Fed's jobs goal means misery
By Hossein Askari and Noureddine Krichene
Ever since his appointment to the Federal Reserve board in 2002, the now
chairman Ben Bernanke has been a principal architect of a loose monetary policy
that has, in conjunction with other policy missteps, inflicted immeasurable
harm to the US economy - ending two decades of growth and full employment,
bankrupting the banking sector, causing millions of housing foreclosures,
increasing the US external deficit, and pushing budget deficits and national
debt to record levels.
The recent announcement of another US$600 billion of Fed bond purchases to
drive down interest rates has sent shivers down the backs of central bankers
around the world and pushed gold prices to yet another nominal record above
$1,400 an ounce. And
contrary to the Fed's expectations, interest rates on US debt, instead of
falling, surged upwards, and the yield curve, instead of flattening, became
These developments have reminded investors that uncertainty is alive and well
and when it strikes it will wipe out many investors who believed in the Fed and
bought government bonds and state and local municipal bonds.
While in the Fed's make-believe world inflationary expectations are low and
inflation non-existent, run-away gold-cum-commodities prices have revealed that
inflationary expectations are high and financial markets face unparalleled
uncertainties. The race for competitive devaluation has become pronounced. It
was difficult to imagine that trading partners would let their currencies
appreciate relative to the dollar as had occurred during 2002-2008. The flight
to gold was inescapable given the widespread belief that the major currencies
are interlocked in a race to depreciate.
The Fed's recent initiative has been applauded by Keynesians. The Fed and its
supporters have argued for a second round of quantitative easing because of an
unusually low rate of inflation and a high rate of unemployment. Bernanke has
argued that this was inconsistent with the mandate of the Fed that required
full-employment and a higher rate of inflation.
As might have been expected, President Barack Obama was among the staunchest
supporters of these policies and rebuked global criticism of Fed policies
during his Asian tour this month. He noted that the $600 billion Fed stimulus
would create jobs and demand in the United States and in turn would benefit all
What should become clear to realists is that Obama needed the Fed's
acquiescence to finance the government's unparalleled peacetime fiscal
deficits. The financing of huge budget deficits is an exercise in unpleasant
Bernanke's quest for full-employment was intended to make the financing of
deficit easy for the Keynesian Obama. Given the high level of US public debt,
which is near the ceiling of $15 trillion, there was a pressing need for
monetary financing and low interest rates, to cut the real value of the debt
through a sharp devaluation of the dollar and high inflation. Consequently, US
creditors will be penalized through a combination of low yields and a loss in
the real value of their capital (from inflation).
The unemployment argument would make it easier to sell the Fed's billion plan
to the general public, while hiding the true design of the plan - to finance
unprecedented fiscal deficits through depreciation.
Unexpectedly, and to the biggest surprise of international markets, in the
middle of all this, World Bank president Robert Zoellick recently and ahead of
the Group of 20 Seoul summit last week called for a reform of the international
monetary system, suggesting the pegging of leading currencies to gold. Zoellick
could be the first policymaker of such high rank in the post-Bretton Woods era
to propose a central role for gold in the context of a reformed monetary
In a global environment that generally scoffs at a return to gold, Zoellick is
courageous to repudiate the US dollar and call for re-establishing some form of
gold standard to anchor the international payments system.
Zoellick's appeal for a gold-anchored system could only be echoing the pain and
fears of financial institutions threatened by unending currency depreciation
and near-zero interest rates. In fact, most of the World Bank's capital is
locked in the form of long-term loans; a rapid depreciation of the dollar would
evaporate the real value of these loans. The World Bank and other financial
institutions may be forced to head towards gold, commodities, and stocks in
order to protect their capital base.
In reaction to the uncertainties that Fed policies have created, even former
Alaska governor Sarah Palin, who is not known for her economic pronouncements,
was may among the few high-profile US politicians to disavow Fed policies and
call for a radical change in US policy that could lead to real growth, a strong
dollar, and lower external deficits. She must have seen a direct link between
the falling dollar, high commodity price inflation, and risk of another ominous
banking collapse, which were the culmination of Fed policies during 2002-2008.
Although Zoellick spoke in favor of gold, and Palin was in favor of strong
dollar, their concerns were not in conflict. Zoellick was addressing world
monetary stability and dangers to trade and investment; Palin was addressing US
economic growth and monetary stability and perceived serious threats from
unrestrained fiscal and monetary expansion.
