G-7 points to more instability
By Hossein Askari and Noureddine Krichene
Finance ministers and central bank governors of the Group of Seven (G-7)
leading industrialized countries used their meeting in Rome last weekend to
state that their highest priority was the stabilization of the global economy
and the financial markets.
Yet amid what is the severest global economic downturn and financial turmoil
since the Great Depression, the G-7 meeting then merely vowed to propel the
same overly expansionary fiscal and monetary policies that have brought about
the instability and ongoing recession and financial disorder they seek to fix.
Their intention to enact unorthodox money instruments - printing money with no
limit to stem the crisis - will, if anything, fuel further instability.
Economic performance in the G-7 countries - the US, Germany, Japan, Britain,
France, Canada and Italy - was dismal in the fourth
quarter of 2008. Most disappointing, the recession was deepening in spite of a
spectacular relaxation of monetary policy combined with rapidly expanding
fiscal deficits, multi-trillion dollar bailouts, and unprecedented stimuli.
Policymakers in the G-7 were confident that by cutting interest rates,
unleashing money supply, mounting large bailouts and enlarging fiscal deficits
they would by magic avoid recession and higher unemployment and would even
boost economic growth by mid-2008. Their expansionary actions were on top of
policies that were already excessively expansionary during 2000-2008.
Their rushed actions to stave off recession in fact curtailed growth in a
number of economies and precipitated the current recession and high
unemployment. Believing wrongly that the US was in the midst of a depression
and determined to re-inflate the economy to stave off the collapse of housing
prices, US Federal Reserve chairman Ben Bernanke's imprudent actions sent the
US dollar plummeting and intensified inflation in food and energy. He caused US
unemployment to rise to 7.6%, well on the way to the double-digit level, and
destabilized the world economy.
The expansionary demand policies of the G-7 during 2000-2008 has had disruptive
effects through a number of channels in all markets, including speculation,
financial disorder, wealth redistribution, and price distortions. They created
problems ranging from high energy and food inflation, volatile exchange rates,
a stock market crash and loss of trillions in financial savings, a banking
collapse, an increase in toxic assets, higher defaults of consumer loans, large
bailouts, vast numbers of home foreclosures, falling auto industries, declining
construction, bankruptcies, higher unemployment, and rapidly falling real
incomes.
During 2008, world leaders had emergency meetings to tackle crises ranging from
food and oil to financial collapse, yet new problems arise by the day,
including rising protectionism both in finance and trade.
Unrestricted demand policies have brought hyperinflation in a number of
countries, destruction of money, economic decay and impoverishment for a
prolonged period of time. The unleashing of expansionary fiscal and monetary
policies in the G-7 can only bring more problems in the future, and even if it
manages to stir up economic activity, recovery will be short-lived. As interest
rates have to rise or large fiscal deficits have be contained, credit crises
and unemployment will break out again. The uncertainties these policies create
will discourage private investment and the ability to do sound long-term
planning.
The G-7 communique stated that "the policy response by the G-7 has been prompt
and vigorous, its full effects will build over time. Policy interest rates have
been reduced to very low levels and unconventional monetary policy actions are
being taken as appropriate. Budgetary action has been resolute. In addition to
the full functioning of automatic stabilizers, substantial further fiscal
stimulus packages are being implemented. By taking action together the effects
of our individual actions will be boosted. Our fiscal policy measures adhere to
principles that will increase their effectiveness, namely they will be
frontloaded and quickly executed, and will include the appropriate mix of
spending and tax measures to stimulate domestic demand and job creation and
support the most vulnerable."
G-7 central bankers have not yet learned the consequences of depressing
interest rates. Forcing interest rates to zero bound will in the long run bring
down economic growth rate to low levels (Japan 1990s) or even to contraction.
Thanks to former Federal Reserve chairman Alan Greenspan's record low interest
rates, banks now have a large mortgage portfolio and non-mortgage frozen
assets, trillions of dollars in toxic assets, and have written off more than
$1.5 trillion in non-recoverable loans.
Now banks have much less to lend since they cannot lend frozen or lost loans.
Low interest rates cause public and private consumption to rise and savings to
fall. In sum, there is smaller real investment, which may not suffice for
capital maintenance let alone generate new growth.
In the history of most G-7 countries, monetary policy has never been pushed to
such extremes as zero interest rates and unlimited expansion of credit
irrespective of risk. Governments are forcing banks to lend to subprime
borrowers at ridiculously low interest rates.
The US Fed has created a $1 trillion facility to lend to what is called the
triple-A subprime market. Governments and central banks want to turn banks into
institutions that simply hand out cash as they did in the period prior to the
crisis.
Remaining with unorthodox instruments, the G-7 may just as well consider
dropping money from helicopters. This would be faster and easier than hoping
that banks do the same. Legalizing looting is tantamount to eliminating the
existence of money and banks.
With credit standing at 350% of GDP, it would be unlikely that such enormous
credit could be serviced. Pushing this ratio to higher limits through
unorthodox instruments would be simply asking banks and investors to hand out
money that can never be realistically recovered.
In the financial summit of the Group of 20 countries on November 15, 2008, it
was decided to enhance the regulatory framework. In the same vein, the G-7 Rome
meeting renewed the commitment to enhance financial regulation. Yet unlimited
liquidity expansion and unorthodox monetary instruments will endanger even the
safest banks that comply fully with prudential regulation.
