Who is paying for the beer?
By Hossein Askari and Noureddine Krichene
Charles Kindelberger, the late international economist, recounted (1958) the
parable of an American tourist who went to Mexico. On arrival, the tourist
changed his dime into pesos on the parallel foreign exchange market. He drank a
few beers. Later, he converted back his remaining pesos into a dime at a
Mexican bank at the official rate. He returned to the parallel market and
converted his dime into pesos. He drank a few more beers, then converted
leftover pesos into a dime at a Mexican bank at the official rate. He kept
repeating this practice and enjoying free beers during his Mexican holiday. On
the last day of his vacation, he converted his pesos into a dime at the
official market and returned home. Kindelberger’s question: who paid for the
beer? Let's see if we have an answer before we are done.
Throughout history, financial crises have been invariably caused
by monetary factors. Since Irving Fisher (1933) advanced the theory of
over-indebtedness, that is, excessive credit expansion, followed by deflation
of asset prices and general bankruptcies, central banks have had an ominous
role in engineering systemic financial instability and economic dislocation.
The Great Depression of 1929-35 was caused by deliberate policy of low interest
rates by the US Federal Reserve in support of an overvalued UK pound sterling.
In turn, very low interest rates fueled a credit boom, encouraging speculation
and setting off speculative asset bubbles. The collapse of the stock market in
1929, combined with conversion of foreign exchange into gold by some major
central banks, precipitated the Great Depression.
The Fed has been at the center of the financial crisis that broke out in August
2007. By setting the federal funds rate at 1% during 2003-2004, the Fed fueled,
not one but many bubbles - housing, stocks, commodities, including oil and
gold, and in currencies. As suggested by Fisher, these bubbles were nurtured by
an over-expansion of credit that pushed liquidity toward speculative
activities.
As confirmed by the response of the Group of 20 countries to the current
crisis, central banks are not primarily interested in the stability of the
banking system. Their chief objective is clearly stated by Fed chairman Ben
Bernanke: achieve maximum employment. They hardly mention, let alone stress,
the systemic stability of the banking system. Central banks never moved to
arrest the exploding credit boom, the over-leveraging or addressing the asset
bubbles. They proclaim perfect price stability even in the context of rising
commodity and food prices and exchange-rate volatility. They only cite core
inflation, thus excluding food and energy price inflation, and asset price
changes.
Even when crude oil prices hit US$147 per barrel, food prices rose to riot
level, and the US dollar collapsed, core inflation in the US remained below 1%.
A price index restricted to one group of commodities cannot serve as a measure
of inflation. Boasting perfect price stability at a time of high commodity and
asset price inflation (and exchange-rate volatility) has been a key factor in
misleading policymakers.
Credit markets have been frequently analyzed in a dichotomic fashion: a prime
market and a subprime market. Hyman Minsky proposed a dichotomy that
encompassed hedge units and Ponzi units. The prime market (or hedge units) has
the cash flow for servicing its debt. The subprime market is composed of
speculators who, by definition, are interested only in price movements, and
Ponzi borrowers who have no savings for servicing the interest and principal of
their debt and borrow with the intent of default. Besides increasing the rate
of expansion of credit, a credit boom changes the composition of credit toward
the subprime markets.
The prime market has a limited demand for credit, which is determined by the
Real Bill Doctrine, which implies that credit is influenced by real economic
activity and is re-paid once cash flow from sales materializes. Subprime
markets' demand for credit is not related to economic activity. Credit can be
expanded only by pushing liquidity to subprime markets that have unlimited
capacity for absorbing loans essentially for speculation and consumption
purposes. Hedge funds, mutual funds, and equity funds had a leverage ratio that
could exceed 100 times their equity capital. A fast rise of speculative asset
prices such as stock, housing, and commodity prices is a reflection of higher
credit to subprime markets. John Maynard Keynes (1936) made a similar dichotomy
for demand for money, namely demand for money for transaction purposes and
demand for money for speculative purposes. When demand for money for
speculation rises, it translates into higher asset prices.
