Forget the silver bullet
By Hossein Askari and Noureddine Krichene
The initial reaction of US Treasury Secretary Henry Paulson and Federal Reserve
chairman Ben Bernanke to the financial crisis was to argue that their proposed
US$700 billion Troubled Assets Relief Program (TARP) was better for American
families than any other plan, although they did not allude what any other plan
might entail.
They wanted their proposal to be adopted in a "clean and quick" way before the
sky fell. Unfortunately, soon after the passage of a modified plan, the TARP
quickly and cleanly intoxicated capital markets in the US, Europe and Asia,
wiping out trillion of dollars in share values and retirement savings within
the span of five trading days. Had Paulson and Bernanke not forced their
controversial TARP but had instead adopted a comprehensive
plan the ensuing nightmare in stock and capital markets might have never
occurred.
Since August 2007, Paulson and Bernanke have responded aggressively by
unleashing monetary policy, cutting interest rates and injecting massive
liquidity into capital markets, only to exacerbate food and energy price
inflation, undermine financial institutions, and cripple economic growth. In
their testimonies before the US Senate banking Committee and the US Congress in
February 2008, they reassured lawmakers that the financial system was fully
capitalized and interest rate cuts had favorably worked their way through the
economy. Combined with a $170 billion stimulus package, this encouraged
President George W Bush to anticipate strong recovery of the US economy in the
second half of 2008.
Why have Paulson and Bernanke failed so badly? Could they have been a key
factor in all this mess? Did their actions build up the market's bailout
expectations and put us more into a corner and further limit our options?
Paulson and Bernanke always acted hurriedly, and wanted to repair in five
minutes the chaos of former Fed chairman Alan Greenspan's cheap monetary
policy, and the absence of supportive regulation, supervision and enforcement,
which had been building up over a decade.
For example, they wanted their TARP to be approved instantaneously and
unconditionally, before the opening of the markets on Monday, September 22,
without allowing lawmakers any chance for reflection. They only acted in
response to crisis, and never ahead of crisis.
Above all, TARP was never a comprehensive plan and it left banks to act when
they wanted. It was like pushing, as opposed to pulling, on a string.
Economic policy is usually guided by an economic model that simulates the
economy over the short and medium term, identifies major economic and financial
disequilibria, and calls for timely and orderly policy adjustment. In
macroeconomic policy making, the radars have to remain unlocked all the time.
Monetary authorities should be fully able to identify ahead of time ailing
institutions, or unsustainable credit trends, and make required adjustment
before a crisis erupts.
Paulson and Bernanke discovered problems only when problems materialized and
became contagious. Their decisions appeared political and contradictory. For
instance, it is not easy to comprehend why the JP Morgan-Bear Stearns deal was
necessary to avoid a systemic risk while the collapse of 158-year-old Lehman
Brothers would pose no systemic risk. Why a bailout of $700 billion to buy
distressed assets and not capitalization (increasing bank capital)? Why not
more than $700 billion and why not less? What will be the impact on real
economy, inflation, taxes, and so forth?
Besides, being political and arbitrary, Paulson and Bernanke have rejected
value theory and opposed the free-market price mechanism. They have striven to
reinflate high speculative housing prices and staunchly opposed a return of
these prices to some long-term equilibrium. They acted intentionally to
depreciate the US dollar so as to increase competitiveness of US exports and
reduce the real burden of US foreign debt. They forced negative real interest
rates in an environment where interest rates have to be totally freed and help
in making sound economic policy.
This environment was characterized by rapidly falling real savings, outrageous
food and energy price inflation, and mounting loan defaults. Recently, the Fed
has become over-leveraged by injected close to one trillion dollars of
liquidity into the financial system, simply by printing money out of thin air.
Had the Fed allowed free interest rates, financial markets would have never
become frozen. A market freezes only when the government decrees a price far
below the equilibrium price, which forces suppliers to withdraw their commodity
from the market. Moreover, equilibrium interest rates would have allowed banks
to strengthen their incomes, and would have called for a small amount, if any,
of liquidity injection by the Fed since demand for credit would be checked and
deposits and foreign savings would increase. That Paulson and Bernanke's action
is dangerously destabilizing is clear. Just ask what will happen when the Fed
cannot add another trillion or decides to withdraw liquidity; most likely, the
whole system will freeze again.
The destabilizing policy of Paulson and Bernanke has been rightly addressed by
Professor Jonathan R Macey from Yale University in a Wall Street Journal
article on October11, 2008, titled "The government is contributing to the
panic: it's time to let markets do their messy work". He showed that Paulson
and Bernanke have always acted in panic, distorted market mechanisms, rewarded
speculation, punished conservative bankers, and heightened uncertainties to a
point of freezing capital markets. He could have also added that the demeanor
of Paulson and Bernanke was hardly the stuff to encourage trust and confidence
among the public, the needed ingredient in a state of panic.
Central bankers from the Group of Seven leading industrialized countries met
over the last weekend in Washington DC to confront the mountainous bankruptcies
that have followed their decade-long cheap monetary policy, and in the midst of
collapsing capital and stock markets. Unfortunately, the communique of the
meetings reinforces past policy errors by further unleashing monetary policy
and denying any role for price mechanism, inter alia freeing interest rates, in
the search for a solution to evolving financial crisis.
