A deluded G-20 By Hossein Askari and Noureddine Krichene
In preparation for the Group of 20 (G-20) summit in Pittsburgh on September
24-25, finance ministers and central bankers meeting in London on September 4-5
were congratulatory on the success of their unprecedented fiscal deficits and
monetary expansion in inducing economic recovery and stabilizing financial
markets.
In view of the quick turnaround of the world economy, there was little talk of
an exit from their expansionary demand policies. Their communique read: "We
will continue to implement decisively our necessary financial support measures
and expansionary monetary and fiscal policies, consistent with price stability
and long-term fiscal sustainability, until recovery is secured. Our
unprecedented, decisive and concerted policy action has helped to arrest the
decline and boost global demand. Financial markets
are stabilizing and the global economy is improving."
At their earlier meeting London in April 2009, the G-20 leaders had decided to
push aggregate demand through two channels: adopt record fiscal deficits and
boost credit irrespective. The summit called for stimuli on the order of US$5
trillion. Credit expansion was to be propelled through zero and near-zero
interest rates and massive liquidity injection. How could this fiscal and money
expansion avoid price instability and fiscal unsustainability? The answer has
still yet to be provided by the G-20 policymakers.
Demand policies can be promoted only through fiscal deficits and central bank
monetary policies. They cannot be promoted by the private sector. Governments
and politicians cannot resist demand policies as these are the immediate
response of governments and central banks to fight economic recession.
Unfortunately, these policies are invariably unsustainable and end with
economic and financial turmoil.
In the case of a number of developing countries, demand policies have caused
excessive foreign indebtedness and or inflation. They have contributed to
political instability, a setback of the development process, and widespread
unemployment and poverty. Many developing countries were not able to get out of
their debt hangover except through an outright cancellation of their foreign
debt.
In much of the developed world, demand policies have been adopted since 2001,
following a two-decade long period of balanced fiscal and monetary policies
accompanied by economic prosperity. In the US, starting in 2001, demand
policies were followed aggressively under the George W Bush administration at
an unprecedented scale. Fiscal deficits rose dramatically.
The US Fed lowered interest rates imprudently to 1% during 2003-2004 and
monetized fiscal deficits. These demand policies succeeded in generating strong
economic growth, high employment, and speculative bubbles. They lead to
exceptionally high inflation in food and energy prices and high exchange rate
instability. In the case of the US economy external deficit widened to 5-7% of
gross domestic product (GDP).
The Bush administration literally ignored all deteriorating indicators and
maintained the same lax monetary and fiscal stance, which in turn precipitated
financial collapse with dislocation of the banking system, massive bailouts,
and rising unemployment. Although the G-20 communique mentioned that financial
markets were stabilizing, such stabilization had been brought about at a huge
cost of government bailouts. Even after all these expenditures, banks are still
saddled with enormous level of impaired assets.
Despite the ravages caused by such demand policies, the G-20 continued to
reinforce these policies at a scale not seen before. The G-20 was clearly
guided by the short-term objective of economic recovery using unorthodox
policies. It was not concerned about the broader and wider implications of
these policies and the financial disorders they would entail in the long-run.
Certainly, policymakers in 2001-2004 were interested in high growth and
employment. They were not concerned with the implications of demand policies
and the business cycles for the financial losses that would inevitably follow.
They bluntly rejected all calls for restraint.
The Barack Obama administration is belittling the Bush administration's
economic and financial mismanagement. And yet, it is running the largest
peacetime deficit in US history, at about 13% of GDP, and the most lax monetary
on record.
United States policymakers are not looking beyond the short-term period. They
are not as concerned as they should be about the rising public debt and
implications of large government expenditures in the long-run when such
expenditures turn out to be unsustainable and become a depressant for economic
activity as opposed to a stimulant.
A high public debt may require a substantial increase in taxes, which will in
turn depress economic activity. In the same vein, central banks are interested
in pushing more loans without sufficient concern for speculation, the health of
banks, misallocation of resources, and inflation. The goal is to achieve rapid
economic recovery at any cost.
