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     Apr 8, 2010
Fed policy and the damage done
By Hossein Askari and Noureddine Krichene

United States Federal Reserve chairman Ben Bernanke gave a great example of his power over the fate of the economy, unencumbered by rules to govern his decision-making.

Outlining the Fed's exit strategy from its ongoing accommodative monetary policy, Bernanke recently told the US House of Representatives' Committee on Financial Services that at this time a change of policy was a ''remote possibility'' and would be considered only when the economic recovery was strong enough and the Federal Open Market Committee (FOMC) judged it opportune. While the Fed chairman is free to do as he wishes in determining what is best for the economy, the consequences of discretionary policies can be nothing short of disastrous, as


exemplified by the current crisis that broke out in August 2007.

Bernanke has talked about his exit strategy on numerous occasions before. Yet, he kept on printing more money, with the Fed's outstanding credit at US$2.3 trillion in March 2010 compared with $0.8 trillion in 2006. It is not clear why Bernanke keeps talking about exit from unorthodox monetary policy when he considers such an exit as too remote during his current mandate. If the ongoing monetary policy is the best policy option, then why consider exiting from an it? But if this policy turns out to be devastating, why pursue it? History carries a sad lesson. Namely, it seems to be customary for the US Fed to pursue its loose monetary policy for far too long - until there is evidence of its widespread damage to the economy.

The Fed has been battling to save the banking system from total bankruptcy, Bernanke said in his March 25 testimony to lawmakers. But he forgot to acknowledge that the devastation was inflicted by the Fed's overly loose monetary policy between 2001 and 2005. Bernanke and Alan Greenspan, his predecessor at the Fed, are among the very few in the world who cannot see this plain fact. The Fed is caught in a vicious circle, first wreaking havoc in the economy - recession, inflation, 10% unemployment, monumental bankruptcies in the financial sector, and record budget fiscal deficits - and then trying to repair the damage through even more unorthodox policies from which, according to Bernanke's testimony, the Fed would exit only when inflation becomes a danger. Why not establish non-inflationary and safe monetary policy now before inflation becomes well established and dangerous?

The Fed has not been adequately mindful of the risks of its policies. In retrospect, if the Fed had followed more prudent monetary policies during 2001-2005, the financial chaos, the mountainous bailouts, and the worst post-war economic recession might have been avoided. Instead, its loose monetary policy spread chaos in housing markets, set off the highest commodity price inflation in living memory, sent the dollar into a free fall, and ended a two-decade run of economic prosperity. The last decade was the decade with the slowest growth in the post-World War II era and real incomes for most Americans have not increased in years.

It would have been impossible to dissuade the Fed from the footloose path. The Fed does not accept the traditional role of a central bank - maintaining monetary stability with low inflation, and not managing the economy. It would be impossible to direct the Fed from its present policy of re-inflating the economy, and debasing the value of money and destroying savings in the process. The inflationary effects of this policy, its implied burden on taxation and its distortions will gain momentum over time, damaging economic growth and employment. Put simply, the policy is akin to counterfeiting, whereby counterfeiters and their beneficiaries enjoy free wealth at the expense of the rest of society. Over time, workers will loose and become poorer.

The pure discretionary aspect of the Bernanke policy is deeply rooted in an ideology that wants the Fed to be in charge of achieving maximum employment as well as price stability. In Bernanke's words: "the sequencing of steps and the combination of tools that the Federal Reserve uses ... will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability". Obviously, a central bank is not created to achieve maximum employment. Bernanke's statement is equivalent to saying that money was invented in the pre-historic times to achieve maximum employment. Money was invented to serve as a medium of exchange and a store of value. The primary role of the central bank is to ensure that paper money will preserve its value and safeguard the stability of the financial system. In full contradiction with its dual mandate, the Fed's mandate, based on its historic record, could be easily qualified as the one that has a dual objective of achieving maximum unemployment and highest inflation. Such contrast becomes apparent when the pre-Fed period in the US is compared with the post Fed period.

Historically, the period preceding the creation of the Fed in 1913 was characterized by strong economic growth, a higher level of employment and high immigration inflows to support economic growth, and a long-term sustained deflation at minus 2% per year, thus conferring increasing real income to workers. During 1866-1906, for instance, US real GDP grew at an annual rate of 5.5% and consumer prices declined 2% a year. Today, academicians would say this was deflation, a veritable scourge, which should be prevented by every available means. The period following the creation of the Fed was marked by high inflation, the Great Depression with unemployment reaching 25%, the stagflation of the 1970s (when unemployment peaked at 12%), the current unemployment of 10%, and secular inflation that is a permanent fixture and goes into double digits. Clearly, achieving high employment and price stability did not require a central bank during much of US history.

The Fed has had always a distorted view of inflation. For the Fed, inflation did not exist in the past decade. This view was re-asserted by Bernanke in his recent testimony: "At its meeting last week, the FOMC maintained its target range for the federal funds rate at 0 to 1/4 percent and indicated that it continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Even though gas prices had gone up by 56% in 2009, food prices by 25% - with sugar and sugar-based products prices rising more than 50% and other basic food products going up by more than 30% - for the Fed these price jumps were unworthy of attention and inflation was absent. Food and energy price inflation have however imposed a huge burden on US consumers in recent years, forcing them to cut consumption of basic products significantly - and resulting in 40 millions Americans having to rely on food stamps.

The dangers of a narrow interpretation of inflation are the stuff of history and the parallels with modern era are apparent. For instance, the consumer price index declined by 1.86% in 1927, 1.38% in 1928, and was flat in 1929; while stock prices galloped along at an annual rate of 50% growth over those three years. Stock prices rose by 59% in the 12 months before October 1929, reaching the point that triggered the Great Depression. During 2002-2008, housing, commodity, and stock prices were racing at highest rates in modern times. Yet the Fed was always claiming perfect price stability with core price index remaining consistently below 1%.