They fully endorsed the Paulson and Bernanke approach by throwing the burden of
intoxicated assets and bank recapitalization on taxpayers and poor workers.
A global action is necessary and welcomed, but it should not end up by
worsening the financial crisis, and penalizing workers and taxpayers. The G-7
group cannot afford to perpetuate their cheap monetary policy. It is an utmost
priority that economic making should be with the government and not the central
bank, that central banks have to absorb strict money discipline, money and
credit targets, and safeguard the value of money and safety of the financial
system.
Governments have to defend the value of money, so essential for production and
exchange, and should not kill the goose that lays the golden eggs. Governments
can guarantee the money of depositors. But the purchase of bad mortgages and of
intoxicated assets by governments will create immense fiscal and social
problems, administrative burdens, and should not be acceptable.
It does not make sense to throw good money after bad money. Proponents of
bailouts contend that without these the economy will succumb. Their argument is
not substantiated by monetary data; they only seek a golden opportunity to get
rid of their losses. Economic policy should never be conducted through judgment
and power struggle. It has to be based on the statistical apparatus, and
evaluated carefully by policymakers.
Unfortunately, with each new panicked pronouncement and speech, new proposals,
plans and programs, anxieties and expectations have grown. It seems that no one
knows what they are doing. We have been forced into a corner where our options
have become more limited. Where we find ourselves now, in a state of panic and
market frenzy, we must respond with a plan that addresses most of the problems
that we face and have created. We need a comprehensive plan, and not
politically motivated proposals in dribs and drabs on a daily, if not hourly,
basis.
Developments over the weekend were spearheaded by Europe, not by the US. Europe
has started pulling on the financial string and the US authorities have decided
to follow their lead. Both Europe and the US are stumbling towards a plan, but
they are still too focused on the short term and have not used fiscal policy to
address the problems that are best handled by a fiscal stimulus.
While the US is now planning to do some of the elements below, Washington needs
to embrace more of a comprehensive approach. Here are the bare-bone elements of
what is needed.
Because the government has painted itself into a corner, it should move
aggressively and quickly, on a case-by-case basis, to take preferred ownership
position in troubled financial institutions. It should quietly abandon its
asset purchase plan, as it would be slow to unfold; it would be cumbersome to
implement: and it will not afford the leverage afforded by re-capitalization of
banks. The Federal Deposit Insurance Corporation could move ahead much faster
with this program than a yet-to-be-created institution. To move inter-bank
lending, the government should guarantee inter-bank lending, with stipulated
limits, for a fixed time period.
Second, to enhance trust and confidence, the government should guarantee all
deposits at institutions without limit. This should also cover all money market
(including municipal) funds. The Treasury retracted this proposed policy
(limiting it to funds deposited prior to September 19) because it saw the
danger of a flight to money market instruments. But if policies are adopted in
combination, this fear will be diminished.
Moreover, if a flight toward money markets occurs, it will lower rates,
reducing the attraction of money market deposits especially with FDIC deposit
insurance already increased to $250,000. Selective guarantees will force a leak
somewhere else in the financial system.
Third, to bring financial stability to municipalities and states and to halt
the implosion of the US education system (largely financed at the state and
local level in the US), the federal government should start a two-year lending
facility for states and municipalities, at an interest rate that is reflective
of market conditions and credit worthiness of borrowers. If the federal
government does not move on this front, local and state problems will explode.
State and municipalities have lost access, with AAA-rated 30-year municipal
bond prices falling by over 20% in the past two months.
Fourth, to safeguard social conditions and slow the economic implosion,
unemployment benefits should be enhanced and extended beyond the current six
months in a 12-month cycle (with the difficult possibility of an extension).
Fifth, given the dire straits of the US infrastructure, this is an opportune
moment for the federal government to implement a 10-year infrastructure
program. The program could also address energy independence, public
transportation and the US education system.
Sixth, the government should appoint a non-partisan commission of "wise" men
and women to draw up a comprehensive regulatory and supervisory plan for the US
financial system. We must not tackle related problems sequentially.
Seventh, the US government should demonstrate leadership at the global level.
The United States should urgently convene, with preparation, a global economic
summit (and not just a weekend session with the French president and the
president of the European Commission at Camp David as now planned) that reaches
beyond the G-7 or G-8, to include China, India, Brazil, Australia, South Korea
and a few others.
The focus of the summit should be the restoration of trust and confidence to
financial markets, simultaneous efforts to enhance and support economic
activity by policies (other than reducing government lending rates) and the
commitment to avoid any and all measures to protect their own markets. This
should not be a one-time effort but a sustained effort at the highest level. A
working group should be set up following the summit to address problems
quickly, before they become serious, and to develop an international regulatory
and supervisory system to support an integrated global financial system.
The public and markets need assurance that the government is not acting in a
panic mode, but that it is calm, thoughtful and covering all the bases to
restore confidence and restore financial and economic stability. A one-day
stock market rally is no reason to relax. It's time for thoughtful, not
reactive, leadership.
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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