Bernanke sets the world on fire
By Hossein Askari and Noureddine Krichene
United States Federal Reserve chairman Ben Bernanke recently announced he would
be again mounting a full-court monetary press. His announcement of another
round of quantitative easing (QE2) - that is, a massive purchase of bonds to
drive down the already low interest rates, and to force inflation above the
level that would make real interest rates largely negative, has jolted markets
and heightened uncertainties.
His announcement sent gold prices racing to a fresh nominal record of $1,364
per ounce, leaping by about 15% in only one week, and the US dollar went into
free-fall. The rapid increase in gold prices is an indication of strong
inflationary expectations and a loss of confidence in key currencies. During
this year, gold has appreciated by over 34%. The flight to gold has been
flight to safety and a hedge against expected inflation. As leading central
banks have embarked on what has been the most unorthodox monetary policy of all
time, investors and holders of foreign currency reserves could not wait until
the fire burned their wealth to paper ashes.
With gold soaring, it is a strong indication that central banks have failed in
their near-zero interest rate policy and unprecedented liquidity injection to
restore confidence, encourage investment, and fuel the strong recovery that has
been long promised in Group of 20 (G-20) summits.
Instead, central banks are now entangled in currency manipulation and
competitive currency devaluation. Central banks are striving to depreciate
their currencies to get a competitive edge for their exports and fuel their
economic recovery, while monetary anarchy spreads around the globe. So much for
cooperation and the success of G-20 summits.
In 2007-2008, Bernanke's loose monetary policy fueled unprecedented commodity
price inflation. But Bernanke put the blame on China and on oil producers. So
far in 2010, the price of crude oil has jumped by 27%, of corn by 63%, of wheat
by 84% , of sugar by 55% , and of soybeans by 24%. Without the Fed's
unprecedented loose monetary and near-zero interest rates, it would have been
highly unlikely for commodity prices to increase at these alarming rates. The
rise in wheat, corn, sugar, and soybean and many other commodities prices could
be blamed on bad crops. However, such rapid increases could hardly be possible
without unlimited liquidity.
Today the yield on commodities far outstrips the yield on US Treasuries.
Holding gold would have yielded 34% in less than a year, holding a Treasury
note would have yielded a nominal 1%. Likewise, holding wheat futures contract
or storing wheat would have yielded 84% in less than one year.
The frightening food price inflation has raised the specter of another food
crisis and food riots. High commodity inflation is an indicator of scarcity of
real capital and very low savings for sustaining economic growth and employment
creation. High food and energy prices are instantly transmitted to retail
prices. Consumers suffer dramatic losses in their real incomes and are forced
into scrimping on food, and in the case of consumers in the US to relying on
food stamps. Since liquidity for commodity price inflation is abundant and
cheap, food price inflation could run up, stall world economic growth and
spread social unrest.
While we worry about food price inflation, the Fed with its obsession on core
inflation dismisses any talk of inflation. Fed governors should do their family
grocery shopping and then talk. They should talk to ordinary Americans and see
what they say about food prices after each visit to the supermarket.
It would be unfair to claim that Bernanke's policy did not make some of us
happy. As before, his policy has been most propitious for speculation. It has
been almost a free lunch for borrowers and speculators. Hedge funds reported
their biggest gains of the year in September 2010. Managers assumed more risk
in the context of abundant cheap liquidity and more quantitative easing in
sight. Some hedge funds netted an increase of 12% in the value of their
portfolios in September, while some commodity funds netted an increase of 15%.
Near-zero interest rate policy has created ample arbitrage opportunities for
reaping almost free wealth based on un-mistaken policy setting and almost sure
trends in commodity and asset prices. Namely, there are no prospects for
Bernanke to renounce his monetary unorthodoxy any time soon.
The Fed quantitative easing in 2002-2005, through setting interest rates at 1%
and injecting enormous amount of money, in large part fueled the housing boom
and precipitated the collapse of the housing market. QE in 2007 accelerated
commodity price inflation and sent oil and food prices to unprecedented levels,
in turn stalling the world economy with unemployment rate rising rapidly from
4% in 2007 to over 10% in 2009. Since September 2008, QE after two years has
not achieved the quick turn-around and full employment promised by the Fed. The
Fed could be likened to a gambler who each time doubles the stakes to recoup
Regardless of vast damage caused by ultra loose monetary policy, Bernanke is
still confident that stepping up QE will bring about prosperity. Near-zero
interest rates do not make capital cheaper, oil prices shot up to $147, wheat
prices more than doubled, and corn prices more than tripled.
