Page 2 of 2 Inflationary musketeers
By Hossein Askari and Noureddine Krichene
The central bank has to keep injecting liquidity into the economy at an
unlimited rate to maintain the rate at zero. This makes real interest rates
largely negative. At zero interest rates, banks see no need to lend as their
income would be low while their risk from inflation and default loss would be
very high. As an indication and by-product of this policy, excess reserves at
US banks have increased from less than $1 billion prior to September 2008 to
$900 billion in May 2009.
Zero interest rates deplete savings and therefore the basis for economic
growth. The borrowing at zero interest rates would be mainly by consumers. The
recent trillions of dollars of money injection by leading central banks was
entirely destined for consumers and mortgage borrowers and will sharply erode
real
savings and growth. Consumer loans will be simply lost, as the recent financial
crisis has demonstrated. Who will pay in real term for the loss? The answer is
provided by the recent crisis: poor countries (by an inflation tax), China,
sovereign wealth funds, bankrupt banks, pensioners, workers, homeless people,
and taxpayers.
Zero and low interest rates unleash speculation, as speculators are interested
in short-term gains from price changes while their cost of carry is negligible.
Zero interest rates cannot encourage productive investment that relies on real
savings. Since the latter is depleted, there is smaller amount of real capital
for investment. The supply price of capital becomes extremely high as shown by
the excessive rise of commodity prices and reduced profits.
Even if productive investors can borrow at zero or negative real interest
rates, the quantity of real savings is very small for generating growth. Zero
and low interest rates cannot encourage supply. Suppliers are profit
maximizers. They can maximize profits by raising prices and withholding
supplies, since the cost of inventories is very low and short-term borrowing
for working capital is abundant and at negligible cost. By reducing real
quantities, commodity suppliers push prices to higher levels.
Hence, zero interest rates are pure distortions engineered by central banks,
and they erode the basis for growth, intensify speculation, curtail investment,
supply, and are damaging to the economy. Not surprisingly, zero interest rates
were associated with the protracted stagnation in Japan during 1990-2003.
Reserve central bankers believe their respective economies suffer from
deficient demand, irrespective of their sizeable external deficits and recent
fall in oil inventories. They have all along dismissed inflation that is
inherent to cheap money policy and have totally ignored record two-digit
commodity inflation during 2002-2008. Then they justify their recent monetary
expansion by the absence of inflation.
Yet, food prices are on average three to four times their levels four years
ago. The result has been a multiplication of charity food banks in the US and a
dramatic increase in the number of people seeking food handouts. Needy people
complain that food prices at supermarkets have become unaffordable. This is a
clear indication of food insufficiency and that more monetary injection will
only fuel food price inflation further and again weigh on economic growth.
Central banks have also intervened in the housing market by injecting $1.3
trillion in mortgage loans. Federal Reserve chairman Ben Bernanke has distorted
mortgage interest rates, ignored all underwriting standards, and extended
government guarantees to these loans. Besides the pure inflation-tax effect,
his action has prevented the needed correction in housing market, revived
speculation, and prepared another cycle of default and government bailout of
homeowners. There is no point in enhancing regulation and supervision of
financial institutions when major central banks spread financial disorder,
print money, and push trillions of dollars in loans to subprime borrowers.
Prominent figures, such as Joseph Stiglitz and George Soros, have attributed
the current financial crisis to cheap monetary policy by leading reserve banks
and to the legacy of Bernanke's predecessor as Fed chairman, Alan Greenspan.
These major reserve banks have been myopic and appear determined to destroy the
value of money. They are encouraged by democratic states in the context of the
G-20 summits to destroy the economic foundation for growth and the banking
system. Their massive liquidity injection since August 2007 and successive
interest rate cuts have devastated the world economy and have caused a fall in
real output and employment. They perceive the recent speculative flare up in
asset and commodity prices as a sign of recovery. Yet their reckless money
injections have again brought oil and food prices under renewed pressure. Real
economic growth will soon be constrained by fuel and food supplies. Namely,
crude oil cannot be pushed beyond 85 million barrels per day and will again
weigh on growth as it did in 2008.
Does an economy need an unorthodox central bank and cheap money for economic
recovery? If you are not Ben Bernanke or Mervyn King, his counterpart at the
Bank of England, or Jean-Claude Trichet, who heads the European Central Bank,
the answer is "no". A lasting and stable recovery requires a safe and orthodox
central bank that does not push interest rates to zero or negative in real
terms and engages in uncontrolled money injection in favor of speculators and
consumers.
An unorthodox central bank can only fuel inflation and derail long-term
economic growth. The social consequences are disastrous. Experiences of
unorthodox central banking in the past are numerous and their economic fallouts
were enduring.
Is there an exit from unorthodox central banking? Unorthodox central bankers,
including Bernanke, claim that they can exit from their unorthodox policies of
zero interest rates and mountains of liquidity. Put simply, can the US Fed
reduce its credit from $3 trillion to $0.7 trillion? Such a dramatic
contraction has never happened in the history of any central bank. It means an
explosion of interest rates and deep deflation.
Unorthodox monetary policies have ended in economic decline, falling real
wages, social disorder, and an exit of the currency itself. The experience of
Germany in 1920-23, of France in the 1950s, of Latin America during 1950 to
'85, of the former Zaire in 1970 to 1995, and of Zimbabwe most recently show
that inflated currencies are eventually replaced by a new currency with
formidable loss inflicted on the holders of the inflated currency.
Inflationists and their proponents dominate leading central banks.
Inflationists consider savings as an evil and believe in debasing money as a
way to keep aggregate demand in excess of available supplies. The cost of
inflation does not exist for them, neither do its redistribution effects. They
are after short-term gains in growth and employment at the expense of long-term
growth and financial stability.
Thanks to the reckless trio of Bernanke, King and Trichet, the world economy is
bound for its worst inflationary episode in memory, one that will surpass the
world inflation of the 1970s. As their money injection is fake money, the
recovery will be a fake also. The ongoing crisis clearly shows that the world
economy needs reform of the international financial system to shield it from
unruly reserve central banks, instability and heavy taxation.
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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