Monetary Stalinism in Washington
By Hossein Askari and Noureddine Krichene
Amongst the worst tragedies of Soviet collectivization was the Ukraine famine
of 1932-33, which took six million lives as Joseph Stalin practiced forced
appropriation of crops and imposed very low prices for agricultural products in
favor of industrialization. Interference with the pricing mechanism and
Stalinism in the form of very low prices for agricultural products also caused
famines in India in 1965 and in China in 1969, with a human death toll well
into the millions.
Monetary policy as practiced by the US Federal Reserve for the past decade is
but a form of financial Stalinism, forcing ridiculously low or negative real
interest rates, with catastrophic results that are now plaguing the world. Fed
policy has disabled the price mechanism in capital markets and set off
uncontrolled credit expansion at the expense of capital productivity and
creditworthiness, pushing housing, food, and energy prices to prohibitive
levels, and triggering food and energy riots in vulnerable countries. It has
undermined the dollar and made the US highly dependent on foreign financing.
The dramatic consequences of Fed policy are unfolding before our very eyes. The
financial crisis that broke out in August 2007 has recently taken a turn for
the worse. After claiming international and well-established banks and
investment banks, it has now reduced the financial savings of ordinary
Americans (in retirement accounts) by over 30%.
The fiscal bill for past, ongoing and future bailouts by Fed chairman Ben
Bernanke and Treasury Secretary Henry Paulson will be staggering; the US fiscal
deficit will be blown up to unthinkable proportions, public debt will be pushed
to unprecedented levels, and most public resources will be destined to absorb
financial losses at the expense of social and economic programs.
Last, but not least, the long-term inflationary consequences may turn out to be
even more dramatic. All these consequences are real and were in part
predictable.
So far Bernanke and Paulson have failed miserably in stemming the financial
crisis and have brought the US economy to a standstill, in part because
Bernanke does not have a feel for the free-market mechanism and in part because
he is not a prudent central banker.
It would appear that Bernanke has read a great deal about the Great Depression
of 1929-1933 and perhaps very little, or nothing, about the German
hyperinflation of 1920-1923. His view is that the Fed was liquidationist of
banking institutions during 1929-33. In his view, if the Fed had injected
sufficient liquidity during 1929-1932, it would have precluded thousands of
bank failures. Therefore, Bernanke is determined not to let that mistake happen
again. Consequently, his response to the financial crisis has been a blind and
aggressive monetary policy in form of negative interest rates, massive
liquidity injection, and massive bailouts.
Bernanke is like the medical doctor who is familiar with one drug, and who
prescribes it to every patient he sees at full dose without diagnosis of what
ails the patient or thinking what will happen if he takes the wrong medication.
Thinking that the US economy was in a deep recession in 2007, one similar to
the Great Depression, he precipitously unleashed monetary policy. His rushed
actions have destabilized the financial system, sent commodity prices
skyrocketing, and crippled economic growth. The US economy in 2007 had no
resemblance to either the institutional setting of the Great Depression or to
the immense role and expansionary stance of fiscal policy. Namely, today, there
are institutions that can prevent bank runs, such as the Federal Deposit
Insurance Corporation, and the federal and state governments (both relatively
far bigger than 1929) are running large deficits that should preclude a deep
recession, especially if they adopt appropriate policies.
Hence, his inflationary approach was ill-designed and will be very costly in
bank failures, high inflation and rising unemployment.
The Fed chairman is by far the most important personality on the US economic
and financial landscape. In fact, both Wall Street and Main Street read his
statements more carefully than reading the words of a president or the laws of
the land. His words and actions are the most influential in the financial and
economic world. Being in large part an independent institution, the Fed,
largely under Bernanke's predecessor Alan Greenspan, grasped absolute power
over economic policymaking and decided to abandon its regulatory power,
enabling the development of financial anarchy under the guise of financial
engineering and innovations.
Such myopic faith in the free market has turned the US financial markets into a
casino. The US president has negligible influence on economic policymaking and
has become merely a symbolic figure. By subscribing fully to Bernanke and
Paulson policies, the two presidential contenders have renounced their future
economic role. The US Congress has become a rubber stamp of Fed policies. It
applauded Greenspan�s policies and it now supports Bernanke-Paulson
knee-jerk and costly bailouts. The US public is not so much interested in the
presidential debates as in how Bernanke and Paulson policies will affect their
jobs, retirement savings, tax liabilities and the very livelihoods of their
children.