The bursting of asset price bubbles caused general bankruptcies and fueled unemployment and underemployment. Yet all along the Fed has maintained stable inflation expectations. When the Fed reads inflation expectations from the interest rate term-structure that it forced on the economy through huge money printing, these expectations look perfectly stable. It is Bernanke, not the market, who decided to set interest rates near-zero. Through buying long-term securities in excess of $1.5 trillion, the Fed forced all long-term interest rates, including mortgage rates, to their lowest historical level. In other words, Bernanke is reading inflation expectations from interest rates that he forced to lowest historical levels. If a government sets the price of rice at 5 cents/lb, you cannot infer that rice is plentiful. Forming inflationary expectations from gold prices, oil prices, stock prices and other commodity prices and exchange rates portrays market views of strong inflationary expectations.

Bernanke claimed that "The Federal Reserve also promoted economic recovery through sharp reductions in its target for the federal funds rate and through large-scale purchases of securities". It is difficult to believe that the same policies that sent the US economy into worst economic and financial turmoil in the post-war period would also promote sustained recovery. Achieving economic recovery with record fiscal deficits and the most lax monetary policies would render the solution to economic problems very simple. All that is required to achieve prosperity in any country is to ramp up fiscal deficits, print money without limit and set interest rates to zero. Clearly, US banks were no longer willing to helicopter and drop money and were holding over $1.1 trillion in excess reserves compared to less than $2 billion before September 2008.

Math blocks exit
Can the Fed exit unorthodox monetary policy at a time that US fiscal deficits have exceeded 13% of GDP in the past two years and US debt is about to exceed the value of GDP? Unfortunately, the Fed would have to abide with what is called "unpleasant arithmetic". The US is not Greece. Greece has surrendered its monetary policy and cannot print paper money. The US is printing paper money. The Fed has never been an independent central bank, although some may think it to be. In fact there is no independent central bank. As any central bank, the Fed falls under the influence and authority of the government. The Fed was forced into cheap money policy during the Great Depression, the war, and the post-war period until the 1951 Accord with the US Treasury allowed the Fed to regain interest-rate setting powers. Recognizing this dependence, many famous economists, including the late Harry Johnson, proposed making the Fed part of the US Treasury.

With fiscal deficits at record levels, and US debt building up at fastest rate, the Fed has no choice except to monetize the fiscal deficits as it has done so far. Think of the imaginary scenario whereby Bernanke decides to mop up $1 trillion of liquidity. The so-called credit multiplier will play in reverse, the amount of credit will have to decline by a multiple of many trillions of dollars. This means that banks will be totally starved of liquidity and can no longer buy US government bonds. Hence, the US government would not service its debt and could no longer finance its deficits. As in the case of Greece, it would declare bankruptcy. If Bernanke bailed out the banking system and AIG, he would never deny bailing out the US government on the basis of the Fed's independence. In fact, Bernanke may have been in part re-appointed on the basis of his super inflationary and unorthodox monetary policy record to finance monumental fiscal deficits.

Could the Fed exit from loose monetary policy even in the absence of large fiscal deficits? The answer is no. Lax monetary policy has promoted speculation as it did in 1925-1929 or during 2001-2010, not to forget Japan in the 1980s. The sharp rise in stock indices and in commodities in 2009-2010 was based on near-zero interest rates and unlimited liquidity. Mopping up liquidity will cause speculators to default, housing prices to crumble, financial asset prices to crash, and brokerage firms and banks to fall into general bankruptcies, triggering a financial crisis of similar scale as the one that erupted in August 2007 and that is still underway.

In these circumstances, the Fed has to deploy the "Greenspan-Bernanke put" and maintain even more unorthodox monetary policy. The massive bailouts by Bernanke since August 2007, the TARP, and the expansion of the Fed's balance sheet from $0.8 to $2.3 trillion are clear indication that the Fed cannot end its loose monetary policy without ruining the banking system. As stated by Bernanke: "In sum, in response to severe threats to our economy, the Federal Reserve created a series of special lending facilities to stabilize the financial system and encourage the resumption of private credit flows to American families and businesses." The severe threats to the US economy mentioned by Bernanke were not naturally made; they were purely Fed-made. In other words, the Fed created the threats and cannot exit; it has to bail out banks and transfer the risks to workers, pensioners, and the government budget, ie socializing financial losses.

The Fed's policy will continue to create huge economic distortions, fuel inflation, promote speculation, and undermine confidence in the US dollar as world reserve currency. The powerful inflationary impact of Fed policy in the past decade could hardly be underestimated. In fact, oil at $15-18/barrel or gold at $250-$270/ounce are straight out of the history books. Oil is much cheaper now in terms of the price of gold than in the 1990s; in terms of US dollars, it is at least four times more expensive - indicating the large degree of money de-basing the Fed has created in the past decade. By forcing negative real interest rates, the Fed caused cheap borrowing to build up and banking sectors outside the United States to be disrupted.

The late Henry Simons, Professor at the University of Chicago before the war, asserted that unruly money policy creates too much uncertainties and risks and make it difficult to undertake long-term investment. The Fed's policy has created too much uncertainty and instability, and makes it difficult for banks to lend or for investors to undertake long-term investment planning. It has only promoted most propitious environment for financial markets speculation. Among its most obvious consequences are record fiscal deficits, inflation, bankruptcies, social inequities, and the deeper impoverishment of the underprivileged.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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(24 hours to 11:59pm ET, Apr 6, 2010)



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