No economy and no bank can be spared from the risks of unlimited liquidity
creation. Enhancing financial regulation and prudential lending when central
banks are furiously expanding liquidity and lending directly at lowest interest
rates becomes a futile undertaking.
On the fiscal front, many G-7 governments are expanding already unsustainable
fiscal deficits, committing themselves to unlimited bailouts of banks, housing,
and ailing industries. These deficits will absorb real savings and will depress
investment in the private sector and erode the basis for real economic growth.
Bailing out a homeowner who has $1.5 million mortgage in order to put a floor
on housing prices will prolong the housing bubble is socially inequitable and
will further destabilize the housing industry.
Bailouts socialize losses and achieve a formidable transfer of wealth at the
expense of the homeless and wage earners. Growing fiscal deficits are being
financed at low interest rates thanks to central banks' massive liquidity
injections. Namely, banks are using the flood of liquidity from central banks
to buy government paper.
Demand can be pushed to any limit through expansionary fiscal and monetary
policies. However, supply could be constrained. Thus demand can expand at a
high rate over a number of years, but supply may easily remain inelastic,
translating in higher prices.
By intensifying fiscal deficits and accelerating unorthodox money instruments,
that is to say, the printing of money, the G-7 has only paved the way for
exchange-rate instability and monetary anarchy that could be much worse than
that which prevailed before World War II. Their stimulus, although in trillions
of dollars, may turn out to be on paper only and with harmful effects on the
real economy.
Unorthodox policies may inflate the way out of debt, operate massive wealth
redistribution in favor of debtors, and impose formidable inflation tax on wage
earners and fixed income classes. However, economic recovery can never take
place in an inflationary context. Inflation is known to deflate real quantities
and contract real economy.
Moreover, as inflation intensifies, money looses its fundamental role as a
medium of exchange and store of value. While the G-7 promises to restore fiscal
and money discipline when economic recovery is restored, the path could be
drawn-out, full of potholes and uncertainties; prospects for a long stagflation
as in the '70s can not be ruled out; restoring monetary and fiscal discipline
would still require a recession.
The G-7 has not yet seen the merit of a collective action to truly stabilize
the world economy and financial markets. Economic recovery can take place only
in a stable non-inflationary macroeconomic setting.
The G-7 could still become a true forum for restoring stability and economic
growth. Its highest priority should be to bring central banks back to monetary
orthodoxy and renounce destabilizing monetary policies. Central banks should
have one mandate - to protect the value of currency and soundness of the
financial system. Full employment should be the goal of other government bodies
and should fall within sectoral and growth policies.
Cyclical unemployment may occur and may not be harmful for the economy.
However, large-scale unemployment has occurred historically only because of a
destabilizing monetary policy; such was indeed the view defended by the famous
American economist Irving Fisher in 1933. Real causes cannot bring large-scale
unemployment.
The G-7 has to agree on strict monetary and credit aggregates that are
consonant with exchange rate stability. It should free interest rates. The
practice of zero interest rates since late 1990s by Japan has led to large
international liquidity expansion through the currency carry trade and
contributed to fueling credit expansion in a number of countries.
The zero, or near zero, bound interest rates in most G7 countries has created
immense distortions, depressed economic growth, and prepared the ground for
another round of bank failures. With banks suffering large writedowns, it is
essential to free interest rates so that lending can be resumed and real
savings and investment increased.
The G-7 should agree to eliminate price distortions, including in capital
markets, housing and labor markets. Enhancing competitiveness, pre-empting
inflation pressure, and increasing food and energy supply are key elements of a
recovery strategy.
The G-7 should renounce all forms of bailouts. Bygones are bygones. Banks that
have suffered frozen assets have to recapitalize on their own, merge, or simply
be liquidated. Governments should guarantee only deposits.
Fiscal deficits have to be restrained to say 3% of gross domestic product and
should be financed through real savings and not money creation. Spending could
be restructured to reconcile social safety net, education, health and
infrastructure and to increase spending efficiency. Spending should not be
appropriated by special interest groups and diverted from its fundamental
social and economic objectives.
There is no anchor that will insure global financial stability. Gold was the
anchor until 1914 and served this role well from 1870 to the outbreak of World
War I. Today, only monetary discipline in reserve currency centers can provide
this anchor. There is a wide consensus that the present crisis was caused by
the G-7's low interest-rate policy in recent years, especially during
2000-2008. Maintaining disorderly monetary policy will play havoc with world
economic growth and employment.
Markets, banks, and investors are aware of the inflationary and credit risks
inherent in ongoing G-7 policies. There is a general flight to safety. Failing
to reestablish confidence in financial markets will delay economic recovery
indefinitely. Only prudent fiscal and monetary policies can restore confidence.
With the $787 billion
stimulus becoming a law, combined with record US
fiscal deficit of $2 trillion, US Treasury
unrestrained bailouts, the Federal Reserve's
unorthodox instruments, and the rest of the G-7
adopting the same policies, the world economy
could endure another four years of unorthodox and
intensifying instability. The G-7's Rome meeting
was not a step towards stability, but was further
fuel for instability.
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.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
