Knee-Jerk Bailout Policy as Financial Cure-All? Here’s a Moderate Alternative.

Would the following moderate but sensible approach, offered as an alternative to Federal policy actually work to slowly restore the US economy, as we have known it, back to health?

Even a smart approach to US economic management is unlikely to succeed because it is blind to peak oil/energy constraints. An imbalance between inflexible oil supply and an inflexible but increasing demand for same is a sure prescription for cost-push inflation in the food and energy sector, which simultaneously tends to depress other consumer spending, even if no new money is added to the system. Oil shortages thus naturally tend to lead to stagflation. For the moment oil prices have crashed, but as world oil demand recovers while oil supply contracts, we are soon back to an even worse oil cost crisis.

But at least the following economic essay is an intelligent alternative to the current economic crisis response under Paulson and Bernanke. The point being made by the “Stalinist” reference is that the feds are as rude and crude as Stalin in applying a knee-jerk bailout policy as a financial cure-all.

Federal policy had initially involved bailouts of those stuck with vast derivatives obligations, via buying their bad paper debts. But now a banking or liquidity panic has spread internationally. The dynamics of fear cannot be measured in the numbers of dollars that Bernanke needs to add to the system to cause the fear to subside. If Bernanke’s helicopters start dumping cash on a large scale, it is as likely as not to reduce public confidence in the soundness of the system.

This injection of credit and cash and liquidity is bound to contribute to the other variety of inflation: demand-pull inflation. Bailouts that make good on bad paper, on the required scale, will put vast amounts of new dollars into circulation. These bailout dollars soon diffuse everywhere, causing a more generalized type of inflation.

With these two kinds of inflation are added together, naturally they tend to make the value of the dollar fall in value relative to other currencies. So OPEC will tend to raise the price of oil, which will further depress the US economy because of acute US addiction. That impact will require further bailouts, etc.

While the following prescription does fall well short of the nationalization of US banks and the treasury under public control, it offers a picture of what might be done by a government considerably wiser in its attempts to save the existing system than any that we are likely to have in the near future:

“…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…”

Monetary Stalinism in Washington
By Hossein Askari and Noureddine Krichene / October 11, 2008

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.

Source / Asia Times

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