Page 1 of 2 Will the real Adam Smith stand up
By Hossein Askari and Noureddine Krichene
Will the meetings of the International Monetary Fund (IMF) and Group of 20
finance ministers concluded over the past weekend in Washington restore global
economic and financial balance to a world system that is increasingly in danger
of tipping over? Can politicians preoccupied with their re-elections be
transformed into statesmen and see what is in store if they continue to
represent the interests of lobbyists and their financial masters? Will the
global financial and economic system limp along or can there be a meaningful
turnaround?
Let’s look at how we got here before asking whether there can be any hope that
these powerful finance ministers and their masters can achieve anything
meaningful.
Since 2001, the monetary policy of leading industrial countries
can be simply characterized by the lowest interest rates of the post-World War
II era, with real interest rates that have been at times negative. A main
premise of loose monetary policy has been to stimulate real aggregate demand
through cheap credit. Unmistakenly, cheap monetary policy created abundant
liquidity; credit rose at double-digit rates exceeding 12% per year in leading
industrial countries and led to a worldwide economic boom.
The US Federal Reserve controlled interest rates, with negative real rates over
a long period. However, the Fed had little control over the effects of low
interest rates on the real sector. It did not foresee the dramatic consequences
in terms of a general banking collapse, mountainous government bailouts,
unsustainable fiscal deficits, economic dislocations, and widespread
unemployment at about 10% of the labor force.
Prime markets could not absorb abundant liquidity created by major reserve
currency central banks. It had to be pushed to subprime mortgage markets and
consumers markets, creating very high demand for consumer goods financed by
loans, and equity borrowing that relied on appreciating speculative asset
prices. Hence, a large component of demand and house purchases was financed by
fictitious credit and not by income and savings. At the same time, negative
real interest rates and abundant credit led governments to borrow excessively
and run large fiscal deficits. The US fiscal deficit ballooned, as did those of
countries that are today under the microscope - led by Greece, with others that
could quickly follow in its footsteps, such as Italy, Spain, Portugal and
Ireland.
The Fed's policies set off high speculation in asset markets such as housing
and equities, commodity price inflation that ran at 26% during 2003-2006, and a
free fall of the US dollar. It does not take a genius to predict that a family
with US$30,000 a year would not be able to service a mortgage of an $800,000
house, nor would subprime borrowers be able to service credit for luxury cars
and other expensive and out-of-reach durable goods.
In brief, central banks were able to control interest rates, but they could not
control the economic and financial anarchy that cheap money would in turn
create. This simple principle is always true: a central bank can control
interest rates at near zero bound in nominal terms and make them negative in
real terms only because it can print costless money, but it cannot control the
effects in terms of inflation, speculation, and financial and economic chaos.
With the collapse of the inverted credit pyramid created by the Fed and other
major central banks since 2001, the immediate response of many central banks
was to blindly adopt the same cheap monetary policy that brought about
unavoidable financial chaos: cut dramatically interest rates and inject
unlimited amount of liquidity.
Abundant liquidity could not be easily placed in subprime markets at a time
leading banks were writing off over $1 trillion in subprime loans and were on
the verge of collapse; instead, it found its way into commodity markets,
accelerating commodity price inflation to 67% a year during August 2007-July
2008, setting off high food-price inflation and firing up oil prices to $147
per barrel in July 2008; and it sent the US dollar in a free fall against major
reserve currencies.
At the inception of Fed chairman Ben Bernanke's aggressive response to the
financial crisis, the world economy was growing at its highest post-war rate of
5.5% per year in real terms, the US economy had grown at 3.2% during 2004-2006,
and US unemployment was at 4.6%.
Undeniably, Bernanke wanted to stimulate the US economy. However, his policy
aggravated an ongoing financial chaos and pushed the unemployment rate to 10.1%
in 2009, the US fiscal deficit to 13% of gross domestic product (GDP) during
2008-2010, and the US public debt to close in on the 100% of GDP.
A counterfactual question is the following: would the unemployment rate have
remained at 4.6% had Bernanke not resorted to unorthodox cheap money policy?
Absent Bernanke's powerful monetary disturbances since August 2007, the rate of
unemployment would not have changed much from the 4.6% that has prevailed over
more than a decade in a context of fast world-economic growth. At least it is
highly unlikely that it would have jumped to over 10%.
The excessive fiscal deficits and unorthodox monetary policy, with near-zero
interest rates in most reserve currency countries called for by G-20 in its
summits in 2007-2009, can be classified as demand-oriented, or Keynesian,
economics.
Keynesian theory attributed mass-unemployment to what is called "demand
failure". It calls for the government to create demand, short of Marxism, which
calls for the government to dismantle the private sector. The government has to
step up its spending, hire workers to dig and refill holes, reduce interest
rates, and expand money supply. With the effect of the Keynesian multiplier,
government spending will translate into a multiplication of real GDP, and
full-employment will be restored. If the government keeps up spending, then
full employment will be exceeded, and foreign labor most likely will have to be
brought in. The mysticism of the concept of demand failure for Keynesian
economists cannot be underestimated. Its economic meaning for a layman is not
obvious. It is like attributing a famine to a demand failure when in fact there
is no food being produced!