For a moment assume that the Fed purchases $2 trillion in bonds. Pundits
estimated that this mountain of liquidity would reduce the already very low
long-term interest rate by at most 50 basis points (bp) from 3.25% to 2.75%.
Why hasn't credit expanded while interest rates have been so low, and negative
in real terms? What makes credit expand by $2 trillion when long-term interest
rates fall by 50 bp? These are questions that Fed cannot answer. With the
credit-to-GDP ratio at a record peak of 350% in 2010, high uncertainty, little
confidence, banks saddled with toxic assets, and very low lending rates, it
would be difficult to envisage banks rushing to their deathbed by lending to
the bankrupt subprime sector yet again.
Obviously, when the Fed injects $2 trillion, or more, of paper money to the
economy it does not add even one gram of corn or one drop of oil. It creates
huge amount of money out-of-thin air. Its action immediately alters wealth and
income distribution and distorts prices. The size of distortions is directly
related to the quantity of liquidity; the more liquidity is brought in, the
more severe the distortions. The Fed grabs real wealth from one group and
redistributes to another group in the name of complying with its mandate to
create prosperity and jobs. Banks that play the Fed's game will face high risk
that could potentially wipe them, as has already happened to Lehman Brothers.
The beneficiaries of the Fed's purchase program are bond sellers who reap
capital gains when bonds are sold at very high prices; government that will
sell bonds to expand fiscal deficits; speculators who reap abundant wealth at
zero cost; and borrowers in subprime markets who are the only outlet for rivers
of cheap money. This liquidity will finance mostly, if not only, consumption
with negligible impact on investment and real capital accumulation, and will
thus aggravate public sector and private sector deficits; it will increase
imports and reduce exports.
Who are the losers who will pay for this free lunch? They are those on fixed
incomes, mainly workers and pensioners, creditors, and holders of US dollars
and US dollar-denominated assets. They will suffer from an inflation tax and
will be robbed of their real wealth and income.
The injection of new liquidity in the QE2 will reduce the real savings that are
needed for real investment and capital accumulation and will, thus, curtail
economic growth and employment. Moreover, real capital will migrate from US
towards higher yielding currencies abroad and will precipitate the downfall of
the dollar. Real economic recovery cannot take place in a context of high
commodity inflation, near-zero interest rates, and monetary chaos. Commodity
inflation is already a leading indicator and will run ahead of recovery and
will terminate it. The US and world economies could be back to the nightmares
of 2007-2008: rampant energy and food inflation price and depressed economies.
The policymaker is the same: the Bernanke Fed with its ultra-loose monetary
approach. Like his predecessor, Alan Greenspan, who refused to arrest assets
bubbles before they crashed on their own, Bernanke continues to reject links
between interest rates and housing price inflation and has remained convinced
that ultra-loose monetary policy is best course for prosperity.
Three years into the crisis, the US has refused to change its monetary policy
that has led to the collapse of the banking sector. If US banks release their
excess reserves, today at about $1 trillion but getting ready for a further
rapid take-off under QE2, they would with high probability trigger rapid
inflation. The US Fed is promoting monetary competition throughout the world as
each central bank is counteracting with monetary expansion.
The biggest priority for world governments is to arrest the devastating
monetary expansion initiated by central banks. The stance called for by G-20
summits to unleash money unorthodoxy has turned out to be self-defeating.
Governments have to agree on some form of monetary targeting and renounce
interest rate setting. A monetary conference is urgently needed.
Governments have to realize that employment creation and growth should not be
the goals of a central bank. The late Milton Friedman and other prominent
economists argued that a central bank controls money and credit. Its mandate is
to control money aggregates within safety and prudential regulations. The
present policy course of the Fed could ruin the banking sector no matter how
perfect the regulations. A regime of near-zero interest rate and abundant
liquidity will expose banks to high risks. As in Japan, banks get bitten only
once, and become reluctant to follow the course set by the central bank - to
lend and assume high risk.
Policymakers in the US have to face up to the limits of monetary policy. A
return to sustained economic growth cannot be achieved by simply adopting
near-zero interest rate and cheap liquidity. Such policy, even if it succeeds,
is most inefficient and creates distortions and asset bubbles. It will ruin the
banking sector, as it had done in recent and distant past, and will create a
high degree of exchange rate instability and disorder in international finance
and international trade.
Full-employment can be established only by the private sector. Therefore, the
market and the price mechanism have to be allowed to operate without the
distortions that have been created by government and central bank policies. The
US could have got out of the recession as quickly or even quicker than many
other countries had it not adopted such strong re-inflationary policies.
Astonishing fiscal deficits and ultra-loose money policy will intensify
distortions, erode real capital accumulation, and diminish private sector
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.