Destabilizing US must change course
By Hossein Askari and Noureddine Krichene
In his testimony before the budget committee of the US House of
Representatives, on June 3, 2009, Federal Reserve chairman Ben Bernanke
expressed conflicting views regarding the record US fiscal deficits over
2009-2012.
He restated his long standing view that "Final demand should be supported by
fiscal and monetary stimulus", thus undermining the private sector's role to
generate employment and income. Then, unexpectedly, he contradicted this view
as well as his unconditional support for fiscal stimulus, by noting that the US
fiscal deficits in the years ahead will rise to such prohibitive levels that US
public debt could be pushed to non-manageable levels, especially if interest
rates spike. He hinted at some departure
from his past views on the dangerous level of fiscal imbalances: "Addressing
the country's fiscal problems will require a willingness to make difficult
choices. In the end, the fundamental decision that the Congress, the
Administration, and the American people must confront is how large a share of
the nation's economic resources to devote to federal government programs,
including entitlement programs."
Undoubtedly, US fiscal deficits during 2009-2012 are projected to rise to
dangerous levels, exceeding 12% of gross domestic product (GDP). If these
deficits are to be financed by domestic borrowing, then there will be little or
no domestic savings left to meet the investment needs of the private sector,
and the borrowing needs of cities and municipalities. in this case, economic
growth will plummet.
If financed by foreign savings, then private investment will be dragged down in
the rest of the world and further constrain world economic growth. If financed
through monetization, which seems increasingly inevitable, as low interest
rates on US debt and a depreciating US dollar will deter cheap foreign
financing, inflation will be ruinous for creditors and fixed income recipients
and with ominous implications for long-term US economic recovery.
In view of sizeable US debt and its interest expense, the US Treasury would
compel the Fed to keep interest rates low, undermining real savings and
economic growth and keeping inflation high and the dollar in a death spiral.
The road ahead is anything but rosy.
Unfortunately, Bernanke has not appreciated the need to restrain money policy
and has seemingly ignored the previous bouts of cheap money policy, which have
all ended in financial crisis, and social and economic decay. He has remained
insensitive to the damage his (and that of his predecessor as Fed chairman,
Alan Greenspan) policy has brought to the US and the global economies.
Ironically, he has described the damage quite succinctly himself: "The US
economy has contracted sharply since last fall, with real gross domestic
product having dropped at an average annual rate of about 6% during the fourth
quarter of 2008 and the first quarter of this year. Among the enormous costs of
the downturn is the loss of nearly 6 million jobs since the beginning of 2008."
Notwithstanding the magnitude of the drop of real GDP, Bernanke eluded his
audience by stating a fact of utmost gravity without any explanation. While a
deceleration of economic growth to a low positive or even a low negative rate
is worrisome and a symptom of sub-par economic management, a significant
negative growth rate should be of major concern. The only explanation for such
significant negative growth is Bernanke-cum-Greenspan decade-long aggressive
monetary policy in form of negative real interest rates and unlimited money
injection.
One of the giants of economics, Irving Fisher (1933), after reviewing all
causes for large drops in GDP, determined that, barring war, a big drop in GDP
could only arise from over-indebtedness. Besides an unsustainable credit-to-GDP
ratio, Bernanke (and Greenspan) unleashed speculation in commodity markets that
crippled the US and world economies. Speculation pushed food prices to
prohibitive levels in vulnerable countries and even in the US, where the number
of people living on food stamps stood at 34 million in May 2009 and climbing.
Aggressive money policy has created overwhelming distortions between asset and
commodity prices, the level of indebtedness, and the wage-income structure in
the economy.
Negative economic growth means the "cake" has become smaller, and therefore in
terms of per capita income, people have a lower standard of living than before,
with impoverishment raising its ugly head in some of the more unfortunate parts
of the country. These conditions mean that capital has a negative return and
the rate of profit is negative in the economy. The rate of economic growth has
realigned with the negative real interest rates forced upon the US economy
during the past decade.
There is a close relation between interest rates, rate of profit, productivity
of capital and the rate of economic growth. Depressing real interest rates to a
negative range through a decade-long cheap money policy has caused
misallocation of resources in the economy and brought the return to capital and
the rate of economic growth into a negative range.
Yet, stock prices, albeit a leading indicator, have gone up sharply in spite of
a deepening recession. For instance, the Dow Index appreciated by 35% during
March 9-June 5 this year. Such incredible appreciation at a time real GDP
growth was negative, the rate of unemployment at 9.4% and with little sign of a
significant recovery (even though the Dow Index is a leading indicator) is a
total disconnect between financial markets and the real economy, and the
powerful result of Bernanke's policy in creating distortions and speculation.
Liquidity injection by the Fed has found its way into speculative markets such
as stock and commodity markets and pushed asset prices into another speculative
boom.
