Political courage the missing link
By Hossein Askari and Noureddine Krichene
A meaningful program of economic and financial stabilization for the US should
start with a clear diagnosis of what is ailing the US economy and financial
system.
The US economy suffers from large internal and external imbalances and
inflationary pressures in housing and commodity prices. Internal imbalances are
characterized by large public and private sector deficits. Notwithstanding near
doubling of exports during 2003-2008, external imbalances are witnessed by
record external current deficits ranging between 5-7% of gross domestic product
during 2001-2008. Total net national saving - that is, the saving of
households, businesses, and governments excluding depreciation charges - became
negative in 2008.
In addition to expansionary fiscal policies, these imbalances were
brought about by an overly expansionary monetary policy that kept interest
rates at very low levels, and with real interest rates largely negative.
In turn, very low interest rates have created immense price distortions and
considerable inefficiencies in the economy. More specifically, they have
funneled credit for speculation, they have pushed housing and commodity prices
to exorbitant levels, and depreciated dollar exchange rates. The monetary data
shows that total credit stands at an unprecedented record level of 350% of GDP
in 2008. However, in view of falling asset prices, massive writedowns, capital
injections, and rising default rates, bank lending still decelerated in 2008.
Real economic growth, although robust during 2001-2007, was essentially
underpinned by demand policies and therefore became vulnerable to changes in
domestic demand. As a result of an intensifying credit crunch and strong
commodity price inflation, economic growth decelerated in 2008 and unemployment
started to rise. This is how the US got here.
What has the United States done to combat these developments? The federal
government's response to the financial crisis that broke out in August 2007,
that is the further expansion of fiscal and monetary policies, has only
aggravated the economic and financial difficulties.
Although politically appealing, the government's policy measures have prevented
the crisis from running its course and have instead aimed at re-inflating the
economy with a view to supporting already very high, speculative housing
prices. Sharp cuts in interest rates sent the dollar tumbling, energy and food
prices skyrocketing, in turn adversely affecting real economic growth.
To prevent a decline in housing prices and foreclosures, the US Congress voted
a package of US$300 billion in July 2008 to help homeowners in default with
their mortgages. More recently, Congress voted $700 billion to buy intoxicated
bank debts. Besides their fiscal burden, these measures can trigger an
unprecedented hyperinflation in the US and exacerbate financial and economic
difficulties.
Pursuing the recent monetary and fiscal policies can only exacerbate
macroeconomic imbalances, aggravate inflationary trends and push the economy
deeper into recession. A policy aimed at re-inflating the economy will only
aggravate existing price distortions in the economy, impose a heavy tax burden
on workers and pensioners, and result in an unprecedented wealth redistribution
from creditors to debtors.
By eroding national savings and investment, it will aggravate recession and
unemployment trends. Inflation reduces real wages and real cash balances,
reduces real consumption, and has a self-cumulative depressing effect on real
quantities. The pursuit of a demand-led growth will increase US dependence on
foreign financing, intensifying the credit crisis, and extract a heavy cost in
terms of wealth, incomes and job losses. The government budget will be absorbed
by bailout spending at the expense of growth generating expenditures.
What should be done? In view of the high uncertainties looming ahead, a
stabilization program is critical before the economy goes deeper into
stagflation. It should involve joint actions by main government departments,
state, and local governments. The overriding principles should be to restore
supply-driven growth, lay the basis for sustained balanced growth that reduces
sharp economic fluctuations, and eliminate major price distortions in the
economy.
Besides rehabilitating the financial industry, the program should increase
savings and investment, increasing economic growth and employment, and
eradicate inflationary pressures that have become a major obstacle for the
economy.
A critical element in a stabilization plan should be to free interest rates, as
was done during 1979-1982. Today, banks face their worst crisis since the Great
Depression of 1929-1993. Banks have suffered large writedowns, they are saddled
with non-performing assets, and are in dire need of capital. Forcing very low
interest rates on banks in a high-risk environment and falling incomes will
undermine their share values and expose them to even greater credit and market
risks.
The present low-interest rates regime rewards borrowers at the expense of
lenders. This environment does not allow an allocation of funds to the most
productive sectors. Because of the sharp fall in savings, real resources for
lending have shrunk drastically; hence low interest rates have created a huge
gap between demand for loans and supply of real savings.
Pressure in capital market is conveyed by the London Interbank Offered Rate,
which rose in early October 2008 to 4.5%. There is apparently a liquidity trap;
despite massive liquidity injection by the Fed, banks are not even lending to
each other, let alone lending to sound customers. If interest rates are freed,
banks will be able to resume their lending on sounder basis and will be able to
price risk and strengthen their financial positions. Then the credit mechanism
will operate without interference. This will enable safe borrowers, such as
state governments and municipalities, to borrow from the market.
In line with interest rates in major industrial and emerging countries, higher
interest rates will attract foreign savings and will enable the needed
investment in the real economy. Higher interest rates will encourage households
and private business to be more self-reliant or to rely on equity financing and
reduce excessive recourse to bank lending and leverage.
