The mirage of recovery
By Hossein Askari and Noureddine Krichene
Over recent days, observing a sudden increase in car sales and record profits
of "bankrupt" banks, Federal Reserve chairman Ben Bernanke has announced that
recovery of the US economy was under way. Treasury Secretary Timothy Geithner
echoed the same message and even "globalized" his prediction of a recovery for
the world economy. President Barack Obama saw "glimmers of hope". While these
three top US policymakers were rushing to announce recovery, economist Paul
Krugman exuded skepticism, saying "do not count your recoveries before they are
US policymakers' optimism seems to be founded on their grandiose reflationary
programs. Obama has launched an
unprecedented stimulus package at US$787 billion, followed by the largest US
fiscal deficit ever, at $1.85 trillion, or 13% of gross domestic product (GDP).
Underlying the stimulus package and the fiscal deficit was a Harvard income
multiplier of 1.5, implying an increase in the US real GDP by about $4
trillion, or a record 30% per year. The basic economics advocated by the Obama
team were simple: trillions of dollars in stimulus package and government
expenditures would boost real aggregate demand for consumption and investment
and automatically lead to economic recovery and full employment. Their
mechanical multiplier model provided a strong reason for Obama to announce a
premature economic recovery.
Bernanke's optimism is the result of the aggressive monetary policy that he
forced under the George W Bush administration and has continued to expound
under Obama, irrespective of the devastation it has caused to the banking
sector and subsequent fiscal bailouts. Bernanke has gained the reputation of
the doctor of the "Great Depression" and proponent of monetary anarchy. For him
and his school of thought, inflation seems to be of little concern. His
aggressive monetary policy has sent the US economy, and with it the world
economy, into financial collapse and recession.
Yet, doctor Bernanke kept strong faith in his aggressive anti-Great Depression
medicine. Besides forcing interest rates to zero, never seen in the monetary
history of the US, he decided to unleash money supply by expanding the credit
of the Federal Reserve from $700 billion prior to August 2007 to $2.3 trillion
by end April 2009. Doctor Bernanke's reasoning was simple: zero interest rates
combined with unlimited credit to the sub-prime markets ought to hike up
aggregate demand in such a powerful way that it blasts away recession and
secures fast growth and full employment.
The recent cheers for Geithner were based on similar reasoning, however,
transplanted at the world economic level. A Group of 20 stimulus package of $5
trillion, on the top of a commitment by the G-20 countries to undertake the
most expansionary fiscal and monetary policy, combined with free lending to any
country in any amount, that would in their view guarantee a fast and strong
world economic recovery.
Neither G-20 policymakers nor the US seem to recognize that the current
recession was the product of overly expansionary fiscal and monetary policies
during the past decade. Obviously, these policies yielded a temporary high
demand-led economic growth during the 2002-2007 period accompanied by the
highest commodity price inflation in recent memory; however, they also
triggered a food and energy crisis, general bankruptcies in form of meltdown of
sub-prime loans, an economic recession and trillion of dollars of bailouts in
the US and Europe that socialized financial losses. These bailouts will weigh
on economic growth for a long time in the future.
These same policies are now being replayed around the world. The supporters of
these policies claim to be innovative as if for the first time in history they
were implementing voluminous fiscal expansion and the free printing of money.
Yet these policies were used time and again in the past with startling examples
such as the German hyperinflation in 1920-23, Latin American hyperinflations in
1950-1985, and the more recent Mobutu and Mugabe hyperinflations.
In all cases where these policies were tried, there was devastating inflation,
a substantial decline in real income and a considerable impoverishment and
social malaise. Notwithstanding historical evidence against rapid monetary and
fiscal expansionism, G-20 policymakers and the US now believe in success of
super inflationary policies.
US policymakers diagnosed the current crisis as lack of demand for goods and
services and large excess savings in the form of a piling up of food and energy
goods in the US, and totally dismissed the large external deficits that reached
about 6% of GDP in recent years and negative national savings. They believed in
deflation when housing, food, and energy inflation was crippling the economy.
