The bill will fall due for crisis failures
By Hossein Askari and Noureddine Krichene
For some, the past two years have been an eternity - bankruptcy, loss of
retirement benefits, loss of a lifetime of savings, loss of homes, no work and
worse. For a few - largely bankers and financiers - this has been a period to
lie low, then get back to business as usual, with bigger bonuses to make up for
We are now two years into the financial crisis that emerged in August 2007 -
universally considered as the worst of the post-World War II period - and it is
time to take stock.
Debate on the root causes of the crisis will continue for years - and come with
no definitive answer, but the US Federal Reserve's expansionary monetary
policies during 2001-2007 and the US
Treasury's deregulation ideology of more than a decade were necessary inputs
for the crisis.
The financial system may have been saved only after throwing trillions of
dollars into the wind. Some people consider this a policy "success"; others can
just as well label the entire cycle - the policy failures that led to the
crisis and the measures to save the financial system - an extraordinary policy
failure that may be unparalleled in history.
Economic history has established that the credit system is inherently unstable
and goes through endogenous and periodic crises. Banks emit liabilities, or
money, and they jointly multiply this money through loans, commonly referred to
as the creation of money by the banking system. The Fed was conceived in 1913
as a government agency to control the credit system and prevent major expansion
and contraction of credit. If, however, the Fed itself becomes the
destabilizing force for extraordinary credit expansion, then the system is
doomed to failure.
To keep the interest rate at 1% during 2003-2005, the Fed had to inject as much
liquidity as required to prevent a rise of interest rates above the target
level, irrespective of the volume or creditworthiness of credit expansion
induced by low interest rates. Consequently, liquidity went mostly to subprime
markets with the high likelihood of a meltdown to follow. The evolution of the
present crisis is but a testimony to the dramatic cost of an extended period of
highly expansionary monetary policy.
When houses, cars, appliances and other goods and services become essentially
free (financed by zero or negative real rates of interest), an economic boom is
sure to follow. Consequently, the US and other leading industrial countries
enjoyed high economic growth and near full employment during 2001-2007, led by
a rapidly rising demand and supported by large fiscal deficits and rapidly
However, during such rapid expansion, demand outstrips supply, investment
exceeds savings and speculation intensifies. Incomes and prices (houses,
commodities and goods and services) rise. Such price increases fortify profits
and in turn fuel the demand for more credit. Credit expansion, in turn, can
create huge distortions in the price and production structure. The recent
housing price bubble provided an example of price distortion caused by a cheap
credit policy. Similarly, immense housing and commercial construction activity
provided an example of over-investment, based on demand that was created by
cheap credit and speculative prices.
However, economic boom that is fueled by rapid credit expansion is invariably
short-lived and is followed by financial disorders and economic recession. For
instance, the US enjoyed an economic boom during 1926-1929, followed by the
Great Depression. The losses during the Great Depression were immense and the
US did not regain its 1929 real income level until 1939. The 1926-1939 cycle
can hardly be called a policy success.
The price and wage structure that arises in a credit boom invariably leads to a
distorted price structure. Many key sectors plan their expansion and production
capacity based on demand that is supported by cheap loans and not on demand
that is supported by income. Hence, producers over-invest.
When the demand financed by cheap loans collapses, consumer income contracts,
producers find their high prices can no longer be validated and become buried
by their fixed cost due to their excessive investment. The so-called
accelerator-multiplier effect discussed in economic textbooks plays in reverse
of the role it played in the boom phase and causes an economic recession.
In the process, some consumers enjoy wealth and consumption far exceeding their
incomes, financed through credit at the expense of those who would suffer
inflationary tax. They simply default and the bailout costs are born by
Proponents of cheap money policy among academicians, media and policymakers
largely ignore the price distortions caused by a credit boom. For instance,
prominent academicians blamed China and India for runaway oil and food prices
during 2001-2008, implying that if Chinese and Indians rode bikes as they did
in the past, oil prices would come down. They refused to see the link between
speculation, a credit-based demand, and commodity prices.
Cheap money policy enabled Madoff and Ponzi finance to thrive. Such finance
becomes prosperous in the upward phase of the credit boom when asset prices are
experiencing a bubble. Higher profits boost stock prices. Bernard Madoff was
able to boast success and distribute handsome dividends while bilking investors
of billions of dollars. However, the contraction showed that the emperor was
naked. While 71-year-old Madoff was sentenced this year to 150 years in jail,
the policymakers that provided abundant liquidity and the environment for
speculation were hardly faulted for supplying him with the fuel.
Bernanke's fatal mistakes
Bernanke's response to the crisis in August 2007 may, in hindsight, turn out to
be disastrous for the US and world economy. He quickly mounted what he called
"aggressive money policy", substantially cutting interest rates and, in
conjunction with major central banks, injecting massive liquidity into the
hands of speculators. Such a response to a financial crisis by reinflating the
economy has been criticized by prominent economists. Noted European economist
Friedrich Hayek wrote in 1932:
If deflation is not a cause but an
effect of the unprofitableness of industry, then it is surely vain to hope
that, by reversing the deflationary process, we can regain lasting prosperity.
Far from following a deflationary policy, central banks, particularly in the
United States, have been making earlier and more far-reaching efforts than ever
been undertaken before to combat the depression by a policy of credit expansion
- with the result that the depression has lasted longer and has become more
severe than any preceding one.
