The Volcker-Bernanke puzzle
By Hossein Askari and Noureddine Krichene
The United States unemployment rate rose rapidly from 4% in 2007 to over 10% in
2008 and has averaged about 9.7% in 2010, with little expectation that it will
fall below 9.5% this year. The story is much the same in most other industrial
countries; unemployment rates have remained high in the eurozone and in many
other industrial countries, at around 10%.
Such high and persistent unemployment represents a big loss of economic output,
inflicting economic and social pressures on the unemployed, and has ominous
implications for social unrest. Moving from full employment to mass
unemployment could be an indication of economic and financial policy failure.
Most puzzling
has been the perverse effect of large stimuli, record fiscal deficits, and
aggressive monetary policies on employment.
The US Federal Reserve started its aggressive policies in form of sharp
reduction in interest rates and massive monetary injection when unemployment
was at 4%, with the aim of heading off a recession and preserving employment.
The Fed increased its balance sheet from US$0.8 trillion in 2007 to $2.3
trillion and pushed interest rates to near-zero bound; the US fiscal deficits
averaged at an unprecedented level of 13% of gross domestic product (GDP)
during 2008-2010. In the context of unprecedented fiscal and monetary
expansion, unemployment spiraled to 10% in 2008 and has remained close to this
rate thereafter.
The proponents of large fiscal deficits contend that government spending
increases incomes, consumer expenditures, business investment and, in turn,
employment. Advocates of monetary stimulus argue that near-zero interest rates
and massive injection of money will lead to a credit boom, real aggregate
demand will increase, and higher expenditures will in turn increase business
investment and thus employment, and at the time when inflation becomes a threat
the central bank would consider raising interest rates.
The proponents of these failed fiscal and monetary policies still claim
victory, contending that unemployment would have gone from 4% to a level that
would be much higher than 10%, possibly 25% (that is, the rate of unemployment
during the Great Depression), had it not been for the Fed and the Barack Obama
administration's adoption of bailouts and fiscal stimuli.
An alternative position could be: would the unemployment rate have remained at
near 4% had US fiscal and monetary policies remained stable? A stable monetary
policy would have avoided the deep fall in the value of the US dollar and thus
avoided the food and energy crises of 2008, and would have afforded a stable
economic and financial environment for corporate investment decisions.
The US Fed decided to re-inflate the economy and solve the debt crisis through
re-inflation. What was behind the Fed's policy decision? Re-inflation would
enable borrowers to service their debt with a substantial reduction in the real
debt. An anecdote may illustrate the role of inflation in reducing real debt: a
German family bought a farm with a mortgage before the 1922-23 hyperinflation;
later, the same family paid the mortgage off by selling a dozen eggs at the
peak of the hyperinflation! Such could be the effect of re-inflationary policy.
It allows a huge transfer of real wealth in favor of borrowers, while creating
huge price distortions in the economy.
The housing crisis is an example of ill-conceived monetary policy. Not only did
cheap loans lead to skyrocketing housing prices and a housing bubble, but also
even after recognizing the bubble the Fed has done all that it could to prevent
any adjustment of home prices in line with market fundamentals.
The housing market has needed a sizeable market adjustment to bring home prices
back down to equilibrium levels to increase home sales, reduce the large
inventory of homes, and reduce home prices to levels consistent with incomes
and related fundamentals. Instead, the Fed decided to re-inflate home prices
through $1.5 trillion purchase of long-term mortgage securities and reducing
mortgage rates to historically low levels. Such policy will not help solve the
housing crisis and allow construction industry to recover. Instead, it will
perpetuate speculative prices and high property taxes that can only cause an
even bigger housing crisis in the future.
All along the Fed and federal government officials have kept saying that the
economy will recover only when the housing sector recovers. Their prescription
for a recovery of the housing sector is more cheap loans, rising housing prices
and more fuel for a continuing housing bubble. They are just prolonging the
agony.
In like manner, near-zero interest rates allow the government to run largest
deficits financed at low cost. As a result, considerable private savings are,
therefore, diverted for government consumption, instead of being deployed into
private productive investment that would help create employment.
Moreover, the financing of large deficits and building up of debt has afforded
banks a safe income margin by borrowing directly from the US Fed and lending to
government. No banker in his right mind would do anything different. They have
been given the license to make money with no effort. Why would they take risk
and lend to the private sector?