The G-20 has seemingly ignored the simple fact that it is the demand policies
implemented since 2001 that have brought about the worst economic and banking
crash of the post-war period. These policies have been distortive with
redistributive effects, bankruptcies, and inefficiencies. The G-20 has also
pushed demand policies on developing countries and used them as a vehicle for
revitalizing the exports of industrial countries. This approach could ruin
growth prospects of these countries and disrupt their fragile financial
systems. The G-20 never asked whether demand policies were the right approach
for rehabilitating the financial system and paving the way for growth.
The G-20 has tried to prevent economic adjustment following the boom and
bubbles that preceded the current crisis in the name of fighting deflation. US
policymakers were trying to prevent downward price adjustment of over-inflated
housing prices in the presence of excess supply of housing, pretending that
such adjustment would reduce wealth and therefore consumption.
Similarly, food and energy prices had risen to high levels, which pushed the
number of people who live on food stamps to about 36 million in the US. A main
explanation for such a rise was the high cost of food products. Food prices
have remained very high in most countries and could impair future economic
growth. The G-20 ignored the channels that caused high unemployment and assumed
simply that such high unemployment was brought about by deficient demand and
lack of lending.
Accordingly, their communique stressed: "It is vital for growth that we act to
support lending." In sum, excessive lending brought unemployment, excessive
lending will re-establish full employment! Such is the premise of G-20
policies.
The G-20 finance ministers and central banks wanted to push lending in an
unlimited fashion, at near zero interest rates, irrespective of the dangers of
this policy. Excess liquidity can only be placed in subprime markets that have
unlimited absorptive capacity, especially for consumer loans. As the recent
meltdown of subprime loans has shown, new loans to subprime markets would be
irrevocably lost. They will have to be paid by the government to avoid a
general collapse of the banking system, a new form of socialism.
Moreover, the US economy is over-indebted, with the credit ratio at 350% of
GDP. Pushing more loans for consumption will widen external imbalances and
reduce private investment and, therefore, economic growth.
Central banks have found out that banks can no longer push loans in a hazardous
way. Consequently, they decided to lend directly to subprime markets, which can
no longer be serviced by banks, and directly bear the losses associated with
these loans. Unabated expansionary monetary policy will foster speculation and
drive speculative prices to high levels, in turn disrupting the world economy.
The G-20 ministers and central bankers should explain why fiscal deficits since
2001 and large stimuli in 2008 have failed to prevent the deep recession and
the prevailing and still climbing levels of high unemployment unemployment.
They have not explained how pushing fiscal deficits to 13% of GDP from 4% of
GDP would secure a return to full employment.
Record fiscal deficits will push public debt to unsustainable levels and
increase the size of the public sector. Unless deficits are financed through
external borrowing, they will absorb private savings and diminish private
investment.
In sum, it would appear that the G-20 is trapped in a populist demand
framework, short-termism, and instantaneous recovery, while opposed to market
mechanisms and private sector initiatives. They have assumed no supply
constraints, namely that supply of agricultural and energy products are
abundant, despite repeated warnings by the Food and Agriculture Organization
regarding growing food deficits and rampant food inflation in most countries,
and oil output constraints.
Could the G-20 exit from its demand policies? An exit from unorthodox policies
would be politically very difficult. It is easy to put these policies in place,
however, it is much harder to retract them. Major G-20 governments would oppose
an increase in interest rates as it will make their debt service unmanageable.
A period of many years of very low interest rates seems inescapable. The
reduction of public spending is a most difficult challenge, as government
expenditure are always incompressible and political opposition rises to fight
spending cuts.
The G-20 policymakers have succeeded in creating an environment of high
uncertainty that is unlikely to lead to lasting financial stability and lower
growth. Such an environment turned out to be propitious to speculation. Their
policy mix could lead to long stagflation as in the 1970s. More specifically,
the lagged effects of fiscal and money expansion as well as bailouts will be
felt over the medium-term and will weigh on economic growth.
The G-20 has been deluded: attain strong recovery with price stability and
fiscal sustainability, through accelerating fiscal deficits and overly
expansionary monetary stance, and then exit from these policies when stability
and lasting strong recovery have been attained.
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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