The US Federal Reserve has jolted the capital markets.
From the Asia Times; By Hossein Askari and Noureddine Krichene
The US Federal Reserve's decision to buy more and more bonds and other securities, and to inject even more liquidity has jolted the capital markets. It pushed the price of gold to over US$1,300 per ounce on September 24, before settling at a record nominal price of $1,294 and added more instability to currency markets, with the US dollar depreciating relative to the euro, yen, and other major currencies.|
It also fueled tensions between the US and China over exchange rate manipulation, with a confrontation with China on September 24 as the House Ways and Means Committee passed a bill that would allow President Barack Obama to impose sanctions on China if it was determined that China was manipulating its currency (although this will be easily endorsed by the full House, which is set to consider the legislation this week, it is unlikely to be taken up any time soon in the senate).
Economic and financial uncertainty stand at unprecedented levels. In this climate, it will be difficult to predict how far gold will rise, how far the dollar might fall, and how far and how fast competitive devaluations could intensify? Will other major powers accept a deep appreciation of their currencies relative to the dollar, with the implied loss of competitiveness in export markets at a time of economic fragility?
The Fed is promoting speculation and economic conflict. Speculators are overwhelmed with cheap money and abundant liquidity to reap speculative profits. Such an unstable environment could be hardly conducive to investment, renewed hiring and job creation, and thus lasting economic growth. Thus far, only uncertainty, unemployment, economic stagnation and the fear of future inflation have been the end results of Fed policy. The fear of inflation and uncertainty has fueled the flight to safety, to gold. Central banks as well as investors, who have experienced persistent losses in the real value of their financial assets from rapid depreciation of reserve currencies, have little option but to run to gold.
The statement by the rate-setting Federal Open Market Committee (FOMC) statement on September 21, 2010, maintained:
The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in non-residential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months. ...
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. ...
The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.
The clear objective of maintaining such an unprecedented loose monetary policy is to re-establish full employment; and most pointedly, the Fed even reminded market observers of its dual mandate of maintain price stability and full employment. Since it maintains that inflation is nowhere on the horizon, then all that matters is employment.
It would appear that the Fed's simplistic principle is: near-zero interest rates and abundant money printed out-of-thin air will make banks shovel money to consumers and firms; consumers will spend lavishly; firms will invest as cost of capital is near zero making every project undoubtedly profitable; aggregate demand will be boosted, and full-employment quickly established.
The mechanics are simple. Every layman understands them. It is all but a fairytale. Unfortunately, a great puzzle cannot be ignored. Fed chairman Ben Bernanke's dramatic monetary expansion ever since August 2007, in form of sharp reduction in interest rates and unprecedented liquidity injection, disrupted economic growth and sent the unemployment rate from 4 percent down to over 10% in 2009 and 9.6% in 2010; and stocks markets crashed, wiping out trillions of dollars in pensioners' wealth.
The excessive monetary expansion under Bernanke's predecessor, Alan Greenspan, forcing interest rates to 1% during 2003-2005, fired up speculation, housing prices bubbles, and ended in general bankruptcies and trillions of dollars in bailouts. Concomitantly, the US fiscal deficits reached historic peacetime records at 13% of gross domestic product (GDP). The financing of fiscal deficits through more and more money printing points to a government that is bankrupt.
The Fed has pumped about $1.5 trillion in new liquidity. Where does all this money come from? Out of thin air. It is a form of counterfeiting. It is akin to the central bank (the Fed) grabbing real wealth from someone and gifting it to someone else in the same fashion as a counterfeiter takes away real wealth without offering any compensation in return. While the counterfeiting act is the same, the perpetrator is different; in one instance, it is the government, and in the other instance it is a criminal called a counterfeiter, who, if caught, is jailed.
Real growth needs real capital accumulation and real investment. Since a counterfeiter is not creating any real wealth, his counterfeiting cannot induce economic growth even though his real spending is rising. A combination of extremely low interest and massive redistribution of real wealth creates considerable distortions in prices and income distribution.
It would appear that the FOMC decided that economic conditions warrant "counterfeiting and distortions" for an extended period of time. How far into time this period should extend? So far, three years have elapsed without the US being able to pull out of recession. The Japanese lost decade may imply an extended period, exceeding a decade.
Could there be a miracle in our future with money counterfeiting turning out to be the last best strategy for restoring economic growth and financial order? If so, it would mean that any country can print an unlimited quantity of money and achieve economic prosperity. But since printing money has never created real capital, so badly needed for economic growth, printing money can in the end only turn out to be inflationary and destructive for economic growth.
If Bernanke's theory of cheap money cum full employment is valid, it is not obvious why economic recovery has slowed during a period of unprecedented monetary expansion and near-zero interest rates. This policy should at least have helped to maintain recovery and not decelerate it. It is unclear what further quantitative easing could achieve on top of what it has not achieved so far?