The refusal to link the Bush administration's war spending and excessively
expansionary fiscal and monetary policies and the current financial crisis has
been a main stratagem in the speeches of Fed officials.
Bernanke blamed the financial crisis on China and on oil exporters who invested
their balance of payments surplus in the US, leading to low interest rates and
a credit boom in the US, thus denying Fed influence on interest rates and
credit creation. Certainly, Bernanke did not understand that China and oil
exporters do not decide the US current account deficit.
Often, Bernanke has noted that the Fed's mandate from the Congress was to
promote maximum sustainable employment and stable prices. The failure of the
Fed to achieve either or both objectives has been quite recurrent over the past
decades. Bernanke's aggressive policy since August 2007 has even triggered
stagflation: rising unemployment and inflation. It would be more natural to
have a central bank with one single mandate - to preserve the value of money.
Bernanke has simply dismissed traditional central banking and decided, based on
his own Great Depression doctrine, to go beyond the twin mandates that were
prescribed by the Congress and to create high-risk instruments that go beyond
traditional government bonds held by a central bank for open market operations.
No central bank has the mandate to lend directly to non-depository banks or to
the private sector. That would constitute a violation of standard central
banking practice. No government in the world would allow its central bank to
violate its mandate and hold assets other than government bonds and member
banks' discounts. The arbitrary and overly discretionary power of Bernanke can
be illustrated by the following passage from Bernanke:
the Federal Reserve has also initiated a lending program, with the cooperation
of the Treasury, designed to free up the flow of credit to households and small
businesses. Among the forms of credit on which the program is currently focused
are auto loans, credit card loans, student loans, and loans guaranteed by the
Small Business Administration. We are currently reviewing other types of credit
for possible inclusion in this program. ... Restoring stability to the market
for housing and home mortgages has been a particular area of concern. To
address this problem, the Fed has employed a third type of policy tool -
namely, buying securities in the open market. The FOMC [Federal Open Market
Committee] has approved purchases of well over $1 trillion this year of
mortgage-related securities guaranteed by the government-sponsored mortgage
companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps
to drive down the interest rates that consumers pay on mortgages, and, indeed,
the rate on a traditional 30-year fixed-rate mortgage has recently fallen to
less than 5%, the lowest level since the 1940s. (Speech delivered at Morehouse
College, Atlanta, Georgia, on April 14, 2009.)
not seem to understand the nature of credit. A bank lends deposits it receives
from its depositors and from repayments of loans. When borrowers do not pay
back, the bank no longer has the capital to lend. Bernanke interpreted the
credit freeze as a liquidity problem and had little idea about the extent of
frozen portfolios. His massive liquidity injection translated into a
mountainous buildup of banks' holding of excess reserves that reached $862
billion as of end-April 2009 against less than $2 billion prior to September
Bernanke was fooling the public by saying he wanted to free up the flow of
credit to households and small business, forgetting that most of outstanding
loans to households and small business were simply lost and written down. He
forgot the bailouts he extended under the Troubled Asset Relief Program to
banks in replacement of lost portfolio. He was oblivious about the nature of
Banks accord credit to borrowers from the savings of their depositors. The Fed
does not receive deposits from households; it is not intermediating between
savings and lending and therefore cannot be considered to be freeing up credit.
It is purely creating money out of thin air. As such, the Fed has become a
taxing authority that confiscates wealth and redistributes it to lucky
borrowers. The new mandate for taxation and redistribution has been
self-attributed by Bernanke. Other new mandates were insuring the highest car
sales and highest credit card, student, and small business loans. Bernanke has
also extended his role to the housing market, with the aim of preventing a
downward adjustment of housing prices and pushing down interest rates. Bernanke
wanted to renew the speculative euphoria that characterized the housing market
under his predecessor Alan Greenspan.