Aggregate demand could be dichotomized into two components; one is generated by
income flows in the economy and the other created artificially through pushing
loans to Ponzi borrowers. A credit boom, by creating empty money that has no
backing in terms of savings and pushing loans to subprime markets, expands
aggregate demand and stimulates output and imports. When the financial crisis
erupts, general bankruptcy sets in, and credit contracts, the credit-supported
demand of the sub-prime market vanishes forever.
Many sectors, such as auto and housing industries, find themselves with
excessive production capacity that was based on extraordinary debt-supported
demand by the subprime sector and are doomed to incur losses and lay-offs.
Demand for investment drops and the multiplier and accelerator work in reverse,
causing an economic recession. Moreover, the credit boom causes immense
distortions and misallocations in the economy and a huge redistribution of
wealth to Ponzi borrowers. It causes the price of food and basic commodities to
rise to levels that force reduction in real quantities demanded and in
curtailing demand for non-essentials in favor of essential goods and services.
Wary of the dangers of credit expansion and mindful of the composition and
quality of credit, the proponents of quantity theory proposed a fixed rule for
money supply. Based on the quantity equation MV=PT, where M is money supply, V
is money velocity, P general and all-inclusive price level, and T volume of
real and financial transactions. The fixed rule requires money supply to rise
at a rate equal to the rate of increase of T augmented by a desired rate of
long-term inflation at 1-2%.
This relationship, while advocated by monetarists such as Fisher, Milton
Friedman, and Maurice Allais, was rejected by central bankers and most
academics who favor a discretionary rule that allows the central bank to
control interest rates with a view to boosting employment. The most favored
discretionary rule is the Taylor rule, which sets interest rates in relation to
the rate of unemployment.
The difference between the two rules is fundamental. While the fixed rule takes
money as a medium of exchange and a store of value and relies on Say's law and
the price mechanism for adjustment to ensure allocation of resources, the
discretionary rule sets interest rates, introduces distortions in the price
mechanism, diverts credit to speculators and Ponzi borrowers, and allows the
monetary base and credit to grow to any level possible, as these aggregates are
of little relevance for the central bank whose objective is employment. Hence,
the level and composition of credit turns out to have little relevance for
central banks that are pursuing interest-rate targeting.
Data for Japan (click here for Table 1) shows that private credit raced upward at 11.5%-12.5% per year prior
to the breakout of the financial crisis in 1992, far in excess of a fixed rule
that would have implied a safe rate of 5%-6%. The private credit/GDP (gross
domestic product) ratio, at 187.4%, was among the highest in the world. The
credit boom was supported deliberately by the central bank through a very low
real interest rate and a rapid increase in the monetary base. Noticeably, the
credit boom boosted aggregated demand as reflected by real GDP growth rate at
4.2%-4.6% a year; it created price distortions and shown by consumer price
inflation of 6.6% a year, and a large component of credit-fueled speculation in
real and financial assets, as featured by an appreciation of share prices at
15% a year.
The response to the crisis was to re-inflate the way out of debt. The central
bank deliberately set interest rates near zero and expanded the money base at
9.6%, far in excess of a safe rule of 2%. The re-inflationary policy caused the
private credit/GDP ratio to rise to more unsustainable level at 209.3%. In line
with Fisher's theory (1933), share prices fell at 2.2% a year, reflecting the
speculative nature of the asset bubble prior to the crisis. The re-inflationary
policy has intensified distortions, undermined economic growth, with real GDP
growth rate falling to 0.4% a year, and created more speculation in form of yen
carry trade - speculators borrow yen at near zero interest rate and buy
high-yield assets denominated in other currencies, enjoying big rewards in the
arbitrage process. Japan became a classical case of the impotence of money
policy, with devastating effects on growth, and its unjust taxation and wealth
redistribution.
