Page 1 of 2 Central banks need a Basel lll
By Hossein Askari and Noureddine Krichene
Central banks were created to manage liquidity with fiat money, to preserve the
value of their currency and to safeguard the stability of their national
financial system. Their mandate was to control monetary aggregates, reinforce
safety regulations over banks, and promote a stable and predictable monetary
framework. In the 1907 financial panic, as well as in earlier panics,
uncontrolled money creation by banks had led to financial instability and runs
on bank, resulting in extensive unemployment and bankruptcies.
Today, it seems that central banks have learned very little from history. Many
have renounced their fundamental monetary mandate, have become political
instruments, and have adopted a new mandate of managing the economy, promoting
full employment and financing fiscal deficits. As a result, they have all
but abandoned the control of money, credit, and supervision of the banking
system, and have instead decided to control interest rates, which is after all
a form of price control, with attendant inefficiencies and distortions.
Such a role for central banking has created an unstable and unpredictable
monetary framework and caused large swings in money aggregates, exchange rates,
asset prices, inflation rates and real economic activity. Historically, the
setting of interest rates at low levels by the central bank, with a view to
stimulate growth and employment or support government debt financing through
bonds, has caused high inflation and severe financial crisis.
The current financial crisis, which surfaced in August 2007 with the collapse
of the subprime mortgage market, is considered by many to be the most severe
financial crisis since the Great Depression in the industrial world.
Celebrated economists (Joseph Stiglitz) and financiers (George Soros) have
attributed the financial meltdown to the Fed's low interest rate and cheap
money policy. As financial writedowns have kept rising, already exceeding
US$500 billion, and more financial giants and government-sponsored enterprises
(GSEs) have been falling under bailouts, the ongoing crisis has made the
world's most-advanced financial system highly vulnerable and the crisis could
last longer than any previous financial turmoil. The cost in terms of
inflation, rising unemployment, and slower economic growth could be protracted
and excessively painful.
Cause of instability
During 2001-2008, major central banks kept interest rates low and even negative
in real terms. The US federal funds rate was set at 1% during July 2003 to June
2004; the euro interbank rate was kept below 2.5% from May 2003 to December
2005; Japan’s call money rate was near zero, at 0.01%, during April 2001 to
June 2006; and the LIBOR (the London inter-bank offer rate) fell below 1.5%
during November 2002 to April 2004.
Following the outbreak of the financial crisis in August 2007, the federal
funds rate was lowered to (its again current) level of 2% per year. To maintain
interest rates at a low level, the central bank has to inject as much liquidity
as required to prevent a rise of interest rates above the set target. Thus such
a low interest rate target, in turn, leads to an abnormal increase in liquidity
and credit.
Soros (2008) wrote "when money is free, the rational lender will keep on
lending until there is no one else to lend to".
Evidently, low interest rates caused a strong demand-led economic growth during
2003-2007. However, this growth was accompanied by high inflation. Demand for
consumer goods, durable goods, and commodities were stimulated by excessive
credit expansion. Because of food and oil supply constraint (as output could
not be immediately increased), rapidly rising demand sparked the highest food
and energy price inflation of modern times. Inflation has been running high in
a large number of countries since 2003, triggering food riots and protests.
Over the past few years, inflation has dramatically reduced the real purchasing
power of money and real wages; consequently in 2008, it has culminated in
slower growth and rising unemployment in many industrial countries.
As noted by the renowned economist Irving Fisher, excessive credit expansion
invariably fuels speculation. Indeed, speculation was intense in a number of
asset markets, including housing, stocks, and foreign exchange, as well as in a
number of commodity markets, such as oil and copper. To absorb increasing
liquidity and to increase their incomes in the context of low interest rate
margins, banks reverted to securitization through which illiquid assets were
turned into liquid and tradable securities sold to investors. Banks used new
liquidities for expanding their credit and increasing their fees.
As the US Federal Reserve accommodated higher demand for liquidity, speculation
kept intensifying. Low interest rates caused a flight toward commodities and
away from bonds, which led to a speculative boom in commodities and
unprecedented commodity price inflation. Banks were not able to lend their
excessive liquidity to prime borrowers or to place their funds in productive
long-term investments. Instead, they had to relax their lending standards and
push credits to subprime borrowers, essentially in mortgage and consumer
finance.
