policy would deplete real savings and consequently
capital accumulation. It is a guarantee for a continuation of the financial
crisis. If banks replay the Bernanke-Greenspan credit boom, then the
consequences are obvious. If the monetary brake is re-applied with vigor, then
interest rates will overshoot and, as in the 1980s, a debt crisis would be
inevitable.
Very clear warnings were expressed by a number of prominent people, including
Edward Gramlich, Joseph Stiglitz, Maurice Allais and George Soros, regarding
the dangers of a cheap money policy. These warnings were totally ignored.
A top priority for the new administration should be to stabilize monetary
policy and bring the Fed back to the realm of traditional central banking, that
is mainly in managing liquidity and safeguarding the soundness of the financial
system. The new administration should strictly arrest bailouts. The problems of
banks have to be resolved within the banking sector. Ailing banks have to
recapitalize on their own or simply face bankruptcies. Disappearance of
insolvent banks, or any loss-making business, has never meant in any country or
at any time, disappearance of financial or economic activity.
The slogan according to which we bailout banks or we die is fallacious and
should be abandoned. Isn't it time to cut off the umbilical cord from the Bush
administration's costly policies, or are we doomed to continue to be tied them?
If the Obama administration does not cut the ties, history may indeed judge
President Obama even more harshly than it already has president Bush.
Notes
1. Speech by Bernanke at the Stamp Lecture, London School of Economics, London,
England, January 13, 2009. Click
here.
2. Release dated January 23, 2009. Click
here.
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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