What is monetary insanity? It is akin to going down a remote and narrow country lane and expecting a super highway around each and every corner. The US Federal Reserve pursued a highly expansionary monetary policy during 2001-2005, lowering money market rates to 1% with rapid liquidity injection.
While this policy has brought about the worst economic crisis in the post-World War II period, still the Fed continues to pursue the same with the expectation that full employment is just around the corner.
Historically, whenever central banks adopt highly expansionary policies, the inevitable results are debt crises and general bankruptcies. Fed policies have ruined the banking system – they pushed the credit ratio to 350% of GDP, distorted the price structure, fired up housing and commodity price inflation, and increased exchange rate volatility. Housing prices spiked by a multiple of 2 to 4; oil prices rose from US$18/barrel to $147/barrel; gold prices rose from $250/ounce to $1,250/ounce; and in 2010 staple food prices were three to four times their 2002 level.
In the face of such results, the Fed has kept on boasting of its success in achieving price stability, measured by the core price index (that is, excluding energy and food, but including rents, which have fallen as a result of the housing bubble), ignoring millions of foreclosures or the 50 million Americans living on food stamps.
Loose monetary policy has robbed pensioners, reducing their living standards dramatically, with the sad stories of millions of retirees on fixed incomes around the US having no end. This is not all. Fed policies pushed unemployment to more than 10% in 2009, ballooned fiscal deficits to unseen peacetime levels, and brought economic prosperity to a screeching halt.
Continuing with the same policies and expecting a dramatically different result is simple insanity. When will our policymakers and experts admit their mistakes, acknowledge the shortcomings of their econometric models, swallow their pride and chart a new course?
Inflation from John Law to John Maynard Keynes to Ben Bernanke, the present Fed chairman, has been a favored policy for walking away from debt crises.
For Keynes, inflation would help reduce real wages and restore full employment. For Bernanke, the purchase of $1.5 trillion in mortgage securities should prevent house price deflation and maybe push home prices even higher. By supporting bubbles, through setting interest rates at near zero and mounting massive injections of liquidity, Bernanke has inflicted damage to the US economy and increased uncertainty, distortions, speculation, and outlook for inflation in the future.
What the Fed is doing is imposing an invisible tax on holders of dollars. Printing money must not be confused with the creation of real capital; printing vast amounts of money can be akin to counterfeiting and confiscation of real purchasing power from the poor and workers in favor of the government and borrowers.
The Fed’s unorthodox monetary policy has no foundation. There is no economic theory that supports the assertion that interest rates have to be zero for real savings and economic growth to be forthcoming.
Politicians, academics, and the media are supporting inflationism. For politicians, the Fed is magical as it finances unrestricted government spending that cannot be financed by direct taxes. Academicians equate inflation with high employment, via the Phillips curve, and economic prosperity. Since it costs nothing to print money, why deprive the government from large spending programs and why deprive the economy of prosperity and the unemployed of income? It would thus seem difficult to dissuade a central bank away from inflation, even in financial collapse and economic recession as enduring as the recent turmoil.
In spite of the great economic recession and collapse brought about by its very loose monetary policy during 2001-2008, the Fed is now looking for even more inventive ways to continue its policies. But with the credit ratio at 350%, banks can no longer push credit except to borrowers who are already deeply in the red. This would amount to banks simply handing out money that will never be recovered. For this reason, banks have accumulated over $1 trillion in excess reserves. The only innovative solution remaining is money helicoptering.
Over the past decade, the US economy has become addicted to low interest rates, piling more debt
on top of debt, and leveraging. The US government must finance record fiscal deficits; average homeowners have come to rely on it to enjoy subsided housing and equity borrowing to compensate for their stagnant real incomes; consumers need it to overspend above their disposable incomes; speculators need it to reap large speculative gains; and producers need it to run large profits and have access to working capital at negligible cost. This policy has caused widespread financial and economic distortions, with record fiscal and current account deficits that are simply unsustainable.
Three years into the economic and financial crisis, Bernanke continues to say that his unorthodox monetary policy will be maintained until full employment is restored and the economy is on a strong growth path. Forget about Japan’s lost decade; it is inapplicable to the US. There is no economic theory that applies to all countries; instead, economic theory changes from one country to country.
Forget about the financial crisis, he says; it was due to defective regulation. Forget about inflation, since the US economy is suffering from deflation, even though housing, energy and food prices are at multiples of their levels eight years ago.
The Fed is desperate for short-term success, even though its policy is only spreading more chaos and paving the way for an even bigger financial calamity. What the Fed achieved was simply the creation of a short-term credit boom during 2002-2008 that ended with the worst post-war financial and economic crisis.
Why does the Fed continue down the same narrow lane? The reasoning may be simply something like this. If the Fed creates $1 trillion out of thin air, this is exactly as if the Fed had injected an equivalent amount in food products, oil, clothing and so on into the economy and with no incidence on prices. Prices are insensitive to Fed-created liquidity. With such additional capital, the economy can invest and grow, and consumers can enjoy more output.
Unfortunately, one has to live in a fool’s paradise to believe that money creation out of thin air gives rise to an equivalence in real goods. African countries should not remain in abject poverty when the Fed’s economics policies offer a super-highway for accumulating wealth at the stroke of a pen.
Inflationary experiences in Europe, Latin America, and elsewhere have left behind economic despair, rapid impoverishment, and social disorders, if not wars. The Fed’s money creation ex nihilo is a pure redistribution of wealth, a taxation, and could translate in a destruction of real capital as illustrated by the financial crisis.
An alternative to the Fed reasoning could go something like this. Zero-interest rates will promote speculators and speculation; real supply will be dramatically reduced especially for storable commodities since the cost of storage and the cost of working capital become negligible; producers will be enticed to increase prices and reduce quantities; price increases will be validated by abundance of liquidity. Recently, commodity prices such as sugar, coffee, soybeans, wheat, and meat have surged at an annual rate ranging between 15% for meat and 83% for wheat.
With zero-interest rates, speculative prices will be high and price distortions ever growing. At zero-interest rates, savings pay no return, possibly a negative real return, and pensions incomes are reduced significantly. Capital will have to migrate to higher-yield economies. Investments will migrate towards low-productive sectors. The specter of high inflation, or possibly hyperinflation, will keep investors in search of safety.
The Obama administration has failed to break from the previous administration’s failed economic policies. Instead, it has prolonged the economic agony and enhanced the specter of inflation. It has subscribed to unsustainable fiscal and monetary policies in the name of simple Keynesianism. The administration has even claimed that economic progress has been made thanks to its policies. Such policies the world over may bring about a short-lived economic boom, but are invariably followed by bankruptcies, government deficits, and prolonged mass unemployment.
The administration has failed to restore sound fiscal and monetary policies and expunge the huge distortions and the redistribution of wealth that has impoverished so many Americans over the last thirty or so years. The consequences of this administration’s policies may be even more onerous than the legacy of George W Bush-Greenspan-Bernanke era in terms of unemployment, impoverishment of workers and pensioners, and social inequities. It is truly akin to living in a fool’s paradise.
Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.