Page 2 of 2 Central banks need a Basel lll
By Hossein Askari and Noureddine Krichene
interest rate and discussed the effect of inflationary expectations on loan
interest rates. Even if the central bank increases the loan rate of interest in
response to inflation, the real interest, if not negative, may remain
indefinitely below the real marginal rate of profit, inducing further demand
for bank credit. Accordingly, Thornton argued that central bank should abandon
interest rate pegging and regain control of money supply through ceilings on
credit and monetary aggregates. Recently, investor George Soros has strongly
recommended credit control by central banks.
Based on Wicksell's distinction between market interest rate and natural
interest rate, Friedman (1968) argued that monetary authorities couldn't peg
interest rate or the rate of unemployment for long without setting off an
inflationary process. He noted that
every attempt to keep interest rates at a low level has forced the monetary
authority to engage in successively larger and larger open market operations.
Friedman contended that central bank could only control money supply and
credit. Based on his study of the US monetary history, he proposed a long-term
growth of money supply between 2-5% concomitant with real economic growth and
price stability.
Besides being inflationary, interest rate setting is an inefficient and
distortive form of price control. In any market, setting a price at a low level
creates a shortage and parallel markets. Very low interest rates fuel abnormal
speculation in assets and commodity markets, and discourage the demand for
bonds. Speculation, supported by cheap money, causes a disconnect between the
market price of the speculative asset and its true economic value.
For instance, the construction cost of housing could be declining, thanks to
rising productivity, cheaper immigrant labor, and cheaper materials; however,
because of Fed-supported speculation, their market price increased
dramatically. Similarly, in view of low return on Treasury Bills, which ranged
between 1 and 2%, investors turned to commodity markets, where returns exceeded
100% per year for oil, and food commodities. Speculation causes excessive price
volatility and makes speculative prices highly unstable and unpredictable. Such
price instability impedes investment decisions, creates a market risk for safe
banks, and causes large fluctuations in household financial wealth.
Interest rate setting creates large interest rate differentials and exchange
rate instability. These differentials are obvious among all reserve currencies.
Each central bank seeks competitive gains at the expense of other economies.
The more central banks engage in undermining each other, the more trade and
growth instability will be the result. In the absence of interest rate setting,
interest rates will tend to be close and exchange rates stability will be
restored.
Low interest rates and economic growth
Can low interest rates promote long-term economic growth? The answer is
definitively in the negative. There has been no economy that was able to grow
in a high inflationary context combined with massive credit defaults, massive
bailouts, and rapidly vanishing real savings. As documented, low interest rates
may afford only an initial, and temporary, stimulus to economic activity.
As banks become saddled with losses and voluminous amounts of non-performing
loans, fall under massive bailouts, and attempt to reconstitute their capital,
they can no longer resume the euphoria of the previous credit boom to be hit
again by a new round of even larger credit losses that again will imperil their
capital and existence. Only truly foolish bankers will again play the game
orchestrated by central banks and hand out money to speculators or relax
lending standards. They will stop their lending practice. It is no wonder that
since August 2007, the financial crisis has created a credit freeze that will
not unfreeze.
Low and negative interest rates create an unlimited demand for credit. However,
they severely reduce real savings. For instance, in the US, personal savings
dropped to zero and national savings became negative in 2007. The French
economist Jacques Rueff (1964) argued that cheap money policy could push a
country into starvation. With sources of real savings drying up, the economy
cannot even maintain existing capital and infrastructure. With consumption
exceeding national income over an extended period of time, the economy starts a
process of capital erosion and economic decline. This has been clearly the case
of inflationary economies, which lost control of their monetary and fiscal
stability. Negative real interest rates generate negative economic growth.
Deeper negative real interest rates cause deeper declines in real output.
Vindicating Friedman
As repeatedly shown by the late professor Milton Friedman, unduly cheap money
policy can only provide a short-term gain in output and employment. That
already happened in 2003-2007. The economy has now to grapple with the severe
consequences of unwise money policy. Recent indicators have shown that a number
of industrial countries are facing output contraction or flattening economic
growth and rising inflation.
Contemplating lower interest rates might not stimulate economic growth, as
inflation was seemingly doing a better job by making interest rates
increasingly negative, but even this did not lead to a positive response in
economic growth! Raising interest rates did not work in the seventies when
inflationary expectations became fully entrenched in the economy. Only when
Paul Volcker, the newly appointed chairman of the Fed, controlled money
aggregates during 1979-82 and renounced interest rate setting did stagflation
come to an abrupt halt. Central banks can keep manipulating interest rates and
flood the economy with more and more money for a number of years, but in doing
so, they will be destroying economic growth.
Only when central banks appreciate that economic growth and employment, however
laudable as objectives, do not fall under their control can economic growth and
employment become stable and durable. As advocated by Friedman, central banks
should only control monetary aggregates and follow a publicized fixed rule for
money supply. They should not become a political tool for financing fiscal
deficits or serving special interest groups.
Friedman strongly opposed deficit financing through money creation. Referring
to the 1951 Treasury-Fed Accord, he maintained that in case the government is
compelled to finance war-related deficits, it has to accept higher interest
rates on its public debt and should refrain from forcing interest rate down in
order to keep the cost of public debt financing low.
While there are the Basle I and II international banking guidelines for sound
banking practice, recent financial instability clearly has shown that even the
most prudent banks can suffer major credit and market risks when money policy
creates unlimited liquidity. Only massive bailouts, which are inflationary,
disruptive, and inequitable, prevented the total collapse of financial
institutions and the entire financial system. The lesson from the current
financial crisis is that there is the need for a Basle III, not for commercial
banks but for central banks!
There is a clear need for guidelines for safe central banking that is free of
rivalry among central banks, especially for the central banks that affect the
health of the global economy. Otherwise inflation, and financial and economic
instability will become the permanent landscape of the modern financial era.
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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