Page 1 of 2 Unpleasant arithmetic
By Hossein Askari and Noureddine Krichene
Last year closed on a dark note for the US and world economies. US economic
indicators have kept deteriorating since the onset of the financial crisis in
August 2007. Real gross domestic product contracted by 0.3% in the third
quarter of 2008, unemployment rose to 6.8% in November; unemployment insurance
claims, at 586,000 in December 2008, were considered to be the highest since
1982; the federal deficit widened to more than US$1 trillion; and public debt
has jumped to almost 90% of GDP.
Bailouts have followed bailouts and could have exceeded $1.5 trillion in 2008.
Stocks have lost more than 40% of their value since September. Similar pictures
can be portrayed for the UK
and the euro zone. Besides economic recession and rising unemployment, their
banking systems required massive bailouts close to $ 3.6 trillion to stave off
financial collapse. China and Japan, while enjoying sound macroeconomic
policies, have seen their exports fall sharply.
Central banks have been in a frenzy of interest rate cuts with the US Federal
Reserve and Bank of Japan money market rates at zero bound.
While it is increasingly recognized that the housing bubble was caused by
former Fed chairman Alan Greenspan's over-expansionary monetary policy, it is
undoubtedly true that the current financial collapse and economic slowdown were
caused by his successor, the doctrinaire Ben Bernanke, who embarked on an
aggressive monetary policy from August 2007, consisting of cutting the federal
funds rate from 5.5% to a zero bound on December 16, 2008.
Not conceding that the Fed has run out of ammunition for the first time since
its creation in 1913, Bernanke remained determined to over-expand monetary
policy through inventing more tricks. as evidenced from the December 16
statement by the rate-setting Federal Open Market Committee (FOMC):
The
Federal Open Market Committee decided today to establish a target range for the
federal funds rate of 0 to 1/4%. Since the Committee's last meeting, labor
market conditions have deteriorated, and the available data indicate that
consumer spending, business investment, and industrial production have
declined. Financial markets remain quite strained and credit conditions tight.
Overall, the outlook for economic activity has weakened further.
The Federal Reserve will employ all available tools to promote the resumption
of sustainable economic growth and to preserve price stability. In particular,
the Committee anticipates that weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time. The focus of
the Committee's policy going forward will be to support the functioning of
financial markets and stimulate the economy through open market operations and
other measures that sustain the size of the Federal Reserve's balance sheet at
a high level. As previously announced, over the next few quarters the Federal
Reserve will purchase large quantities of agency debt and mortgage-backed
securities to provide support to the mortgage and housing markets, and it
stands ready to expand its purchases of agency debt and mortgage-backed
securities as conditions warrant. The Committee is also evaluating the
potential benefits of purchasing longer-term Treasury securities. Early next
year, the Federal Reserve will also implement the Term Asset-Backed Securities
Loan Facility to facilitate the extension of credit to households and small
businesses. The Federal Reserve will continue to consider ways of using its
balance sheet to further support credit markets and economic activity.
It might have been different had Bernanke asked himself a simple question: what
brought the US economy from high economic growth and near full employment to
economic contraction, unemployment, and collapsing financial system as
described in the FOMC statement?
A simple and unequivocal answer would be his misguided and doctrinaire
aggressive monetary policy. He is still determined to push banks to speculate
in the housing market and throw away money in the form of bad consumer loans
that are unlikely ever to be recovered. The Fed's assurance that it will buy
all bad loans has still not convinced banks to renew the credit orgy of the
past.
That Bernanke lacks innovative approaches and understanding of the banking
industry is evident from the statement: "The Federal Reserve will employ all
available tools to promote the resumption of sustainable economic growth and to
preserve price stability".
The role of a central bank is only to manage the money supply and not the whole
economy.
Bernanke is caught in a vicious cycle of aggressive monetary policy, declining
economy, and unstable financial system. The longer the US Congress remains
oblivious to the Fed's destabilizing policies, the darker economic prospects
and financial chaos will be?
While the track record of Bernanke and his supporters is hardly stellar, a
competent medical doctor should provide his patient with a treatment that
brings back good health and not a treatment that deteriorates health to near
death claiming that the alternative would have been death!
Interest-rate setting by the central bank and forcing interest rates to zero
bound is the worst form of factor price distortion. Such interference of the
central bank with the market mechanism causes great inefficiencies in the
economy.
What is the equilibrium interest rate for the US economy? Certainly the answer
cannot be known simply because the capital markets face imposed interest rates.
Nonetheless, in a context of a fully stable and solid financial system, the
federal funds rate, once liberated, shot up to 19% in 1980.
Could banks become profitable at near zero interest rates and largely negative
real interest rates? With ridiculously low interest rates, banks cannot pay
their employees wages, office supplies and operating costs, let alone generate
dividends or reconstitute their reserves or recapitalize. Low interest rates
will destabilize further the banking industry and force many banks into losses
or closing down business.
Could an economy grow with near zero interest rates and negative real interest
rates? Japan 1990-2002 provides a clear answer, with real growth on average
remaining below 1%. Empirically, economies with overly expansionary monetary
policies and negative real interest rates have experienced recession or
declining real output, as illustrated by US, UK, and euro zone data for 2008.
The simple Harrod-Domar growth model stipulates that growth requires savings.
Because low interest rates discouraged savings, economic growth could not be
sustained. With falling investment and income, the Samuelson multiplier and
accelerator effects work in reverse mode, pushing the economy further into
recession. If the economy can grow with negative interest rates, it will be a
miracle. This will be tantamount to growth without savings and investment.
Zimbabwe provides a clear denial for such a theory.
While Bernanke seems bent on destroying the value of the US dollar by expanding
credit arbitrarily and without any limit, the economic team of president-elect
Barack Obama, with strong support from media and academics, is putting in place
another ominous stimulus package on the order of $1 trillion, on the top of a
fiscal deficit that has exceeded $1 trillion in 2008. This could push the
fiscal deficit easily to $2 trillion.
Bernanke and Obama's teams, working independently without any coordination,
follow the same objective: stimulate the US economy through expanding aggregate
demand.
The US economy has already been stimulated under the George W Bush
Administration, turning the fiscal balance from a healthy surplus in 1999 to a
monumental deficit in 2008. The US economy has also been overly stimulated by
Greenspan's cheap monetary policy and since August 2007 by Bernanke's
aggressive monetary policy and the $150 billion package of House Speaker Nancy
Pelosi.
These excessive stimuli have not, however, invigorated the supply side of the
economy. They contributed to expanding aggregate demand far beyond real
domestic GDP, pushed household borrowing to unsustainable limits, contributed
to speculation in assets markets, and provided favorable environment for
swindles and Ponzi schemes, the latest of which is Bernard Madoff's $50 billion
scheme.
These entire monetary and fiscal stimuli created large external account
deficits ranging between 5% and 6%, and stimulated China into real economic
growth topping to 10% a year, India, and certainly oil- and commodity-producing
countries.
How much stimulus on the top of stimulus can be added? Does the US economy need
more stimulus than it already has? Obviously, the US economy has embarked on
another four-year of even more lax monetary and fiscal policies than those
pursued by
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