Believing that the US economy suffered from demand failure during the past
decade, or even recently, is not that credible. With the fiscal deficits under
the George W Bush administration running at over 4% of GDP and the external
current account deficits ranging between 6 and 7% of GDP, it would be
incomprehensible to talk about demand failure.
Along the same lines, under the Barack Obama administration, with fiscal
deficits in excess of 13% of GDP and external current account deficits at 4% of
GDP, the concept of demand failure remains a mystery. The idea of goods piling
up and unsold because of lack of demand is just but a dream. With food prices
at four and five times their levels of eight years ago and oil prices hitting
$147 per barrel, pretending that there is plenty of crude oil, meat, fish,
bananas, and vegetables that cannot be sold and are, therefore, wasted is tough
to accept. A store manager would rather sell bananas or fish at a discount
rather than throwing them away. However, since these commodities are scarce
relative to demand, he adopts high prices to equate supply to demand.
Keynes and his followers, including the current G-20 policymakers, were and are
not interested in the causes of unemployment, attributing it simply to demand
failure. Contrary to Keynes' postulates of demand failure, Irving Fisher (1933)
reviewed 49 causes for an economic recession and determined that economic
recessions, similar to those experienced in the 19th or early 20th century,
could not be explained except by monetary factors, which are over-indebtedness,
bankruptcies, and asset price deflation.
This is because excessive credit expansion cannot be serviced. Banks and
lenders go bankrupt. Volcanoes, bad harvests, civil wars, or other real factors
cannot cause economic recessions since these factors do not alter market
mechanisms and financial balances. Commodity-price inflation was blamed on
China and India. The diagnosis of policymakers never mentions large fiscal
deficits, negative real interest, and aggressive money injections by reserve
currency central banks. Central bankers and policymakers are simply deflecting
all blame.
The fallacies that dominate the thinking of US and European policymakers cannot
remain un-noticed. It is often claimed by Bernanke that the mandate of the US
Fed is to establish full employment. He rarely mentions that the mandate of the
Fed is to establish financial stability and to protect the value of money.
Many countries in Africa are running unemployment rates that exceed 35% of
their labor force. The Bernanke solution is simply to mandate their respective
central banks to eradicate unemployment. However, we know that employment
depends on the number of schools in a country, the number of universities, the
different specialization fields, the vocational centers, and the process of
long-term capital accumulation.
Yes, supply does matter. It is savings and capital accumulation that supports
job creation. In short, a central bank has little meaningful effect on the
labor market. Applying Keynesian economics to solve a 35% unemployment problem
in Mauritania is an absurdity. Blindly applying Keynesian economics to improve
conditions in the US, Europe, and other industrial countries may simply lead to
financial and economic chaos as clearly demonstrated by the current economic
crisis.
Keynesian economics was tried actively during 1965-1980 but it did not end the
long episode of stagflation, with inflation and unemployment rates at the
two-digit level. Many economic models, such as Keynesian and Marxist models,
although theoretically eloquent, turn out to be disappointing in practice. A
recent article in the Wall Street Journal titled "Did FDR End the Depression?"
argued that Keynesian economics could not end the Great Depression with
unemployment exceeding 20% in May 1939 and 12% in Europe compared to 25.1% in
1933. It was only World War II that ended unemployment.
Why did unemployment did not occur after the war? The answer was that war
inflation had dramatically reduced real wages. With nominal wages remaining
unchanged, labor became very cheap and hiring more labor became attractive to
employers. In addition, the US Congress discarded much of FDR's policies and
introduced large cuts that enabled the economy to save, invest, and grow
without suffering the confiscatory tax rates of FDR's administration.
The objective of excessive fiscal deficits and near zero interest rates in the
US and in Europe is to inflate the way out of debt and establish a sustained
economic recovery. The dilemma stated by many prominent economists in the 1930s
and now is that how can the same policies of large fiscal deficits and cheap
money that caused bank and economic collapse lead to full-employment? Bernanke
and many other key policymakers have stated that the US economy has recovered
from the recession, thanks to the very same policies that caused recession, and
that the economy is already on a sustainable growth path thanks to near-zero
interest rates and unprecedented fiscal deficits.
Policies cannot be changed on a daily basis, nor can their results be
instantaneous. The policy of the Barack Obama administration cannot be changed
during President Obama's administration; in other words, large fiscal deficits,
very loose monetary policy, and a speculative environment will continue to
prevail with no significant change from the George W Bush administration.
Similarly, Bernanke's super re-inflationary policies cannot be changed during
his mandate. Nonetheless, countries that were politically forced into large
fiscal deficits and monetary disorders suffered economic stagnation, high
inflation, high unemployment, unbearable taxation, and growing social
inequities.
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