Bernanke works on as jobless tally mounts
By Hossein Askari and Noureddine Krichene
The doubling to 15.1 million from 7.6 million in the number of officially
jobless people in the United States since 2007, with the unemployment rate
reaching 9.8% in September from 4% two years ago, excludes those who have given
up looking for work altogether and those working part time. Add those to the
numbers and the rate is a whopping 17.2%.
This rapidly worsening unemployment picture has taken place in the context of
the most expansionary fiscal and monetary policy in US history. Since the
outbreak of the financial crisis in August 2007, interest rates have been cut
to near-zero bound, massive dollar liquidity has been injected into the
economy, extensive stimulus programs have been adopted, and the fiscal deficit
pushed to 13% of gross domestic product (GDP) in 2009.
A chief architect of these policies, Ben Bernanke, nevertheless has earned the
confidence of President Barack Obama, who lavished praise on the Federal
Reserve chairman when reappointing him for another term: "I want to
congratulate Ben on the work he's done this far, and wish him continued success
in the hard work ahead."
While the Fed chairman has been congratulated and the bonuses of bankers
restored, the plight of the unemployed continues to deteriorate, and while
unemployment is a lagging economic indicator, the expectations are that their
numbers will continue to rise for some time and then decline only slowly.
The main policy prescription of the Obama administration can be summed up as
follows: record fiscal deficits would boost spending, and through the
multiplier, real GDP would rise, and full employment automatically
re-established. The main tenet underlying Bernanke's theory is that near-zero
interest rates and ample liquidity would push credit to high levels, boost
consumer spending and real GDP, and restore full employment.
Convinced of the infallibility of their respective theories, the president and
the Fed chairman have been running their expansionary policies, despite huge
external current account deficits ranging between 5% and 7% of GDP; both Obama
and Bernanke had concluded that US economy was suffering from deficient demand
and hence full employment would be automatically restored through gigantic
fiscal and monetary expansion.
It is discomforting to see unemployment worsening at a fast pace in the context
of record fiscal deficits and the most expansionary monetary policy. We are
saddling future generations with debt that does not even alleviate the misery
of the current generation. Most disturbing is the increasing ranks of the
unemployed, whose numbers are expected to continue increasing for many more
months and then to decline ever so slowly. Early on, after embarking on his
program in August 2007, Bernanke often promised a quick return to full
employment. Not only have his policies failed to contain unemployment at, or
near, its 2007 rate, that is 4%, they have kept pushing unemployment to higher
levels.
It would appear that proponents of Keynesian economics assume that government
deficits and monetary expansion work their effects instantaneously in
re-establishing full employment. They reject classical theory of price-wage
mechanism in the belief that price-wage adjustment process is too lengthy and
deflationary and, therefore, not desirable in view of the social cost of
unemployment.
The view for blocking price adjustment was forcefully espoused by the Fed in
August 2007. To prevent a bursting of a housing bubble and collapse of bank
assets, the Fed has mounted a dramatic re-inflation policy, injecting
mountainous liquidity and cutting interest rates significantly.
Obviously, monetary expansion has missed its goal for re-inflating the housing
bubble. Instead, liquidity and very low interest rates immediately fueled an
ongoing commodity bubble. Left unchecked, rampant oil and food price inflation
disrupted vital sectors and triggered a vicious circle of contraction and
unemployment. Imprudence with monetary policy led to perverse effects that were
either deliberately ignored by policymakers or simply underestimated.
Unemployment could have many causes. For instance, frictional unemployment is
attributed to real causes. A bad crop could cause some unemployment. Technical
progress can displace labor in favor of machinery. Some firms may fail and
their employees loose their jobs. Labor may be in transition between
occupations and locations.
However, mass unemployment following a long period of full employment cannot be
attributed to these and is more likely accounted for by monetary factors.
Irving Fisher and Friedrich August von Hayek held such a view during 1932-33,
the height of the Great Depression (although contested by Joseph Schumpeter).
Central banks failed to apply the monetary brake early on and allowed inflation
or bubbles to escalate to a tipping point that triggered a financial crisis.
More specifically, mass unemployment has been a dramatic consequence of
financial crises in the 19th century, the 1907 Panic, the Great Depression, and
stagflation in the 1970s. In each crisis, the economy swung from a long period
of prosperity and full employment to a protracted period of mass unemployment
with millions of jobless workers. Monetary factors triggered a vicious downward
spiral of contraction and unemployment. In these circumstances, wrong policies
can aggravate the situation and prevent the crisis from running its course.
Although during previous financial crises, unemployment rarely exceeded 10% or
extended beyond a two-year period, during the Great Depression unemployment
rose to 25% and extended over a 10-year period, spanning 1929-1939. It was only
the onset of the war economy that re-established full employment.
In contrast to a Keynesian model of instantaneous full-employment, Hayek argued
that attempts to block the market mechanism could unnecessarily extend a
recession or even make it worse. He contended that stock market crash in 1929
was turned into a Great Depression by loose monetary policy designed to prevent
adjustment of inflated prices following the 1926-1929 economic boom.
