Central bankers stuck in a hole
By Hossein Askari and Noureddine Krichene
On August 21 during their annual retreat in Jackson Hole, Wyoming, central
bankers were exuberant about their success in warding off another Great
Depression, rescuing financial institutions and paving the way for global
economic recovery.
They reiterated their determination to maintain cheap monetary policy
indefinitely and dismissed any risk of inflation arising from near-zero
interest rates as economies have spare capacities. In his address to the
symposium, US Federal Reserve chairman Ben Bernanke highlighted two lessons
from the recent financial crisis: "One very clear lesson of the past year - no
surprise, of course, to any student of economic history, but worth noting
nonetheless - is that a full-blown financial crisis can exact an enormous toll
in both human and economic terms. A second
lesson - once again, familiar to economic historians - is that financial
disruptions do not respect borders. The crisis has been global, with no major
country having been immune."
The Jackson Hole retreat truly kept central bankers in the hole as they savored
the success of their sauvetage of failing banks and boasting full
confidence about economic recovery. They drew two lessons: a full-blown
financial crisis can exact an enormous toll in both human and economic terms,
and that financial disruptions do not respect borders.
Yet they did not acknowledge any responsibility for causing the financial
crisis, considering that this crisis is, in part, attributable to overly loose
monetary policy; nor did they realize the dangers besetting their unorthodox
policies. The same causes always bring about the same effects; and those who
persist in ignoring the past are irrevocably doomed to live the same sequence
of events again.
Their pronouncement is akin to a drunken driver saying that the lesson from
being drunk is that one gets a hangover and says and does things that hurt
others - conveniently forgetting that it is excessive alcohol that led him to
his drunken state and the next time he could kill himself as well as others.
By ignoring any responsibility in causing the crisis, central bankers are only
paving the way for an even more severe crisis. Somehow, reserve central bankers
failed to draw the right lesson: namely their cheap money policy can become
devastating for the banking system, highly inflationary, recessionary, fuel
speculation and exact an enormous toll in both human and economic terms; and
because most reserve banks were indulging in the same monetary policy, the
crisis had no borders.
Central bankers have long changed their mission from managing credit and money
supply in the economy to managing economic activity, with the sacrosanct
objective of achieving full employment. Hence, the stability and the soundness
of the financial system were no longer a central objective for central banks.
With politicians pressuring central bankers for full employment, central
bankers behave as if full employment is their primary mandate. With current
unemployment rates standing at about 10% in leading industrial countries,
central banks can hardly claim success in achieving their full-employment
objective. Reserve central banks have ventured to control economic activity, as
it costs nothing to print up money, and run ever-increasing external
current-account deficits without facing any need for economic adjustment. Their
monetary expansion has in turn resulted in wide trade cycles, turned
inflationary, and penalized wage earners and fixed-income consumers with lower
real incomes because of inflation.
In their quest to control real economic activity, central banks have decided to
manage interest rates and prevent price adjustment under the doctrine of
fighting deflation. In setting interest rates, they have effectively set the
price of capital and have thus distorted price structures and exchange rates.
When the Fed forced interest rates to 1% during 2003-2005, its objective was to
push as much debt as possible to achieve full employment. At such low interest
rates, credit boomed at 12% a year and was ratcheted up to 350% of gross
domestic product (GDP) in 2008, with much of it destined to subprime borrowers.
It should have been no surprise that such credit expansion would fuel unsafe
lending and adversely affect the financial system and the economy.
In their drive to achieve full employment, central bankers paid little
attention to the intensifying speculation and skyrocketing food and energy
prices that were rapidly developing. During 2003-2006, central banks showed
little concern about intensifying housing speculation and inflating prices. The
Fed failed to restrain money policy or to exert its regulatory role as
underwriting standards were being completely discarded.
The housing bubble burned itself out, inflicted losses and millions of
foreclosures. In the same vein, following the financial crisis breakout in
August 2007, central banks went on to inject liquidity and reduced interest
rates to historically low levels with the very specific goal of re-inflating
housing prices and staving off an economic recession. The Fed kept on ignoring
commodity price inflation, by denying any link between this inflation and
monetary policy.
Food prices skyrocketed. Oil prices rose to US$147 per barrel. Economic
activity became frozen. Sectors that relied on oil, such as agriculture,
transport, shipping and airlines, were disrupted. Consumers cut their driving,
shopping and their food spending.
Central banks were guided only by what is called core inflation and disregarded
food and energy inflation until such inflation had dealt a lethal blow to the
world economy. In adversely affecting the financial system and pushing the
economy into deep recession, central banks have caused huge fiscal deficits and
rising public debt, with the US budget deficit rising to 13% of GDP from 3%.