To use Hyman P Minsky wording, speculative and Ponzi financing became
widespread. Banks became exposed to excessive credit and market risks. As in
any excessive credit expansion, credit risk became certain. When Ponzi units
defaulted, the financial crisis erupted, and financial institutions were
suddenly torpedoed by massive default, loss of capital, and widespread asset
price deflation, which has now spread outside of the mortgage market.
A number of economists, including Irving Fisher, Kenneth Galbraith, Charles
Kindleberger and Milton Friedman, have attributed the Great Depression to
monetary factors. Specifically, it was attributed to the Fed setting interest
rates at low levels in order to help Britain restore the gold standard (at the
pre-1914 parity of gold to the pound sterling). This was translated to massive
liquidity creation during 1926-1929, which, in turn, led to speculative booms
in housing and stock markets, and was accompanied by high economic growth.
The Fed's reluctance to raise interest rates, with a view to protecting
farmers, builders and the rest of the economy, contributed to uncontrolled
credit growth during 1927-1929 and unusual speculation in stock markets that
degenerated into the Great Depression. The ordeal that resulted was
overwhelming in the US and in Europe. Financial dislocation was widespread. All
real income gains achieved for years prior to the Great Depression were wiped
out during the depression. Unemployment became massive, real GDP fell by over
one third and could not recover to its pre-depression level until 1939.
As the recent financial crisis has clearly demonstrated, when monumental loans
are in default, only massive bailouts by central banks can prevent the total
collapse of the banking system. Bailouts are the inevitable offsprings of money
creation out of thin air intended to provide liquidity to banks. While for
central banks bailouts are costless, for the economy they are extremely costly
and have delayed disruptive effects. Massive liquidity injection, since August
2007, and the bail out of banks has, in turn, increased money supply at faster
rate and contributed to sharp exchange rate instability and acceleration of
energy and food price inflation. It has also stalled economic growth.
Bailouts mean that the central bank validates uncontrolled and disorderly money
and credit creation by banks. In view of their high inflation and income (and
wealth) redistributive effects, bailouts impose a huge outright tax burden on
fixed income and working classes. Massive bailouts socialize financial losses
and protect private gains from speculation. They, therefore, lead to
considerable social injustice.
Inflationary and distortive
Eminent monetarists (such as Henry Thornton (1802), Knut Wicksell (1898), and
Friedman (1968, 1972)), while opposing discretionary monetary rules, sharply
criticized interest rate setting and unbacked money creation by central banks.
They considered such actions by central banks as the main factors behind
financial instability and inflationary episodes.
Interest rate setting, while not feasible under the gold standard, as the
central bank would loose its needed gold reserves, is a form of price control
that causes considerable distortions and inefficiencies; it leads to an
excessive and imprudent credit expansion, speculation, and therefore to asset
and commodity price instability. By targeting interest rates, the central bank
has in effect decided to abandon its control of monetary aggregates, ignore
safety rules, and reduce substantially its direct contacts with individual
banks.
For instance, in the United States the role of Federal Reserve District Banks
have been curtailed and liquidity operations have been entrusted to the New
York branch of the Fed.
Thornton, in his classic article, The Paper Credit of Great Britain (1802),
provided the first rigorous and systematic analysis of a two-way relation
between interest rates and inflation. As a precursor to Wicksell, he
distinguished between the market (loan) rate of interest rate and the interest
rate (marginal rate of profit or neutral rate) which equilibrates savings and
investment. He expressed the doctrine that inflation results from a divergence
between the two rates.
Under fiat money, when the central bank pegs the loan rate of interest below
the marginal rate of profit, it sets in motion a cumulative expansion in the
demand for and supply of loans, currency issue, and the price level. Inflation
could continue without limit because, contrary to the gold standard, which
precluded credit expansion that would drain gold reserves, there existed no
automatic corrective mechanism under costless fiat money to bring inflation to
an end. Inflation, in turn, is an indicator that real savings are rapidly
falling, and therefore economic growth is slowing.
Thornton analyzed the reverse causation from inflation to loan
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