Bernanke does not believe in any regulation of the financial system. By pushing
trillion of dollars in liquidity to the sub-prime market, he is likely to
bankrupt the Fed within a few short years. Loans pushed on borrowers will never
be repaid. Moreover, consumer loans by definition finance consumption. Contrary
to investment loans that generate income for their repayment, consumer loans
generate no income and cannot be repaid. A stress test applied to the Fed
itself would surely predict a huge lost portfolio.
While banks have already been bankrupted and are no longer ready to play out in
the hands of Bernanke again, he has decided to go on his own, turning a central
bank into an all-encompassing institution, showering free money to consumers
and reaching out once again to ninja's - no income, no job, no asset,
borrowers. The injection of over $1.25 trillion in mortgages is already setting
off another speculative wave, with speculators surging everywhere after high
commissions and profits and enticing borrowers into cheap loans that are
secured by Bernanke's Fed.
Bernanke considered the rise in car sales as a sign of economic recovery. When
Bernanke has become himself the car dealer of the US, handing out luxury cars
for free, could this rise in car sales be considered as a sign of recovery?
Certainly, the rise in car sales did not reflect savings and growth in the
economy. It only reflected Bernanke's overly cheap monetary policy. Bernanke's
successor will be saddled with trillions of dollars in bad loans and faced with
uncontrollable inflation. A Fed saddled by a mountain of bad debt should be the
cause of serious concern for Obama.
Most astonishing of Bernanke's magic tricks is to turn bailout banks into
record-profit-making banks in such a record time, while Geithner is still
setting up his toxic asset banks. The TARP money served to pay bonuses to
managers. Why not use some for paying bonuses to stockholders? Moreover, the
Fed is paying an interest on excess reserves held by banks following massive
liquidity injection. That interest could be considered as another subsidy to
banks that contributes to create illusory profits and the mirage of economic
recovery. Banks' profits are not rising from real economic activity and are
pure bailout money and subsidies from the state.
How much credibility could be accorded to the soothsayers Bernanke and
Geithner? It would be safer to talk about recovery when it really has occurred
and strengthened over a period of a few quarters, not through distorted
indicators such as those manipulated by Bernanke, but through real GDP growth
and a pick up in general employment. If durable growth occurs in such
incredible fiscal and monetary chaos, then the disastrous experience of
countries that undertook these policies would be baffling. Namely, Zimbabwe
should not have experienced four digit inflation and its employment and real
income should have grown at highest possible rates.
High US inflation, while not admitted by US policy makers, has eroded real
income, had reduced dramatically food consumption, and has certainly caused
rising unemployment. The more an economy is inflated, the more its real
activity is deflated and the more unemployment rises. The creation of money out
of thin air could lead to starvation. Others have called it counterfeiting.
Counterfeiters could bring as much stimulus and confiscation as does Bernanke's
Paul Volcker applied prudent central banking soon after his appointment as Fed
chairman in 1979 and achieved a durable recovery in a financial environment of
strong and healthy banks by tightening monetary policy and allowing the federal
funds rate to remain at 19% for several quarters. He did not invent tricks.
Bernanke had caused financial disorder by pushing his theory of anti-Great
Depression ever since he was appointed as a governor in 2002 and later as a
chair of the Fed in 2006.
He announced recovery with zero interest rates, bankrupted financial system,
unorthodox central banking, and most expansionary money creation in the US
history. He has kept on inventing tricks and showing genius and innovation.
Certainly there is a huge dichotomy between Volcker's plain-vanilla prudent
banking and Bernanke's advanced and dangerous financial engineering. But it can
be easily solved when we recognize that all roads lead to Rome.
While the Volcker recovery proved to be real, the Bernanke pick-up has so far
been a mirage. Bernanke has announced that the Fed credit is to expand to $4
trillion by end-2009. Besides the effects of a breakout of the swine flu, over
the coming months and years we also have the results of the Bernanke credit
breakout to look forward to.
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.