At present, with zero and near-zero interest rates, central bankers do not
appear to be that concerned with the safety of the banking system. Central
bankers, as well as politicians, are urging banks to extend loans, irrespective
of risk, with the purpose of stimulating aggregate demand and employment.
Realizing that banks have become reluctant to lend unconditionally and throw
money into the trash can, central banks have decided to circumvent the banking
system and lend directly to the subprime markets, thus they are directly
responsible for the eventual losses that will surely follow - while coining
their activity as "creative".
In his Jackson Hole address, the Fed chairman noted, "History is full of
examples in which the policy responses to financial crises have been slow and
inadequate, often resulting ultimately in greater economic damage and increased
fiscal costs. In this episode, by contrast, policymakers in the United States
and around the globe responded with speed and force to arrest a rapidly
deteriorating and dangerous situation."
Certainly, the speed and force of Bernanke's aggressive response ever since he
joined the Fed in 2002 cannot be denied. What is to be contested, however, is
that such speed and force may have caused the trillions of dollars in bailouts
and pushed unemployment to 9.4% in July 2009. It is worth asking how much
bigger the damage would have been had Bernanke been slower in his response?
Bernanke implied that his response was adequate, whereas history was full of
inadequate responses. How adequate was his response? Certainly, he bailed out
banks and secured continued large bonuses for their managers. However, the
burden was forced onto taxpayers and ordinary workers. The fiscal "hole" that
his monetary policy had caused is a hole that the US may find difficult to
exit.
It is too soon to talk about an adequate response to the crisis. The arithmetic
could certainly turn out to be unpleasant. Financing the deficit through
dramatic tax increases or through runaway inflation would play havoc with real
economic growth and create more disorders. Only time will tell who deserves a
medal. Success or failure must be assessed over a longer period than one or two
years. More completely, it will take time to assess the real cost of Fed policy
since 2001 - its cost in terms of lost economic output, bailouts and stimuli
versus a policy of stable money growth.
At the same time, in an interconnected world, the monetary policies of reserve
central banks are effectively fueling competitive currency devaluations. Zero
and near-zero interest rates have been favorable for speculation in asset,
commodity, and exchange markets. The direct statistical association between low
interest rates, falling GDP, rising fiscal deficits and public debt, and rising
unemployment could be baffling for central bankers who believe that low
interest rates always secure full employment. By announcing in Jackson Hole
that zero and near zero interest rates would be maintained indefinitely,
central bankers believe that eventually low interest rates will lead to full
employment. They are oblivious to all the perverse effects of zero-interest
rates.
To keep interest rates near zero, central banks keep pumping money into the
economy. US banks have never piled up as much excess reserves in their history
as they have since September 2008. Their excess reserves were less than $2
billion, but stood at $708 billion in August 2009, indicating that banks had no
safe and productive outlets for this money. If banks release these massive
reserves into lending, inflation will skyrocket, with another round of bank
failure unavoidable.
Faced with such an eventuality, the Fed chairman has indicated the Fed could
pay higher and higher interest rates to banks to encourage them to keep their
funds with the Fed. Who would pay for this? You guessed it, the taxpayer would
pay to increase bank profits and fuel their bonuses yet again! Zero interest
rates carry other potential problems. They could become highly distortive by
maintaining high bond prices and discouraging savings.
An assessment of the causes of the crisis would include the fundamental role of
reserve central banks in causing financial chaos and dislocating the economy.
In hindsight, if the Fed had not forced an ultra-cheap monetary policy for
nearly all of the present decade, the financial crisis might have never taken
place and the US economy might have kept its balanced growth path of the 1980s
and 1990s without incurring massive bailout costs and high unemployment.
Similarly, if chairman Bernanke had not tried to over-inflate the economy after
August 2007, the recession might not have taken place or might have been
milder.
A number of prominent economists have called for a restricted role for central
banks under legislated rules that regulate money and credit. They have
expressed deep skepticism about the power of a central bank in achieving full
employment. They considered that central bankers can only control money
aggregates and called for a fixed rule for money and credit.
Central banks should not have the absolute discretionary power they now do, and
they should not minimize the importance of supervising and regulating the
financial system. A stable money framework would reduce uncertainties and
promote growth and employment. In retrospect, it is clear that the Jackson Hole
meeting would never accept traditional central banking that aims at solely
controlling money and credit.
As things stand, leading reserve countries will be saddled with cheap monetary
policy, near-zero interest rates, record fiscal deficits and recurrent
bankruptcies for many years to come. There is also the danger that such a
policy mix could turn highly inflationary, eroding real incomes and standards
of living, and create an unstable international environment that will not be
conducive to trade and growth.
In the end, it would appear that central bankers found their "hole" in Jackson
Hole either too comfortable or too painful to leave and are likely to remain
there - in attitude if not in person - for the foreseeable future.
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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