No escape for Fed
By Hossein Askari and Noureddine Krichene
In contrast to Federal Reserve chairman Ben Bernanke's testimony last week, we
cannot see a safe "exit strategy" for the Fed from its current loose monetary
policy. Bernanke's ambivalent testimony of a safe exit strategy can only
heighten uncertainty and exacerbate instabilities. Let's explain.
In his recent testimony on July 21 before the Committee on Financial Services
of the House of Representatives, Bernanke was felicitous that aggressive money
policy had averted the collapse of the financial system. However, he omitted to
say that the same policy had failed to avert a collapse of real gross domestic
product (GDP) and private investment and rising unemployment.
The economic recession continues despite interest rates being
near-zero, money supply rising at 22% a year, unprecedented stimuli packages,
and record fiscal deficits reaching 13% of GDP in 2009. Bernanke and President
Barack Obama's team had clearly believed that a combination of aggressive money
and fiscal policies would secure the return to full-employment and quickly.
After all, Larry Summers had predicted the unemployment cresting at about 8%.
These expectations were standard Keynesian predictions that have proven to be
substantially off the mark.
As clearly implied by Bernanke himself, this policy has so far been
self-defeating: "Aggressive policy actions taken around the world last fall may
well have averted the collapse of the global financial system, an event that
would have had extremely adverse and protracted consequences for the world
economy. Even so, the financial shocks that hit the global economy in September
and October were the worst since the 1930s, and they helped push the global
economy into the deepest recession since World War II.
"The US economy contracted sharply in the fourth quarter of last year and the
first quarter of this year. More recently, the pace of decline appears to have
slowed significantly, and final demand and production have shown tentative
signs of stabilization. The labor market, however, has continued to weaken."
This counter-performance testimony should be contrasted with Bernanke's first
testimony as Fed chairman in February 2006: "The US economy performed
impressively in 2005. Real gross domestic product increased a bit more than 3%,
building on the sustained expansion that gained traction in the middle of 2003.
Payroll employment rose 2 million in 2005, and the unemployment rate fell below
5%. Productivity continued to advance briskly."
In his 2006 testimony, Bernanke was claiming credit for high growth induced by
the cheap monetary policy he forcefully advocated as Fed governor. However, he
never foresaw the financial shocks of 2008 (which he considered to be the worst
since the 1930s) his policy would bring about, despite the flash of red
indicators such as the housing bubble, oil and food price inflation, widening
external deficits, depreciating currency, and rapidly growing subprime credit
in the market.
What good is a central bank if it cannot see the approaching storm until after
it has devastated the landscape?
In the footstep of his predecessor, Bernanke was not moved by the housing
bubble or oil and food inflation until inflation had crippled the world
economy. Long-run stability was not relevant for policymakers interested in
short-term economic booms. Unsafe money policy and near zero interest can only
foster speculation in commodities and assets, exchange rate instability, and
increase distortions in the economy. Indeed, the past decade of cheap monetary
policy could be appropriately labeled as the speculative decade.
Aggressive policies might have saved bankrupt banks through massive liquidity
injections and bailouts and even turned them into profit-making institutions,
but these same policies have only shifted the losses to the government and
taxpayers, increased the potential of an inflation tax, and could bankrupt the
government itself. They have also caused economic losses in form of millions of
joblessness and falling economic growth.
In his recent testimony, Bernanke sent conflicting messages describing an "exit
strategy" from the unprecedented monetary expansion while reassuring the
political establishment that such exit is not immediately in the offing and
near-zero interest rates and abundant liquidity would be maintained for some
time to come: "The Federal Open Market Committee anticipates that economic
conditions are likely to warrant maintaining the federal funds rate at
exceptionally low levels for an extended period."
Bernanke's message appears to be a campaign for no-exit and for re-appointment
as a chair of the Fed, aimed at winning the confidence of two key groups: (i)
politicians, that the Fed would firmly maintain its present policy stance; and
(ii) foreign investors, particularly China, which holds more than $2 trillion
in US debt, and other countries holding such debt, that the Fed has the
technical means to rein bank reserves and prevent a dollar collapse and
inflation when it is opportune to do so.
Bernanke noted that many instruments are available to a central bank for
draining reserves; however "the most important such tool is the authority that
the Congress granted the Federal Reserve last fall to pay interest on balances
held at the Fed by depository institutions. Raising the rate of interest paid
on reserve balances will give us substantial leverage over the federal funds
rate and other short-term market interest rates, because banks generally will
not supply funds to the market at an interest rate significantly lower than
they can earn risk free by holding balances at the Federal Reserve.”
Past experience showed that any slightest attempt to drain reserves could
easily send interest rates to two-digit levels. Would the Fed pay high interest
rates on reserves, say at 19%, which was the federal funds rate in 1981 when
the Fed slightly drained banks reserves, compared with 0.25% it is paying now?
If it would, that would entail huge subsidies to banks, at the expense of the
US Treasury, with serious implications for financing the US budget deficits.
In 2008, realizing the impotence of aggressive monetary policy to stem an
economic recession because of the reluctance of banks to lend to subprime
borrowers, a wave of foreclosures, and households' over-indebtedness, Bernanke
urged the government to run record fiscal deficits as a direct way to hike up
aggregate demand and avert economic recession.