What we need is a re-adjustment of those elements in the structure of
production and of prices which existed before deflation began and which then
made it unprofitable for industry to borrow. But, instead of furthering the
inevitable liquidation of the maladjustments brought about by the boom during
the last three years, all conceivable means have been used to prevent that
re-adjustment from taking place; and one of these means, which has been
repeatedly tried though without success, from the earliest to the most recent
stages of the depression, has been this deliberate policy of credit expansion.
More than that: while the advantages of such a course are uncertain, the new
dangers which it creates are great.
To combat the depression by a forced credit expansion is to attempt to cure the
evil by the very means which brought it about; because we are suffering from a
misdirection of production, we want to create further misdirection - a
procedure which can only lead to a much more severe crisis as soon as the
credit expansion comes to an end.
Contrary to the market
approach and restrictive money policy proposed by Hayek above, Bernanke and his
supporters were striving to protect debtors and prevent an adjustment in
housing prices as well as in other sectors that had boomed on the basis of
demand fueled by cheap credit.
Speculators became certain that cheap money policy would not be reversed and
interest rates would be maintained at extremely low levels for many years to
come. Hence, they were able to reap huge speculative gains in currencies and
commodities based on the predicted policy course of major central banks.
Commodity speculation intensified as liquidity was plentiful and interest rates
became extremely low. Food prices shot up to levels that necessitated a food
summit in Italy. Oil prices shot up to US$147 per barrel in July 2008 and
necessitated a world oil summit in Jeddah.
President George W Bush went to Saudi Arabia begging for more oil. The US
Congress was reeling against oil producers, threatening punitive measures. It
summoned oil company officials and blamed them for high oil prices. While
governments and the public were in disarray, Bernanke was sheltered from any
blame, pointing to oil producers and emerging countries as culprits for
commodity inflation; all the while loose monetary policy is what fueled
commodity inflation and exchange-rate instability, with negative consequences
for the global economy. World trade imploded and unemployment has risen to near
10% in many countries.
In short, there was a failure of the international community to identify the
monetary aspect of commodity price inflation and exchange-rate instability and
to move decisively to solve it. More disappointing, there was a failure to rein
in monetary policy earlier in 2004 when credit was expanding at an alarming
rate and bubbles were obviously gaining strength.
Obama's frightening fiscal deficits
Unfortunately, the Obama administration has added to the Bush administration's
disorderly financial policies that caused the present crisis. Advised by
Keynesian gurus, Obama's approach has called for gigantic stimuli and an
outright fiscal expansion to force an end to recession and re-establish full
The Keynesian model rejects Say's law (crudely put, the principle that supply
constitutes demand) and the Walras price mechanism (on market equilibrium) as a
way out of the depression. It assumes unlimited supply of oil, food and
everything else, and calls instead for outright deployment of fiscal policy to
re-establish aggregate demand at its boom level.
To achieve this end, Obama's budget will increase the US fiscal deficits that
have ranged between 1% and 3% of gross domestic product (GDP) to about 14% of
GDP. The immediate goal of Obama's policy was to create demand at any cost.
Supply was given little or no consideration, despite food and energy inflation
and wide external deficits.
Recently, Obama was in a rush to announce that US GDP fell by 1% in the second
quarter (Q2) of 2009, which he considered a remarkable achievement in
comparison with a fall of 6% in Q1 of 2009. He gave no importance to the fact
that while US industries were showing negative growth, the overall growth
performance was due to a 10% increase of government spending in real terms.
As a result of these ominous deficits that will continue, the future is lined
with dark clouds. Fiscal deficits are known to absorb real savings and to erode
private-sector investment and growth. Adjustment to lower deficits has been an
extremely difficult political and social problem. Cutting expenditures is a
most difficult task that a government can face. Raising taxes is equally
difficult and will meet with political and social difficulties.
There will be a day of reckoning. Investment will be deterred. Maintaining high
deficits will in turn lead to an increase in public debt and high inflation.
Traditionally, governments have had no choice except to default or inflate and
reduce the real debt burden.
The uncertainties ahead
The Group of 20 summit in London in April called for a coordinated assault
against the financial crisis by relaxing money and fiscal discipline. Creating
demand has not been the principle issue. Simply throw money from a helicopter.
But what cheap credit does is an issue.
Higher prices are associated with a cheap credit policy. When prices start to
adjust downward in relation to real market imbalances, policymakers will see
deflation as the enemy that has to be combated. This will then necessitate even
more inflationary policies, including drastic currency devaluations, to fight
deeper recessions as a way to inflate prices. Hence, the fall of oil prices
from $147 per barrel to $71 per barrel is seen as a dangerous deflation;
however, its rise from $18 per barrel to $71 per barrel is not considered as
Two years hence, an exit from cheap money and near zero interest rates policy
may be much more difficult than outlined by Bernanke. These low interest rates
depress bank incomes, savings and investment. Today, speculators have the
surest environment for reaping speculative gains in assets, currencies and
commodity markets. Central banks are pumping unprecedented liquidity into the
financial markets and are monetizing fiscal deficits.
The underlying forces in the form of record fiscal deficits and unorthodox
money in most leading countries has significantly increased the risk for much
higher inflation. Oil, food and gold prices have risen remarkably since April
2009. Other commodity prices have shown persistent upward trends with no
tendency for reversing their gains. For the future, stagflation - with rising
prices and economic stagnation - may be a more likely scenario than
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.