Page 1 of 2 Bernanke still a speed demon By Hossein Askari and Noureddine Krichene
The major reserve currency central banks escalated their monetary unorthodoxy
over the past month. On June 24, the European Central Bank (ECB) injected
US$614.8 billion at 1% interest rate to stimulate the euro-zone economy. As for
the US Federal Reserve, it decided on the same day to keep its interest rate at
near zero. Its statement reads: "In these circumstances, the Federal Reserve
will employ all available tools to promote economic recovery and to preserve
price stability. As previously announced, to provide support to mortgage
lending and housing markets and to improve overall conditions in private credit
markets, the Federal Reserve will purchase a total of up to $1.25 trillion of
agency mortgage-backed securities and up to $200 billion of agency debt by the
end of the year. In addition, the Federal Reserve will buy up to $300 billion
of Treasury securities by autumn."
In effect, central banks have become interlocked in a devaluation
war by imposing near-zero interest rates and resorting to unlimited money
printing. The ECB became retaliatory after the euro appreciated significantly
against the US dollar (and thus lost export competitiveness) over a number of
years, appreciating by 88% against the dollar from $0.84 per euro in October
2000 to $1.58 per euro in March in 2008. Consequently, the euro appreciated
dramatically in relation to Asian and other currencies that were essentially
fixed to the dollar and were vigilant to the US Fed’s deliberate depreciation
policy.
Combined with an energy shock, such considerable appreciation of the euro
turned out to be devastating, inflicting the worst post-World War II recession
on the euro-zone area. The euro-zone will in all likelihood suffer from an
overvalued currency that weighs on its external competitiveness, exports and
growth for some years to come. Hence, confronted by an overly aggressive US
monetary policy, the ECB and other major central banks have had no choice but
to retaliate to regain their lost competitiveness. Such is the case for Japan,
China, the United Kingdom, Switzerland, and a number of other countries with
export-oriented economies that want to defend their export markets.
On June 24, the Wall Street Journal (WSJ), in an article tilled "Bernanke at
Creation", was critical of Fed chairman Ben Bernanke's over-aggressive monetary
policy after he became governor at the Fed in 2002 and later as chairman
beginning in 2006. His monetary adventurism has been unparalleled in US
history. Ignoring vehemently the housing bubble, runaway commodity prices, and
depreciating exchange rate, he forced the federal funds rate to 1% in 2003-2004
and stepped up money supply and cheap credit.
What has his aggressive monetary policy achieved since 2002? It certainly did
not lead us down the path of durable economic prosperity and stability;
instead, it ended a two-decade period of economic prosperity and led to
unparalleled instability in the US and the world economy. It quickly sent the
US banking system crumbling, inflicted a huge fiscal cost in form of trillions
of dollars in bailouts, played havoc with the housing market, caused free fall
of the US dollar, runaway food and oil prices, unsustainable external deficits,
and an economic recession and rising unemployment. The final fiscal tally of
this monetary adventurism could reach unbearable levels, especially for future
generations. Sequels of the financial crisis could be with us for a long period
to come.
In the June 24 editorial, the Wall Street Journal reprinted an editorial from
December 9, 2003, titled "Speed Demons at the Fed", where it had predicted that
the Fed was embarking on a dangerous money path with dire financial, exchange
rate, and economic consequences. It noted that commodity prices rose by 30% in
2003, oil reached $31 per barrel, and gold had climbed to $406 an ounce.
Moreover, the economy was growing at 8.2% a year. Based on these indicators,
the editorial called for tight money policy.
On the same day, Bernanke rejected the WSJ warning, denied any link between
commodity prices and inflation, or between the US dollar depreciation and
inflation, and called for renewed monetary expansion. While Bernanke was able
to ignore WSJ warnings, he was not able to predict the quality of loans that
followed from mountainous liquidity he pushed onto the markets. He was unaware
of the trillions of dollars in toxic assets that he was manufacturing. Much of
his liquidity creation went to subprime loans that will never be recovered.
Neither did he predict that his liquidity infusion would fuel speculation in
assets, currencies and commodity markets, setting off food and energy riots,
and disrupting economic expansion and employment. Bernanke blamed it all on
credit default swaps and lax underwriting.
In his remarks on December 9, 2003, Bernanke said: "Do not worry about
commodities or the exchange value of the dollar." He argued that commodity
inflation and US dollar exchange rate had no effect on US inflation. Instead,
according to his theory, inflation was related only to the output gap. As long
as the output gap was negative, that is, if actual gross domestic product (GDP)
was below potential GDP, the economy was at no risk of inflation. Hence, he
argued that the central bank had to adopt an aggressive money policy until the
output gap closed. Such is the policy prescription from what is called the
Taylor Rule or the Phillips Curve. Because potential GDP is not a measured
macroeconomic variable, it can be estimated in millions of ways. There are,
therefore, millions of ways for estimating an output gap, making the concept
difficult to use as a policy tool.
Besides its arbitrary nature, the output gap has less relevance for the US
economy, which has an external current account deficit ranging from 5% to 7% of
GDP, implying that US aggregate demand far exceeds its actual GDP. Similarly,
an output gap has little relevance for Zimbabwe, which is running extraordinary
large current account deficits. In both cases, demand far outstrips supply. In
both cases, the remedy is for production to adapt to the demand structure, or
demand to be constrained or adapt to the production structure, or exports to
grow to cover for essential imports such as oil and food.
When the current account deficit is large, an economy has no slack resources.
Monetary expansion has less effect on the output gap and will widen the
external current account deficit or turn inflationary. It cannot address
structural and technical rigidities that make the economy over dependent on
imports. The Zimbabwe central bank cannot make Zimbabwe manufacture
Japanese-type cars that Zimbabwe consumers would love to buy. Hence, its labor
surplus has no economic value for its consumers. Development and sectoral
policies can best address structural slack.
In reprinting the 2003 editorial, the WSJ noted that Bernanke was replaying the
same policy as in 2003:
Fed officials say not to worry, they're as
vigilant about inflation as ever - which is itself a reason to worry. We've all
seen this movie before, when the Fed's failure to act in time gave birth to the
housing bubble and credit mania that eventually led to panic and today's
recession. Will it make the same mistake now? ... But this time the Fed has
also gone to greater easing lengths than it ever has, taking short-rates nearly
to zero and making direct purchases of mortgage securities and even Treasuries.
These are extraordinary acts that push the Fed deeply into fiscal policy,
credit allocation and directly monetizing Treasury debt. Combined with the
2003-2005 mistake, they have also raised grave doubts about the Fed's
credibility and independence.
Bernanke has remained dismissive
of a link between commodity prices and inflation or any credit risk and
deterioration of credit
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