Now, he has realized that the Fed has totally lost its independence and has to
accommodate large fiscal deficits through maintaining near-zero interest rates
as well as through monetization. In particular, monetary policy can no longer
be restrained as long as the fiscal deficit remains very large.
The higher interest cost of the growing fiscal deficits ($1.8 trillion this
year and only declining to $1.2 trillion by 2019) for the US Treasury could be
potentially devastating.
Suddenly, Bernanke has begun to call for fiscal adjustment as a way to regain
control of money policy and prevent excessive monetization of fiscal deficits
or a sharp rise of interest rates: "Our economy and financial markets have
faced extraordinary near-term challenges, and strong and timely actions to
respond to those challenges have been necessary and appropriate. ... The
Congress also has taken substantial actions, including the passage of a fiscal
stimulus package.
"Nevertheless, even as important steps have been taken to address the recession
and the intense threats to financial stability, maintaining the confidence of
the public and financial markets requires that policymakers begin planning now
for the restoration of fiscal balance. ... Addressing the country's fiscal
problems will require difficult choices, but postponing those choices will only
make them more difficult.
"Moreover, agreeing on a sustainable long-run fiscal path now could yield
considerable near-term economic benefits in the form of lower long-term
interest rates and increased consumer and business confidence. Unless we
demonstrate a strong commitment to fiscal sustainability, we risk having
neither financial stability nor durable economic growth."
The last sentence of the quote could have been re-worded as: "Unless we
demonstrate a strong commitment to monetary sustainability, we risk having
neither financial stability nor durable economic growth."
Politically, the Fed may not be able to restrain money policy in the context of
large fiscal deficits and soaring public debt. Any money restraint will send
interest rates rising and make deficit financing prohibitive. Similarly, the
Fed may not accept a restrained monetary policy and induce a dollar
appreciation when other major central banks have adopted equally unorthodox
policies of near-zero interest rates, massive money injections, financing
excessive fiscal deficits, and depreciating their respective currencies.
The simultaneous money and fiscal expansion in major industrial and emerging
countries may be paving the way for the worst world-wide inflation with
negative effects on growth and employment for years to come.
Foreign holders of US debt have become increasingly concerned with the
potential of the dollar's collapse as a result of the Fed's inflation-debt
trap. The Fed's policy to delay exit until near full-employment is restored may
be ill-conceived. Moreover, the Fed's deliberate policy to re-inflate housing
prices and the price level would conflict with growth and employment.
US banks hold more than $800 billion in excess reserves. This is a clear
indication that the prime market has no ability to absorb unlimited credit and
the only outlet is the subprime market. Banks have learned the hard lesson and
can no longer extend subprime loans that will be pure losses.
Although securitization of subprime loans is dead, Bernanke is trying to revive
it and even rate it AAA. The Fed has decided to circumvent banks (who have
learned their lesson and do not want to extend credit as before to the
sub-prime market), inject $1 trillion in consumer loans in the subprime market,
and bear potential losses from these loans.
Stabilization policies aimed at extricating inflationary pressure, stabilizing
commodity prices and containing fiscal deficits should be introduced without
delay. These policies worked with success in Western Europe in the 1950s,
notably in France and Germany, and in the US in 1980s. There are other policy
instruments, additional to monetary and fiscal policy, for promoting durable
growth and employment.
Promoting competitiveness and flexible price adjustment, although refuted in
Keynesian economics, is essential for clearing markets. Sectoral policies in
agriculture, energy, and manufacturing would help increase output and
employment. Addressing world food shortages and energy constraints would make a
great contribution to growth. Not all unemployment is conjunctural. A large
component of unemployment is structural and cannot be solved with
macro-policies. Long-term education and training are essential for matching
skills with technologies and available and emerging opportunities.
Bernanke's ambivalent exit strategy can only heighten uncertainty and
exacerbate instabilities. Continued fiscal and monetary expansion may widen US
external deficits and end-up creating employment elsewhere in the world.
Speculation will continue to be fueled by near-zero interest rates, affording
speculators huge arbitrage potentials, or free lunches, between money and
non-money assets. Rising public debt could weigh on future economic growth.
Bernanke and the Obama team wanted a short-term miracle of full employment
through a narrow mix of unorthodox money and fiscal policies, the consequences
of which, namely inflation and violent business cycles, are very well known,
and they have ignored supply-oriented policies that could remove distortions,
lessen foreign dependence, and restore stable growth.
Most disturbing is that exit from unorthodox monetary policies can only come at
the cost of a deep recession, much higher interest rates and effectively
placing the exit strategy burden on the Congress and on fiscal policy.
We must emphasize that the prediction of large deficits for the next 10 years
by the Congressional Budget Office will do more than unnerve financial markets.
The latest prediction, that the deficit will only be $1.2 trillion by 2019,
leaves it at a still unmanageable deficit level on the order of 5.5% of GDP.
How can the Fed have a safe exit strategy when the higher interest rates of a
"safe strategy" would blow what are already unprecedented deficits out of the
ballpark?
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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