Under ongoing policies, domestic credit in the US has reached its highest level
ever at 350% of GDP, and it has ended with bank failures and trillions of
dollars in bailouts. Trying to push the credit ratio to 500% of GDP would not
be sound policy in view of the prevailing over-indebtedness. Banks are after
all private entities and are not helicopters from which to drop money printed
by the Fed and then beg for bailouts or face liquidation.
US companies are flush with liquidity and face no borrowing constraints for
their working capital. US banks hold over $1 trillion in excess reserves,
compared to zero in 2007. Banks could not push credit in any productive way
expect to dump money on subprime markets, which as we all know have unlimited
use for credit in form of consumer loans and mortgages and accompanied by
monumental risk and attendant losses.
The Fed has been trying to fight any sign of deflation as if deflation has been
caused by deliberate policy, or that deflation was the cause of the recession
or the ongoing financial crisis. Academics and the media who were adamantly
against any form of deflation have advocated the most lax monetary policy and
near-zero interest rates, and even direct purchase of all toxic assets of banks
so banks can again take on more toxic assets.
There is apparently very little understanding of deflation. Could the fall in
oil prices from $147 per barrel to $70 per barrel, by about 50%, be considered
as a terrible deflation compared to $20 per barrel in 2002. Similarly, could
the drop of corn prices from $7.9 per bushel to $3.8 per bushel, or by about
50%, be considered terrible deflation compared to $1.7 per bushel in 2002.
At $70 per barrel, oil producers and oil companies are still happy making
handsome profits; likewise for corn producers. In housing, the adjustment of
house prices from a speculative peak could not be considered deflationary when
home prices are still far above their intrinsic values. A deflation cannot be
defined in terms of the bursting of a speculative bubble. When prices are still
highly profitable and allow normal or above normal profits, they cannot be
considered as deflationary prices.
The Obama administration and the Fed are even today contemplating more stimuli
and more "innovative" easing of monetary policy, respectively, with the aim of
speeding up economic recovery. Fed policies have created massive distortions in
the economy in the past decade through actions on interest rates, exchange
rates, housing, company shares, and commodity prices. The Fed has put in place
a monetary framework that has been propitious to speculation in all financial
and commodity markets, destabilizing the financial system and exposing banks to
the worst financial crisis in the post-World War II period.
The ongoing monetary stance has created unprecedented uncertainties that make
investment decisions risky and difficult. It has set off strong inflationary
expectation, as exemplified by rising pressure on gold prices. Moreover,
rapidly rising debt in excess of nominal GDP and the lapse of Bush tax cut have
created strong fear of crushing taxation over many years to come. All these
uncertainties reduce incentives for investment and consumer's confidence in the
future, discouraging enterprise and employment.
Assuming Fed chairman Ben Bernanke succeeds in reverting the US economy to full
employment and rapid growth, then economic historians will be facing a
difficult puzzle that could be coined the Volcker-Bernanke puzzle. Paul
Volcker, Fed chairman from August 1979 to August 1987, got the US economy out
of 11-12% unemployment by pushing money market rates to 19%. Bernanke pushed
unemployment from 4% to 10% through aggressive monetary policy with near-zero
interest rates, massive monetary injection, and buying all toxic bank loans;
however, Bernanke, if he does succeed by his indicated path, will have pulled
the US out of 10% unemployment by even more monetary stimulation.
Somehow, either extreme, very tight or very loose monetary, could be followed
by policymakers to solve the unemployment problem and propel the economy back to
prosperity. It makes no difference which extreme is adopted!
The Obama administration and the Fed have become entangled in unsustainable
fiscal and monetary policies that have created massive economic distortions, an
unprecedented level of uncertainty and a highly speculative financial
environment. The unsustainability and instability of their approach have been
confirmed by the financial crisis and deep economic recession.
There are more signs of faltering recovery and persistent high unemployment
than signs of confidence and sustained economic recovery. At a time that many
countries have become highly skeptical about the soundness of gigantic fiscal
deficits and loose monetary policy, US policymakers have decided to intensify
the same policies that caused financial and economic chaos in the first place.
Hoping that these policies would finally produce a magical turnaround is at
best a wishful thinking. It will be left to future administrations to reduce
fiscal deficits and restore financial stability.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.
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