The appeal from Zoellick for international monetary reform is nothing new. A
number of prominent figures have called for restoring some form of the gold
standard and others have gone further. US Congressman Ron Paul has gone much
further, calling for an end to the Federal Reserve and re-establishing the
pre-Fed monetary system where money in the form of gold would be in
Putting aside the details, there is an urgent need for reform of the
international monetary system. The international economy has suffered from
rapid monetary expansion forced by the Fed. The US is still in recession, as
are most European countries; public debt, fiscal deficits and rapid capital
inflows encouraged by low US interest rates have ignited instability in a
number of countries; bank incomes have been squeezed; and investors have been
forced in to risky stocks and commodities to seek higher returns.
If and when the Fed starts to increase interest rates, banks will be exposed to
serious interest rate risk as demonstrated by the collapse of savings and loan
associations in the United States in the late 1980s. In that event, bondholders
such as pension funds will see a large part of their capital wiped out.
These effects are not limited to the US as the acceleration of money injection
by the Fed and other reserve currency countries could increase capital flows to
emerging market economies to dangerous levels, resulting in rapid appreciation
of their currencies and threatening global trade and investment.
The prevailing monetary conditions are similar in many respects to the ones
that existed in 1930s. Major reserve currency countries, then as now, fearing
domestic recession and unemployment, were reluctant to contract monetary policy
and incurred large balance of payments deficits, followed by competitive
devaluations, speculative attacks, and inflationary spirals. In spite of the
1944 Bretton-Woods Agreement and successive reforms of the international
financial system, a main deficiency of the post-1914 system was the absence of
monetary discipline and ultimately a reserve anchor (formerly gold) for
monetary policy in reserve centers.
In this regard, the dollar and the British pound sterling, by becoming reserve
currencies, expanded monetary liquidity freely through protracted balance of
payments deficits until reaching non-convertibility with gold - in September
1931 for sterling and August 1971 for the dollar.
Under the post-1914 system, known as the gold exchange standard, and
Bretton-Woods' fixed parities and flexible exchange rate systems, a reserve
center was able to run extended balance of payments deficits without loosing
foreign currency reserves, until market forces imposed a disorderly and costly
adjustment, including widespread trade barriers and restrictions.
Frequent and drawn-out financial upheavals of the world economy have led to the
formulation of a number of bold proposals for reforms of the international
payments system, such as Keynes (1943), Triffin (1960), Rueff (1963),
Modigliani and Askari (1971), and more recently Mundell and Volcker (2000).
While the proposals varied in details, they shared broadly a common objective,
namely safeguarding the world economy against disruptive financial instability.
A common reserve currency, the bancor (proposed by Keynes), was one
formulation; a reserve asset with constant purchasing power in terms of a
basket of internationally traded commodities coupled with a system of crawling
exchange rates to encourage long-term capital flows and discourage short-term
speculative flows (Modigliani and Askari) was another; or simply restoring the
gold standard (Rueff). A number of the proposals called for establishing a
central bank for central banks, which for Triffin would be the International
Absent any debate and reform, gold will dominate and countries out of necessity
will demand gold for international settlement in the case of a free-falling
The Seoul G-20 agenda was wrongly concerned with trade imbalances. President
Obama's administration and its European allies have reached the wrong
conclusion that trade imbalances were caused by China's exchange rate policy.
The US trade imbalance has been attributed to the role of the US dollar as a
reserve currency and the ability of the US to run external deficits without
losing real resources, a fact that was pointed out by Germany.
These deficits were self-multiplying and could only become larger. The dominant
position of the US dollar as a reserve currency has put the US in a
mercantilist position, the same position that Spain found itself with the
discoveries of gold in its colonies. Other European countries went through the
industrial revolutions and had to rely on exports to pay for their imports.
Spain used its gold for imports and lagged far behind the rest of Europe in its
industrialization process. In the same fashion, the US has relied on printing
dollars for imports now over many decades, while Japan, India, South Korea,
China, Brazil, and other emerging countries have been leaping forward.
The G-20 has failed to restore financial stability. Antagonism between its
members has become deep. The US has refused to rein in its over-expansionary
fiscal and monetary policies during the past decade and has wanted the rest of
the G-20 simply to follow in its footsteps and support its policy agenda.
It seems that the US believes in monetary expansion as a panacea for all
economic problems. There is little hope that the Fed will change the course of
its monetary policy or that Obama will renounce large fiscal deficits.
It will be hard to predict how far gold and commodity prices will rise when all
$600 billion are injected. The monetary injection will become a tax on workers
and creditors and will redistribute wealth in favor of borrowers.
The ideology that the central bank is in charge of achieving full-employment
has become too embedded in the US political establishment. Politicians and
academicians turn to the Fed for immediate solutions to restore full
employment. The Fed's pursuit of full employment and price stability will mean
more instability and misery for the future.
Hossein Askari is professor of international business and international
affairs at George Washington University and Noureddine Krichene, who has
a PhD from UCLA, is professor of finance at INCEIF in Kuala Lumpur.