The US learned nothing from the Japanese financial crisis (click here for Table 2). The Fed set interest rates very low and pushed credit to
expand freely. Thanks to financialization, the private credit/GDP ratio rose to
193.7% compared with 86.2% in 1961-70, among the highest in the world, at about
12% a year, exceeding the rate implied by a fixed rule at 5%-6% a year. A large
part of the increase was destined to subprime markets, as the investment/GDP
ratio was falling and the real GDP growth rate fell from 4.2% a year in 1961-70
to 2.8% a year prior to the 2008 crisis.
Besides undermining growth, the expansion of credit in favor of speculation and
sub-prime component has turned the external current account from a surplus into
a monumental deficit. The credit boom set off intense speculation as a large
part of the credit markets became dominated by thousands of non-regulated money
market funds that have the pseudo financial role of collecting savings and
engaging in overleveraged speculative schemes.
The fast expansion of speculative credit jerked up the price of shares, gold,
crude oil, and food prices. These prices had shown considerable stability
before the credit boom gained momentum.
The US response to the crisis was a replay of the Japanese experience, namely
re-inflating the way out of debt through unorthodox money policy, amazingly
large fiscal deficits, and mountainous bailouts. The aim was to prevent any
decline in speculative asset prices. As did the Japanese, the Fed set interest
rates at near zero. It expanded its money base at 106.7% a year, and engaged in
gigantic empty money-creation schemes aimed at pushing directly trillions of
dollars to sub-prime market borrowers.
Banks had to be bailed out at a colossal cost, shifting losses to taxpayers,
workers, pensioners, and homeless. Bernanke's aggressive money policy fired up
commodity prices and pushed the US economy deep into recession and rising
unemployment.
Near-zero interest rate and unlimited liquidity have intensified further
distortions in the US economy and wealth redistribution. The carry trade in
dollars has expanded very fast, yielding gains for speculators who borrow at
zero cost in dollars and invest in higher yielding assets in other currencies.
Could the US crisis and post-crisis performance resemble that of Japan, namely
a drawn out economic recession and more financial disorders? In view of an
excessively high debt burden, failing banks, misguided policies, and
intensifying speculation and distortions, the US economy may experience a long
agony similar to Japan's.
The Fed has been printing money and fanning loans at near zero interest rates.
Speculators and borrowers have been enjoying gains and wealth. Japan's central
bank has been doing the same thing since financial crisis broke out in 1992.
The question is: who is paying for free gains by speculators (and bankers) and
subprime borrowers? Let's see if we have an answer?
In the case of the American tourist in Mexico, the answer was obvious: the US
banks that lent to Mexico lost their shirt. In the case of the US, the cost is
paid by bailouts, high energy and food inflation, fiscal deficits, and China,
which holds largest share of US foreign liabilities? Knowing the inevitable,
the Chinese have repeatedly expressed concern about the Fed's aggressive policy
and record US fiscal deficits.
The Japanese and US experience illustrate the devastating impact of
financialization, the sprawling expansion of speculative funds and finance, and
misguided monetary policy. In spite of the impotence of money policy and the
inability of banks to continue fanning loans to subprime markets with a
certainty of loss, central banks have chosen to intensify empty money creation,
reduce interest rates to near zero, and redistribute wealth in favor of
speculators.
New lending facilities were put in place by the Fed to lend directly to
subprime markets, ignoring the potential risk of such lending. Experience has
shown time and time again that many central banks never reverse course
irrespective of the disastrous effects of their policies, as shown by erosion
of growth capacity in both the US and Japan.
Some countries such as South Korea, Norway and Thailand suffered financial
crises by allowing credit and speculation to expand to a crisis point. However,
these countries dismissed re-inflationary policies and their severe distortions
and accepted a recession following monetary tightening; consequently, they were
able to return to growth in a stable monetary framework with a diminished
credit for speculation.
The US, along with many other countries, chose to remedy the disastrous effects
of loose monetary policy by further monetary expansion and intensifying
distortions and capital erosion with rapidly rising unemployment, while
enriching bankers beyond their wildest dreams. It has been business as usual!
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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