Higher interest rates would be not popular because they add to the cost of
funding public debt. While this is certainly true, think of the cost of
bailouts and tax rebates that are now absorbing close to 55% of tax revenues.
Monetary policy has to change from exclusively controlling interest rates to
controlling monetary aggregates and the regulatory and supervision framework.
While it is important for the monetary authorities to secure deposits in banks
and in money funds, it should allow for an orderly adjustment of the banking
sector that minimizes the cost for banks of strengthening their balance sheets.
In view of the regulatory gap, monetary authorities have the primary
responsibility of protecting the safety of the financial system by upgrading
the regulatory apparatus.
Expelling inflationary pressure in commodities and housing markets is
important. There is obviously a positive correlation between housing and
commodity prices. Preventing speculative housing prices from adjusting toward
equilibrium has compounded commodity price inflation with adverse effects on
economic growth. Forcing distorted prices on the economy is like strong labor
unions forcing high wages, which ends up in millions of lost jobs.
At present, housing prices are still dominated by a speculative component and
are not affordable except through full borrowing from banks. While the
government did not mind the upward phase, it should not oppose housing prices
returning to normal equilibrium in line with disposable incomes and
construction costs. Proponents of high housing prices refute the price
mechanism and want to replay the credit boom that led to these speculative
prices. Neither banks nor responsible households are ready for another such
party. Forcing distorted housing prices can only prolong the credit and housing
crisis.
A stabilization program should address the energy and food sectors. Special
attention should be given to increasing energy production from all sources of
energy and to food production. The US Department of Energy on one hand and the
US Agriculture Department on the other should elaborate plans and appropriate
fiscal incentives for supporting investment and growth in these two crucial
sectors.
Investment in the rest of industry should be encouraged essentially through
lowering the corporate tax to 20-25% in line with rates prevailing in other
industrial countries and through more funding for research and development.
A stabilization program has to emphasize capital expenditure at the federal,
state, and local governments levels. Restructuring public expenditures toward
infrastructure, education and health can do this. Infrastructure programs can
absorb the slack in the real estate construction sector and ameliorate
employment creation.
On the fiscal side, large deficits can become unsustainable and absorb private
savings. These deficits are now complicated by additional costs of bailouts and
new administrative costs for managing the banking bailout scheme. Nonetheless,
there appears a need to support economic growth so that tax revenues recover,
and to increase the efficiency of public expenditures through cost control and
prioritization of expenditures. Most important, the United States must avoid
full monetization of these deficits; if not, the result will be devastating
inflation.
Finally, we recommend six specific steps to lay a foundation for a financial
turnaround. To get banks to start lending, the federal government cannot simply
rely on the bailout to do the job. The government should establish lines of
credit with banks that have acted responsibly. These lines of credit would be
used with strict federal guidelines to lend to businesses and to individuals.
These would be government funds that the banks would lend.
Once the banks start lending these funds, they will feel more comfortable about
lending their own funds to these same borrowers. Simultaneously, the Federal
Deposit Insurance Corporation could take a temporary equity position in
selected banks to impart more confidence to markets.
Second, to bring stability to money markets, the government should insure all
money market (including municipal) funds. The Treasury retracted this proposed
policy (limiting it to funds deposited prior to September 19) because it saw
the danger of a flight to money market instruments. But if policies are adopted
in combination, this fear will be diminished. Moreover, if a flight toward
money markets occurs, it will lower rates, reducing the attraction of money
market deposits especially with FDIC deposit insurance increased to $250,000.
Third, to bring financial stability to municipalities and states and to halt
the implosion of the US education system, the federal government should start a
two-year lending facility for states and municipalities, at an interest rate
that is reflective of market conditions and credit worthiness of borrowers.
Fourth, to safeguard social conditions and slow the economic implosion,
unemployment benefits should be enhanced and extended beyond the current six
months in a twelve-month cycle (with the difficult possibility of an
extension).
Fifth, given the dire straits of US infrastructure, this is an opportune moment
for the federal government to implement a 10-year infrastructure program. The
program could also address energy independence, public transportation and the
US education system.
Sixth, the US government should demonstrate leadership at the global level. The
United States should urgently convene, with preparation, a global economic
summit that reaches beyond the Group of Eight leading industrialized nations
(the US, Japan, Germany, UK, France, Canada, Italy and Russia) to include
China, India, Brazil, Australia, South Korea and a few others. The focus of the
summit should be the restoration of trust and confidence to financial markets,
simultaneous efforts to enhance and support economic activity by policies
(other than reducing government lending rates) and the commitment to avoid any
and all protection measures.
The present economic and financial crisis is certainly not the work of nature,
nor should it have been unpredictable. While unprecedented in scale in the
post-World War ll period, it is the predictable result of overly expansionary
monetary and fiscal policies and deregulated and disorderly financial industry.
Political courage is needed to implement the most appropriate, perhaps the
least popular, policies.
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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