Somehow, the Fed has been trapped into a vicious circle of aggressive monetary policy that has precipitated high unemployment and, three years hence, failed to restore sustained and significant economic growth. The Fed's monetary stance is paving the way to more intractable financial conditions, intractable fiscal deficits, rife speculation, and more bankruptcies. The Fed is apparently unable to adopt sound monetary policy.
Bernanke is religiously attached to monetary magic, that money helicoptering is the way to economic growth. John Maynard Keynes coined such magic "turning stone into bread". Bernanke will not admit why his policy backfired in 2007-2008. He has simply denied any link between such unprecedented expansionary monetary policy and the housing price bubble, commodity price bubble, and financial collapse. He has claimed that researchers at the Fed have found substantive evidence of the absence of any link between low interest rates and housing prices. Despite the economic misery of the the last three years, he appears unmoved by gold hitting $1,300 and the dollar falling.
A pragmatic policymaker would drop policies that have repeatedly failed, while an ideologue would remain strongly committed to his ideology for decades. Bernanke and his supporters are earnestly yearning for short-term results in the form of a rebound of the economic activity. How the monumental fiscal deficits and unprecedented liquidities are dealt with is not relevant as in the long-run we are all dead. It is like a patient who suffers from a serious tumor, yet the doctor only gives him opium to relieve the pain and does nothing to cure him.
While the Fed had learned little from its errors, capital markets and banks have become vigilant to the devastating risks of such loose monetary policy. The flight to gold is a clear sign that the Fed is highly unlikely to change course in the foreseeable future and the risk of high inflation or even hyperinflation cannot be discounted. Banks have learned their lesson that excessive liquidity can only be pushed to subprime markets and can never be recovered.
Does un-backed money creation create wealth? The answer is no, but instead it might destroy wealth. Imagine that every worker in the US wakes up in the morning to find a bag full of dollars at his or her doorstep, say $1 million, with a tag saying that this is a gift from uncle Ben to spend and to enjoy. How many workers will show up for work on that happy day with everyone becoming millionaire? Very few if any.
But other results are immediate. Suddenly, output falls dramatically. Since everyone wants to spend and not work, goods have to be imported from China. The result is a fall in output and exports and sharp rise in imports, not forgetting a dramatic depreciation of dollar and a jump in inflation.
Now imagine a different channel of gifting, where corporations instead of workers are given billions of dollars in free cash by uncle Ben. They have no longer any incentive to increase production or sales since they have plenty of cash to distribute to shareholders. They may even reduce production and discharge labor.
Whether cheap money made out-of-thin air is handed over free or in form of loans, the result is the same. It leads to a drop in output and employment. Hard-won money means hard work by workers and by corporations to expand output and employment. In the past, some prominent economists have even gone so far as to argue that un-backed credit could lead to famine and starvation.
As mentioned above, congress, appalled by the United States' large trade imbalances, is preparing to "shoot the messenger" through a punitive bill targeting China. Trade imbalances in any country are created by credit policy, a principle long and widely known, named the monetary approach to balance of payments. The US trade imbalances are the result of the Fed's unrestricted credit policy and fiscal deficits and have little to do with China, Japan, or any other country.
In large part, US fiscal deficits were luckily financed by China; otherwise, inflation would have devastated the US economy. Overly expansionary credit policy pushed US current (external) account deficits to 6-7% of GDP during 2005-2006. The present unorthodox credit policy can only worsen trade imbalances and unemployment, regardless of the bills adopted by the US Congress targeting China.
As to currency manipulation, the Fed has manipulated the dollar through near-zero interest rates and lax credit policy. The manipulation of interest rates is an indirect manipulation of exchange rates. The US dollar at one point depreciated from roughly $0.80 against the euro to $1.60 in April 2008. Today, the Fed is again forcing a depreciation of the dollar relative to the yen, euro, and other currencies. Yet, these trading partners have not even made a peep in protest.
A countervailing bill will not solve trade imbalances and exchange rate instability. It may only hasten more exchange instability as every country in the world would act to protect its export competitiveness, through competitive devaluations. A US bill will not impinge China's export competitiveness as a country may establish, as currently is the case of Japan, competitiveness through more innovation, reduction of labor cost, and price discounts.
So far, US policymakers have been unwilling to admit that monetary policy is not a panacea for all that plagues the economy. The administration has lost two years without bringing about its promised change. The return to Harvard University of a staunch Keynesian, Larry Summers, who has indicated his intention to leave his post as White House economic adviser, may indicate a loss of faith in Keynesianism, as in many European countries that have opted for austerity.
The November elections are close. A clear message about the administration's economic performance will be sent. There is a real risk that the Obama administration will not be able to change course, restrain monetary and fiscal policy, and address the real problems facing the US economy.
Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.