Wrong course will continue Once the Fed follows a policy path, it hardly changes course, which means
the Fed will perpetuate its cheap monetary policy indefinitely. After
institutionalizing negative real interest, the Fed wants to institutionalize
high housing prices and rents, and a depreciated dollar. While US banks are in
the process of strengthening their balance sheets and opting for safe banking,
the Fed is forcing them to extend credit regardless of risk and profitability,
and to finance with short time resources long-term loans.
Recent desperate actions by the Fed consist of bypassing the banking system and
extending directly low-cost loans to borrowers regardless of risk and
nationalizing the banking system. The Fed sees no limit for issuing trillions
of dollars by electronically crediting borrowers.
The Fed has arguably created the most uncertain and unstable economic
environment in US history. No one would have predicted that the value of shares
would tumble by nearly 5,000 points, or approaching a decline of 40%, in the
past three months. There is no basis for making sound financial or economic
forecasts. No rational entrepreneur can undertake investment plans under such
uncertainties. Foreign investors are scared of inflation and a depreciating
dollar and are rushing to gold and safer currencies. It is at best a wait and
see attitude.
Central bankers are this week convening for their semi-annual meeting in
Washington DC, only to find that the world is no better than it was six months
ago. Certainly, they will not surrender their excessive powers and most likely
will not accept blame for their imprudent monetary policies that have led to
the worst financial crisis in the post-war period.
Interest rate setting by central banks has long been repudiated by monetary
economists; it creates distortion between the market and natural interest
rates, and triggers a self-cumulative inflationary process. As a form of price
control, it creates considerable inefficiencies and misallocation of resources
into non-productive uses. With a view to unlocking credit markets, it is an
utmost priority both in the US and Europe to free interest rates. Such a step
will enable banks to mitigate credit risk, improve their earnings, and for
productive borrowers to have access to borrowing. It will dispel inflation fear
and pave the way for financial consolidation and recovery. If they reject this
step, central banks will only aggravate the current crisis.
Central banks' misguided role
The role of central banks has never been to regulate the economy or promote
full employment. It is a simple truth that an economy needs safe money, which
serves as a medium of exchange and store of value. The central banks should be
principally in charge of managing liquidity and regulating the banking system.
These are the most important functions of a central bank. If properly done,
they will contribute to a stable macroeconomic framework conducive to economic
growth and employment. Given their total neglect of bank regulation in the past
two decades, central banks have a long way to go in updating the regulatory
framework, streamline financial products, and mitigating sources of risks and
speculation.
Regulating the level of economic activity and counteracting recession should
fall under fiscal policies. The government has better means, agencies and
fiscal instruments to fight economic recession than central bank monetary
policy. The recent world crisis has shown that governments have to address
shortages in food, energy, infrastructure, and social programs. Each government
can draw a comprehensive stabilization program with properly designed fiscal
and sectoral policies without compromising monetary stability.
A 10-year spending program on infrastructure, including education and
alternative energy development, would be appropriate today, especially in the
United States. At the same time, federal credit should be urgently extended to
state and local governments until financial order is restored. However,
excessive reliance on credit or ex-nihilo money creation is wrong and
hazardous.
Central banks should not interfere with the price mechanism; in this respect,
institutionalizing long-term housing price controls would be detrimental to the
economy. Central banks have to put in place monetary programming consisting of
safe limits on credit and money aggregates. Monetary economists never claim
that fixed rules for credit and money supply are free of instability. However,
if instability were to occur, it can be addressed by fine-tuning.
The US economic ship could capsize in the coming days and weeks. There is
urgency for action before chaos spreads farther a field. The same central banks
that have announced a coordinated rate cut should admit that this measure is
not the proper solution. It will be damaging to financial institutions and will
exacerbate world inflation and economic recession.
Instead, they should announce a coordinated decision for freeing up interest
rates. They have to allow banks to undertake orderly and long-term
recapitalization, relying in the first instance on shareholders or other
private holders of capital and only on a case-by-case basis on federal
injections of capital with preferred share ownership for the public. And they
must adopt urgent regulatory reform, accompanied by strict supervision and
enforcement.
Finally, Bernanke and Paulson must jettison their policy of one bailout at a
time. with the intention of addressing other issues later, and adopt a
comprehensive plan to address all issues now, including support for state and
local governments.
Unfortunately, it would appear that the notion that monetary policy is the
panacea for addressing all economic problems has gained total currency among
central bankers and politicians.
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.
(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