As in previous testimony, Bernanke has dismissed the presence of any inflation
or inflationary threat, saying: "In this environment, we anticipate that
inflation will remain low. As a consequence, inflation is likely to move down
some over the next year relative to its pace in 2008." Yet, gas prices shot up
by 30% and food prices rose by 15% during April-June 2009. Noting that average
US consumers spend much of their incomes on buying fuel and food, such
inflation will drag consumer spending down and weigh on economic growth, as it
did in 2007-2008.
No responsible central banker should ignore such two-digit inflation in food
and gas prices and maintain that there is no inflation. US central bankers have
long decided to ignore the effect of monetary policy on energy and food
inflation and asset prices (for example, housing prices) and to pay attention
only to core inflation, irrespective of the vicissitudes of the excluded
inflation and its powerful adverse effect on economic growth.
The gap between financial investors and Bernanke was irreconcilable. While
investors, rightly expecting inflation, were fleeing dollar assets and the
falling dollar, Bernanke was anticipating no inflation in a highly unstable
policy environment. Even though Bernanke has always played down inflation, his
deliberate policy at the behest of his supporters was to re-inflate the US
economy out of over-indebtedness and push housing and stock prices to high
levels to prevent impending bankruptcies.
By reducing interest rates to zero and expanding money supply at over 15% a
year, Bernanke wanted to achieve high inflation for asset and commodity prices
and a lower dollar to alleviate the cost of US public and private debt. This
policy has created exchange rate instability and high inflation in the world
economy. The more the Fed attempts to inflate, the more other central bankers
are forced to do the same; the inflation spiral could become competitive, fed
by competitive devaluations and massive liquidity expansion.
Bernanke plays down the fact that oil prices could be as inflammable as oil.
The ravages of high oil prices have been evident. With a view to stabilize oil
prices and help the world economic recovery, the Organization of Petroleum
Exporting Countries has decided to maintain its output level in face of falling
oil demand. Unfortunately, as in the past, Bernanke has pushed oil prices up
and up through his relentless zero interest rate, a depreciating US dollar, and
unlimited money printing. Oil prices are again on the march upwards. When oil
prices rose to $147 a barrel in July 2008, the US Congress was mad at oil
companies, summoned their officials for hearings, and never saw the link
between Bernanke's policy and oil price inflammation. Equally disturbing is the
total silence of Congress and the administration in the face of oil and food
price inflation.
Over the next four years, the US economy will face a combination of record
fiscal deficits and unsafe money policy that will debase the US currency. Such
policy has so far depressed the US economy, cut real incomes, and caused
heightened uncertainties. Real savings will be absorbed by gigantic fiscal
deficits and will be totally discouraged by zero interest rates. Hence, private
investment will drop to low levels that would not enable the economy to recover
and create badly needed jobs. In such an environment, world-wide inflation
could accelerate, food and energy supply could dwindle, and economic growth
could be further derailed.
The media and policy makers started to "see" the end of the tunnel and
confidently projected US economic recovery for the second half of 2009.
Unfortunately, with looming and irreversible US fiscal deficits and Bernanke's
merciless money debasing, the order of the day will be speculation and
uncertainty.
Economic recovery will require massive real investment and a stable
macroeconomic environment. Financial markets have lost confidence in the
soundness of US policies and expect a possible collapse of the dollar and
growing US debt difficulties, namely, that US debt service is forced to decline
in real terms through accelerating dollar depreciation and inflation. These
expectations will not favor economic recovery. The most likely scenario will be
a depressed economy for as long as the Fed continues its policy stance of the
past decade.
Bernanke admitted in his speech that the US has to make difficult choices and
had to rein in its runaway fiscal deficits. The administration and Congress
have to admit that they have to make a much less difficult choice: renounce
unorthodox money policy. The idea of turning a recession into a boom overnight
through money printing should be disbanded. The US economy is trapped in a
vicious circle: cheap money policy, bankruptcies, inflation and recession, and
fiscal expansion.
The US Fed has long been seen as a source of instability in the US economy. Its
discretionary power and deliberate role in fueling unsafe credit expansion and
asset bubbles have cost the US two years of negative growth and excessive
social and economic dislocation.
The Group of 20 policy of transplanting Bernanke's aggressive monetary policy
to the rest of the world is yet another mistake. World leaders should realize
that the exit from the present financial crisis, brought about as a natural
consequence of cheap money policy, is not through further monetary chaos.
Without reinforcing money discipline, the world economy will in time suffer
high inflation and economic decline.
The world cannot afford the severe consequences of present financial
instability, the devastation of unruly reserve central banks, excessive
taxation of the poor and free wealth redistribution in favor of speculators and
borrowers. The world economy has to achieve price stability and restore prudent
monetary policy before it can restore significant sustained growth.
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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