If loose monetary policy has been one factor leading to the financial crisis
and consequent unemployment, then a genuine approach, based on causes and
effects, should aim at remedying monetary policy. It has long been debated that
central banks cannot control the rate of unemployment, nor the rate of
interest. Attempts by the central bank to control unemployment can degenerate
into perverse effects and large distortions that can only worsen unemployment.
Central banks can only control money and credit aggregates. They have been
exhorted to keep these aggregates in balance to avoid expansion, contraction,
bank failures, and exchange rate instabilities.
It would appear that there has been little attempt to understand the nature of
the current US employment problem, or its causes, and to chart accordingly the
right policies that would re-establish full employment. The Fed has not yet
recognized the limitations of its monetary policy, despite its impact on the US
banking system - the loss in trillions of dollars in capital, the general
bankruptcies and the mountain of toxic assets sitting on bank balance sheets.
Nor has the Fed incorporated the fact that the monetary channel was completely
clogged and unorthodox policies to further inject liquidity into the economy
carried risks. These monetary experiments could have been the trigger for the
worst financial crisis in the post-World War II era and the deteriorating
unemployment picture since August 2007.
The monetary base has doubled during September 2008-September 2009. Most
strikingly, the US banks have been overloaded with excess reserves that rose
from nothing a year ago to US$855 billion in September 2009. There has been no
public analysis of excess reserves, their origins, and their bearing on
unemployment.
Why have banks not been able to place these excess reserves? Or why have
depositors piled up deposits at banks and not used their money on real
investments? If these enormous excess reserves were released into the economy,
they could turn into a bomb of mass-destruction; hyperinflation might be
unavoidable with still more devastating effects on unemployment, and capital
losses from unsafe lending would result in a new generalized round of
bankruptcies.
Similarly, little attention seems to have been paid to the sectoral composition
of unemployment. The hardest hit sector has been construction, followed by
manufacturing, leisure and hospitality. The composition of unemployment would
indicate that unorthodox monetary policy does not help resolve unemployment and
may instead delay it.
There is a significant misalignment of housing prices relative to household
incomes, and an oversupply of residential and commercial real estate. Thousands
of houses have simply been abandoned. Preventing a re-adjustment will
indefinitely delay the resolution of unemployment in this sector. Near-zero
interest rates will encourage builders to maintain high prices and delay the
sales of their housing inventories.
Similarly, demand for leisure cannot expand when more than 36 million people in
the United States live on food stamps and others struggle with high food and
energy prices. Households would certainly reallocate their budgets away from
durable goods and leisure toward pressing vital needs. To the extent monetary
policy has led to very high food and energy prices, its further expansion will
aggravate this inflation, squeeze non-essential spending, and aggravate
unemployment.
Why have the gigantic stimuli and record fiscal deficits not prevented
deterioration of the unemployment picture? It would be unfair to say that US
fiscal deficits have had no growth effects. They have certainly stimulated
growth and employment in countries exporting to the US, including China, and
oil producers.
Contrary to Keynesian assumption of demand deficiency, the US has had excessive
aggregate demand in relation to its national income that has translated into
widening external deficits. Hence, most of the stimulus money has been spent on
imported goods such as oil and other goods, with a much smaller effect on local
production than advertised.
Moreover, fiscal deficits reduce national savings and, therefore, real private
investment. Private investment is a major determinant of employment. The more
fiscal deficits replace private investment, the less employment is created.
Pushing fiscal deficits to a record 13% could turn out to be devastating for
the US economy if real private investment is severely reduced.
Finally, a fallacy underlying proponents of demand policy is that the more you
consume, the higher production will be. It may turn out that demand can be
expanded without limit; production, however, is constrained by time, natural
resources, and other fixed factors. Hence, fiscal deficits will only increase
consumption with possibly negligible effect on production and employment.
The impact of misguided US Fed policies has so far been significant in terms of
financial losses, unemployment, and social pressures. Unemployment represents a
loss of output. Yet, policymakers have become even more determined to chart an
unorthodox monetary policy in order to reverse the severe consequences of
already failed monetary policies. They have not accepted the words "deflation"
or "price adjustment".
To avoid deflation, the central bank should have avoided the inflation that led
to the crisis. The extent of deflation is influenced by the extent of the
preceding inflation and distortions created by loose monetary policy. As during
the Great Depression, policymakers have kept interest rates very low and
charted a course of prolonged cheap monetary policy in order to finance the
fiscal deficits and force economic recovery. This can create a deadlocked
policy stance that perpetuates unemployment.
Loose monetary policy is a powerful form of taxation and causes huge
distortions in the economy, disrupting growth and employment. It has undermined
the banking system and was very favorable for speculation in assets and
commodities. Fiscal deficits at 13% of GDP will crowd out the real private
investment that promotes growth and employment.
With gold crossing the $1,000 per ounce mark, commodity prices on a rising
spree, the US dollar depreciating, and the conventional measure of unemployment
nearing 10%, a possible scenario resulting from the current policy mix could be
inflationary stagnation.
An employment policy has to extricate inflationary pressures, allow for price
adjustment, and stimulate real private investment. This would promote a sound
environment for growth, and reduced risks of speculation and instability.
Employment requires supply-oriented strategies that emphasize competitiveness,
support of private investment and the removal of all distortions.
Unfortunately, experts of the Great Depression appear to be applying some of
the same policies that made it worse by increasing and prolonging unemployment.
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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